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Series 7 Whisperer
Series 79 Function 1.2 part 2 Essential Financial Ratios and Valuation Metrics for Corporate Transactions
00:57:24
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- [00:01]
A
Hey, this is Ken Finnan, also known as a Series 7 whisperer. And my job is to get you passed the SIE exam, the Series 7 exam, Series 65, all the FINRA and NASA exams. So going forward, I'm going to be going a mix of like short little videos, long ones, maybe some podcasts about like interviewing some people who took the tests. But a lot of these are going to be where I use a external source to create a script and then I have somebody else read it because I stumble and mutter a lot and, and I think these are working really well. So let's get into it and we're going to have some fun here. And before we get into it, let's talk about one thing I do live Q and as every Tuesday night for the FINRA exams and every Thursday night for the NASA exams, 8pm Eastern on YouTube. Come have fun, ask questions about whatever you want, celebrate the wins, commiserate with the losses. But meet me every Tuesday night for FINRA stuff, every Thursday night for NASA stuff. Live on the tube of you and we can get this done, baby. Let's go.
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B
Imagine a company that's just, you know, making absolute record breaking profits.
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C
Right. The kind of company everyone wants a piece of.
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B
Exactly. I mean, their stock is trading at an all time high, the CEO is practically living on the COVID of every financial magazine and customers are, well, they're lining up around the block to buy whatever they're selling.
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C
Sounds like a dream scenario.
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B
It does. But then by Friday afternoon, that exact same company quietly files for chapter 11 bankruptcy.
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C
Yeah, that's the nightmare.
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A
Right.
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B
And you have to wonder, how does that even happen? How does a company drown in a sea of profit?
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C
Well, it happens. Because on Wall street, profit is really just an opinion. But cash. Cash is a fact.
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B
Cash is a fact. I love that. And welcome everyone to today's Deep Dive. We are incredibly excited you're joining us for this one.
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C
Yeah, it's going to be a fact. Fascinating discussion.
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B
It really is. Today we're taking on a very specific mission for you. We are going to decode the actual language of high stakes finance.
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C
The real Wall street vocabulary.
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B
Exactly. We've got a dense, comprehensive stack of sources in front of us today, which is essentially the master list of financial ratios and valuation metrics.
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C
The exact tools used by top tier professionals.
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B
Yeah, we're talking about the metrics used for massive equity transactions, debt restructuring, mergers and acquisitions, and, you know, just general corporate advisory services.
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C
And honestly, it's a toolkit that is absolutely essential to understand. I mean, Whether you're just trying to manage your own investment portfolio with a bit more sophistication, or you're one of
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B
those professionals currently grinding through those brutal late night study sessions.
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C
Right, Exactly. Like the folks studying for the Series 79 exam.
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B
Oh yeah, the Series 79. That's the license you basically need to become a registered investment banker, right?
- [02:44]
C
Yeah, it is. And it's notoriously brutal. Exactly. Because it tests your ability to practically apply this massive Alphabet soup of Wall street jargon.
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B
The Alphabet soup. I mean, we're talking ebitda, wcc, kgr, lifo, fifo, dcf. It just, it sounds like a completely foreign language.
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C
It really does to most people.
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B
But I promise you, by the end of this deep dive, you won't just know what these acronyms stand for. You're going to understand exactly how they dictate the fate of, of multi billion dollar companies.
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C
Absolutely. We're going to give you a really clear, understandable toolkit today.
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B
Right. And we'll structure it around three simple steps to analyze a company balance sheet today. And then we'll culminate in the really complex art of valuation.
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A
Yeah.
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C
We'll be building a logical framework because you know, you can't value a company if you don't know how its profit engine works.
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B
That makes total sense.
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C
And you can't trust that profit engine if you don't understand its risk. And, and it's debt.
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B
Right. And you don't even need to look at the debt if the company doesn't have the cash to survive until next Tuesday.
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C
Exactly. Survival comes first.
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B
Okay, so let's unpack this. We're going to run a full diagnostic on corporate finance.
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C
Let's do it.
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B
Step one of our framework is the pulse check, which is liquidity. Step two is the engine check, so profitability. And step three is the stress test, which is leverage.
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C
And then once we have those three solid, we move to the final price tag, the valuation.
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B
Perfect. So let's start with the pulse check. Because as you said, the foundation of all financial survival is liquidity.
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C
It is. It really doesn't matter if you're engineering some massive hostile takeover or just trying to keep the lights on. You have to understand working capital.
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B
Working capital. Okay, so break that down for us.
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C
Well, working capital is the fundamental measure of a company's short term financial health. Conceptually, it is simply your current assets minus your current liabilities.
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B
Okay, so define current in this context.
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C
Good question. A current asset is basically anything you expect to turn into cash within the next 12 months.
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B
So actual cash in the bank, obviously.
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C
Right. Cash. But also accounts receivable from your customers. So money people owe you and the inventory currently sitting in your warehouse.
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B
Got it. And a current liability, that's any bill
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C
you have to pay within that exact same 12 month window.
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B
Okay, I'm following. So if I have say 100 million doll in current assets and 80 million in current liabilities, my working capital is 20 million.
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C
Exactly. And the most basic way analysts measure this is called the current ratio. Some people call it the working capital ratio.
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B
So you just divide the two?
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C
Yeah, you just divide current assets by current liabilities. So your hundred million divided by 80 million gives you a ratio of 1.25.
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B
And as long as that number is above 1.0, theoretically, I can pay all my bills this year.
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C
Right, Theoretically. But theoretically is the operative word there. The current ratio is a decent starting point, but it's famously deceptive.
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B
Deceptive how? If I have more assets than liabilities, shouldn't I be fine?
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C
Well, this is exactly why financial analysts, especially the ones working in restructuring or distressed debt, rely on a much stricter metric. It's called the quick ratio, also known
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B
as the acid test ratio.
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C
Right, Exactly. The acid test.
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B
Okay, wait, let me push back here for a second. If the current ratio already tells us we have more assets than liabilities for the year, why do we need an asset test? I mean, why? Complicated. A dollar of assets is just a dollar of assets, right?
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C
What's fascinating here is that you totally think so, but the reality of a liquidation scenario is very, very different from the clean theory of accounting.
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B
Okay, how so?
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C
The biggest distortion in that current assets bucket is inventory. The acid test formula actually strips inventory entirely out of the equation.
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B
Entirely?
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C
Entirely. It only allows you to count your most liquid assets. So cash, cash equivalents and accounts receivable, you take just those and then divide by your current liabilities.
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B
But why are we treating inventory like it's radioactive or something? I mean, if a company makes a product, that product clearly has value.
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C
It definitely has value. Yes, but it doesn't necessarily have immediate liquidity.
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B
Oh, I see where you're going.
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C
Yeah. Imagine a heavy machinery company. Let's say they manufacture these custom multi million dollar semiconductor fabrication machines.
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A
Okay?
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B
Huge expensive pieces of equipment.
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C
Right. Now, if the broader tech industry enters a sudden recession, this company might have like $500 million worth of highly specialized equipment just sitting in a warehouse. Exactly. Now, under the current ratio, they look incredibly healthy. Their current assets massively dwarf their liabilities.
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B
Because they get to count that 500 million in inventory.
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C
Yes. But what if a massive bond payment is due on Friday and the creditors demand say, $50 million in cold hard cash?
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B
Right. The company can't just roll a half finished semiconductor machine into the bank lobby and say, hey, keep the change.
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C
Precisely. They can't pay a bondholder with the machine. In a true distress scenario, specialized inventory might take years to sell. Or worse, it might have to be sold at a 90% discount just for scrap metal.
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B
Wow. So the current ratio completely hides that risk.
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C
It does. The acid test reveals the immediate unvarnished reality of firm risk. It basically asks a terrifying question to management, which is if your sales dropped to absolute zero today and you couldn't sell a single piece of inventory, could you still pay the bills coming due this month?
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B
Geez, that is a terrifying question. But it makes the distinction crystal clear. It's the difference between having wealth on paper and having actual immediate spending power.
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C
Exactly.
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B
And you know, speaking of how cash actually moves through a business in the real world, our sources dive pretty heavily into the cash collection cycle.
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C
Yes, the cash conversion cycle.
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B
Right. This is such a fascinating mechanism to me because it involves these three distinct speeds. Right. You've got receivables turnover, inventory turnover and payables turnover.
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C
Yeah. I like to think of the cash conversion cycle as the metabolic rate of a company. It measures exactly how many days it takes for a company to convert its investments like inventory and resources into actual cash flows from sales.
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B
So let's break that metabolic rate down for everyone. First you have receivables turnover, which essentially translates to days sales outstanding.
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C
Right. How long does it take your customers to actually hand over the cash after you've provided the good or service?
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B
Then you have inventory turnover or a day's inventory outstanding. That's, you know, how long does a product sit on the shelf gathering dust before a customer even buys it? And finally, payables turnover, which is days payable outstanding, meaning how long can you delay paying your own suppliers before they get mad and cut you off?
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C
When you look at these three metrics together, you uncover the true operational efficiency of management.
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B
Okay, give us an example.
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C
Let's contrast to theoretical companies. Company A is, let's say a struggling industrial supplier. Their inventory sits in a warehouse for 60 days before it's sold.
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B
Okay, 60 days.
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C
And when they finally do sell it, they allow their customers 90 days to actually pay the invoice.
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B
Ouch. So that's 150 days from the moment a product enters their warehouse to the moment they actually see any cash.
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C
Exactly. Meanwhile, their own suppliers are demanding payment in 30 days.
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B
Oh, wow. So for 120 days, company A is essentially financing their customers operations out of their own pocket.
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C
They are acting exactly like a bank, which burns through their cash reserves incredibly fast.
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B
That sounds like a fast track to bankruptcy. If there's a hiccup.
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C
It is. Now contrast that with company B. Let's say it's a massive, highly efficient tech hardware retailer.
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B
Like a big box electronics store.
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C
Right. They have such phenomenal supply chain management that their inventory turnover is maybe just 10 days.
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B
Wow.
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C
And the moment a customer buys a laptop in the store, the cash is collected instantly via credit card. So their day sales outstanding is basically zero.
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B
Right. I'm not walking out with a laptop and saying bill me in 90 days.
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C
Exactly. I. But here's the kicker. Because they are this massive retail giant with huge negotiating power. They force the laptop manufacturers, their suppliers, to accept 90 day payment terms.
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B
Wait, hold on. So they receive the product, sell it in 10 days, get the cash instantly from the customer, and then they don't actually pay the supplier who made the product for another 80 days?
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C
Yes, that's exactly what happens. They operate with what's known as negative working capital.
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B
That's wild. They are literally using their suppliers money to fund their own corporate expansion.
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C
They are. They can take that cash, invest it, earn interest on it, or use it to build three new stores long before the supplier ever sees a dime.
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B
Which is brilliant. Until I guess a macroeconomic shock hits and the music suddenly stops.
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C
Right. And that's when negative working capital can turn deadly.
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B
This really highlights why our sources bring up debt perspectives. While we are still just checking the patient's pulse in step one, you know metrics like net debt and free cash flow yield.
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C
Net debt is a crucial concept to grasp here. It's essentially your total debt minus your cash and cash equivalents.
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B
So it's netting out what you owe versus what you have on hand.
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C
Right. So if A company has $1 billion in long term debt, but they have $2 billion of cash just sitting in offshore accounts, mathematically their net debt is negative.
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B
Even though they owe a billion dollars.
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C
Yeah, exactly. They are heavily indebted. Yes, but they are also highly liquid. They could pay it off tomorrow if they wanted to.
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B
And what about free cash flow yield? That's another one the sources highlighted.
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C
That one takes the free cash flow, which is the cash left over after paying for all your operating expenses and capital expenditures, and it divides it by the enterprise value of the company.
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B
And what does that actually tell me as an investor?
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C
It basically Tells you for every dollar you invest in buying this company, how many cents of hard, cold, unencumbered cash does the business generate?
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B
Ah, so it strips away all the accounting gimmicks completely.
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C
It looks purely at the raw cash generation engine.
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B
Okay, so that completes step one of our balance sheet analysis framework. We've officially checked the liquidity pulse.
- [12:59]
C
The patient is breathing.
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B
Exactly. But as we move to step two, which is evaluating the profitability engine itself, we have to confront a massive accounting illusion.
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C
Oh, yes, the inventory mirage.
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B
Right, because when we talked about the acid test earlier, we talked about stripping out inventory entirely because it isn't cash. Yeah, but how a company chooses to value that inventory on their spreadsheets, that can radically alter their reported profit.
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C
Radically. And therefore it alters their taxes and ultimately their entire perceived value. On Wall street, this is where we
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B
transition from the stark, hard reality of cash into the somewhat subjective, squishy world of asset turnover and inventory valuation. Methods. We're talking about the infamous lifover versus fifo.
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C
The classic accounting debate.
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B
Right. So LIFO stands for last in, first out, and FIFO is first in, first out.
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C
Exactly.
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B
Now, to make this relatable for everyone, if we were talking about a physical supply chain, you could kind of look at a grocery store versus a coal plant.
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C
That's a good comparison.
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B
Right, Because a grocery store basically uses physical FIFO for perishable goods. The stock clerks push the older milk to the front of the shelf, so you buy it first, and they load the fresh milk in the back. First in, first out.
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C
Right. Otherwise the milk spoils.
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B
Exactly. But a coal plant operates more like lifo. A truck dumps a giant pile of coal in the yard, and when the furnace needs fuel, a tractor just scoops the coal off the top of the pile.
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C
Meaning the newest coal that just arrived is the very first to be burned. Last in, first out.
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B
Exactly. But in corporate finance, we aren't talking about physical inventory at all, are we?
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C
No, not at all. That's an excellent way to visualize the physical movement. But financially, LIFO and FIFO are purely accounting assumptions. I mean, an oil refinery might physically mix all its crude oil together. In a massive tank, the physical concept of first or last becomes completely meaningless.
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B
It's just a giant puddle of oil.
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C
Exactly. So LIFO and FIFO are just methods used to determine the cost of goods sold or caught GS on the company's income statement.
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B
Let's slow down and really map this out for the listener, because this is wild. How does moving imaginary barrels of oil around on a Spreadsheet actually change a company's financial reality.
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C
It all revolves around the destructive power of inflation.
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B
Inflation.
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C
Over time, the cost for a company to produce or acquire inventory generally rises. Right. Let's use that oil refinery example.
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B
Sure.
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C
Let's say the refinery buys a million barrels of crude oil in January for $50 a barrel. They just hold it in reserve. Then by June, global conflicts cause inflation to spike and they buy another million barrels. But this time it costs them $100 a barrel.
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B
Okay, so they possess 2 million barrels of oil total. Half of it was cheap at 50 bucks, and half of it was expensive at 100 bucks.
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C
Right.
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B
Now, fast forward to December. They refine and sell exactly 1 million barrels of gasoline. The question for the accountants is which cost basis do they deduct from their revenue to calculate their profit? If they use FIFO first in, first out, the accountants say, let's pretend we sold the January oil. So? So they use the older, cheaper $50
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C
cost, which means their cost of goods sold is artificially low, making their profit margin look incredibly high. Investors are thrilled. The stock price goes up. The CEO gets a huge bonus.
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B
Exactly. But if they use Lipolastin first out, the accountants say, let's pretend we sold the June oil. So they use the newer, more expensive
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C
$100 cost, and suddenly their cost of goods sold doubles. Their reported profit shrinks drastically. Wait a second. Let me wrap my head around this. The physical oil they refined was exactly the same. The price they sold the gasoline to the customer for was exactly the same. But simply because management checked a different box on an accounting form, their profit margin collapsed.
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B
That's the reality of it. Why would any company voluntarily choose life of them? Why would management intentionally make their profit look worse to Wall Street? That seems counterintuitive because of the Internal
- [17:01]
C
Revenue Service taxes, always taxes. Lower reported profit means a substantially lower corporate tax bill during periods of high inflation. LIFO significantly increases your cost of goods sold on paper, which compresses your profit margins. But it saves the company millions, sometimes billions, in actual cash taxes. Wow. Whereas FIFO inflates your earnings on paper because it matches older, cheaper costs against current revenues. That looks phenomenal to investors, but it results in a much higher tax burden, which drains actual physical cash from the business.
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B
That is wild. It perfectly illustrates our opening thesis. Right. Profit is an opinion, but cash is a fact.
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C
Absolutely.
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B
LIFO preserves cash at the expense of looking profitable, while FIFO sacrifices cash just to maintain the illusion of high profitability.
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C
And that's why, if you are an analyst comparing two Industry competitors say two major chemical manufacturers, and one uses lifo, while the other uses fifo. You cannot just look at their net income and compare them side by side.
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B
You're comparing apples and oranges.
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C
At that point, you absolutely cannot do it. The FIFO company will always boast higher profit margins and stronger earnings per share during inflation. But the LIFO company might actually be a much healthier business because they are preserving more free cash flow.
- [18:19]
B
They have more actual money in the bank.
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C
Right. If you are an investment banker advising on a merger and you fail to adjust for different inventory valuation methods, you will wildly miscalculate the true operational efficiency of the target company.
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B
And you'll probably fail the Series 79 exam, too.
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C
You definitely will.
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B
Which leads us perfectly into the meat of step two of our balance sheet framework, the profitability engine. Let's really dive deep into what the company actually gets to keep.
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C
Let's do it.
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B
The sources outline an entire staircase of profit margins here. It's almost overwhelming. We've got gross margin, operating margin, pre tax margin, net margin, net profit margin, and operating profit margin.
- [19:00]
C
That's a lot of margins.
- [19:01]
B
It feels incredibly redundant. Do we really need six different ways to measure profit?
- [19:06]
C
It seems like overkill, but think of the corporate income statement like a massive waterfall.
- [19:10]
B
Okay, a waterfall. I'm picturing it.
- [19:12]
C
You start at the very top of the cliff with total revenue. So that's every single dollar that a customer handed over to you. As that water flows down the cliff face, different expenses take a sip from the stream.
- [19:24]
B
So the river gets smaller and smaller.
- [19:26]
C
Exactly. By looking at the margin at different ledges of the waterfall, analysts can pinpoint exactly where a company is bleeding cash.
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B
Okay, so the first ledge is gross margin. Take your revenue and subtract the cost of goods sold, which, as we just learned, is heavily impacted by LIFO and fifo.
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C
Right.
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B
What's left is your gross profit. Divide that by revenue, and you get your gross margin. This basically tells you the fundamental viability of the product itself, right?
- [19:53]
C
Yes, exactly. If it costs you $80 in raw materials to make a widget that you sell for $100, your gross margin is 20%.
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B
And this is before you pay for marketing, before you pay the CEO's salary, before you even pay rent on the building.
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C
Right. If your gross margin is negative at this stage, you don't really have a business. You have a charity. You are literally selling a dollar bill for 90 cents.
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B
I'm not a great business model.
- [20:18]
C
No. Assuming you survived that first ledge, the waterfall continues down. You subtract your operating expenses, the sales commissions, the administrative salaries, the research and development, the rent for headquarters.
- [20:31]
B
And that brings us down to operating profit, which yields the operating margin, which I imagine is a crucial metric because it tells us if the core business model actually works on a day to day basis, ignoring how it's financed.
- [20:43]
C
Right. And from there you keep subtracting. You pay the interest on your debt, you pay the government their taxes, and finally, whatever water is left pooling at the very bottom of the cliff is your net income. The bottom line, your net profit margin is that bottom line divided by your revenue. Basically, out of every dollar a customer gives you, how many pennies actually survive the entire waterfall to become wealth for the shareholders?
- [21:06]
B
But this is where the sources throw a massive wrench into the gears. They introduce what they call the E suite of earnings. Ebit, EBITDA and ebitdar.
- [21:16]
C
The famous E suite.
- [21:17]
B
Right, because analysts and investment bankers, particularly those taking the Serie 79, rarely rely solely on net profit margin when evaluating mergers and acquisitions.
- [21:28]
C
No, they almost entirely rely on the E suite.
- [21:30]
B
So let's break these acronyms down for the audience. EBIT is earnings before interest and taxes. EBITDA takes that and adds back depreciation and amortization. And EBITDAR adds back rent.
- [21:41]
C
Exactly.
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B
Now I have to stop here and push back hard. I know EBITDA is like the golden calf of Wall Street. Everyone worships it. But to an outsider, it sounds like a magical, deceptive metric designed just to make bad companies look good.
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C
It's a very, very common criticism. And a fair one, honestly.
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B
I mean, if a company runs a massive fleet of delivery trucks, those trucks are actively rusting, the engines are wearing out. That physical deterioration is exactly what depreciation measures, right?
- [22:07]
C
Yes, it is.
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B
So eventually the company will have to spend millions of dollars in cold hard cash to buy new trucks. Why on earth would a buyer or an investment banker pretend that expense doesn't exist? Depreciation is a real unavoidable cost.
- [22:25]
C
It absolutely is.
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B
Doesn't Warren Buffett famously hate ebitda? I feel like I read somewhere that he asks if management thinks the tooth fairy pays for capital expenditures.
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C
He does. Your skepticism is entirely justified. And Buffett's critique is legendary in the industry. If you use EBITDA to measure the actual cash an owner can take out of a business at the end of the year to put in their pocket, you will go bankrupt.
- [22:47]
B
Because the tooth fairy does not, in fact, buy new delivery truck.
- [22:50]
C
Exactly. The trucks have to be paid for.
- [22:53]
B
So then why is it Arguably the most important metric on the Series 79 exam. Why does every single investment banking PitchBook revolve around EBITDA?
- [23:02]
C
Because you really have to understand how it's being used by these bankers in the context of M and A advisory services. EBA is not about ignoring reality. It is about creating a level playing field.
- [23:13]
B
A level playing field. Okay. Explain that.
- [23:16]
C
It isolates the core operational engine of a business from its capital structure and its history.
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B
Walk me through a scenario. Make it concrete.
- [23:23]
C
Okay, let's say you are a massive private equity firm looking to acquire one of two competing telecom infrastructure companies. They both lay fiber optic cables underground.
- [23:35]
B
Okay. Company A and company B.
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C
Right. Company A is a legacy firm. They bought all their trench digging equipment and built their corporate headquarters 30 years ago. They their assets are fully depreciated, meaning their depreciation expense on the income statement is basically zero. Today, company B is an aggressive, fast growing upstart. They bought identical brand new equipment just last year, so their depreciation expense is massive.
- [24:00]
B
So on a pure net profit basis, company A was wildly profitable, while company B looks like it's barely scraping by simply because of when they happen to buy their trucks.
- [24:10]
C
Exactly. But if you, the private equity firm, acquire either of them, you are bringing your own massive debt load to finance the purchase. You are going to completely wipe out their old capital structure. You will be operating under your own tax strategies and you will likely restate the value of all their assets anyway through a process called purchase price allocation.
- [24:33]
B
Ah, okay, I'm starting to see it. I don't care what interest they pay because I'm going to refinance their debt anyway.
- [24:38]
C
Right?
- [24:39]
B
I don't care what taxes they pay because I'm folding them into my complex corporate tax structure. And I don't care about their historical depreciation because I'm only concerned with what it costs to run the business tomorrow.
- [24:52]
C
Precisely. You just want to know how much raw operating cash flow does this fiber optic network actually generate? By stripping away interest, taxes, depreciation and amortization, EBITDA gives you a standardized metric. It allows you to place company A and company B side by side. And say, ignoring the historical accidents of when you bought your bulldozer and how you finance them, which one of you is fundamentally better at digging trenches and laying cable?
- [25:19]
B
That is brilliant. That completely flips my perspective on it. Net profit margin shows you the company's historical baggage, but EBITDA shows you the fundamental horsepower of the engine isolated on a test block.
- [25:30]
C
That's a great way to Put it. And that raw horsepower is what an acquirer is actually buying.
- [25:35]
B
Wow. Okay. Now, alongside these profitability margins, our sources list several return metrics. ROA, Return on Assets, ROE, Return on Equity, ROI Return on Investment and roic Return on Invested Capital.
- [25:48]
C
The return on family.
- [25:49]
B
Right. And ROE is heavily emphasized in the material as the ultimate measure of general business efficiency.
- [25:55]
C
It is. ROE is net income divided by shareholders equity. Basically it asks for every dollar the owners, the shareholders leave in the business, how much profit did management actually generate with it?
- [26:06]
B
So it's basically grading the management team.
- [26:08]
C
It is the ultimate gauge of management stewardship of capital. If you give a management team a million dollars and they generate $50,000 in net income, their ROI is 5%, which isn't great.
- [26:20]
B
You could have gotten a better return just buying risk free treasury bonds.
- [26:23]
C
Exactly. But if a different management team can take that exact same million dollars and generate $250,000 in profit, their ROE is 25%. They are highly efficient operators. You want them managing your money makes sense.
- [26:38]
B
The sources also mention EPS earnings per share, which is just the net income divided by the number of outstanding shares. But there's a vital caveat. The sources highlight here adjustments including extraordinary items or non recurring items. Why is normalizing the earnings so critical?
- [26:54]
C
Because remember, Wall street values the future, not the past. If you are valuing a company, you are trying to predict its sustainable recurring cash flows. Let's say a retail chain reports an absolutely massive spike in net income this year. Their EPS just doubles overnight. If you blindly build a valuation model, assuming they will maintain that incredible EPS forever, you might massively overpay for the stock.
- [27:19]
B
But then you actually read the footnotes in the annual report.
- [27:22]
C
Always read the footnotes.
- [27:23]
B
Right. And you discover that the retail chain sold off their massive downtown corporate headquarters building for a huge one time profit.
- [27:31]
C
Yes, that is an extraordinary non recurring item. They cannot sell their headquarters again next year.
- [27:36]
B
They only have one headquarters.
- [27:38]
C
Exactly. So to understand the true profitability engine of the underlying retail business, an analyst absolutely must subtract that one time windfall from the net income to find the normalized earnings.
- [27:50]
B
That makes perfect sense. Okay, so that covers step two. We've checked the liquidity pulse, we've measured the profitability engine. But as you mentioned with ROE just a minute ago, there's a very famous trick to making your return on equity look absolutely incredible without actually being a better business operator.
- [28:06]
C
Oh yeah, the leverage trick.
- [28:08]
B
Exactly. And that brings us to step three of our framework, the risk check. We are diving into section four. The Outline the edge of risk and the double edged sword of leverage.
- [28:19]
C
Leverage. It is the use of borrowed money to amplify returns. And it is easily the most intoxicating and dangerous tool in corporate finance.
- [28:28]
B
Let's use an analogy to explain exactly how leverage manipulates roe, because the math is fascinating. Let's say you want to buy a small commercial building for $100,000, okay?
- [28:37]
C
A real estate deal, right?
- [28:38]
B
You pay entirely in cash, no debt. The building generates $10,000 a year in rental profit. Your return on equity, your $10,000 profit divided by your $100,000 cash investment is 10%, a solid, safe, respectable return.
- [28:52]
C
It is. But Wall street doesn't like safe and steady. It likes extraordinary returns. So let's introduce leverage to your deal.
- [28:59]
B
Okay, so instead of paying all cash, I put down only $10,000 my own money as equity. I borrow the remaining $90,000 from a bank at, let's say a 5% interest rate, right? The building still generates $10,000 in rent, but now I have to pay the bank $4,500 in interest every year. That leaves me with $5,500 in profit.
- [29:16]
C
Right? Now, let's recalculate your ROE. Yeah. Your profit is $5,500, but your equity, the actual cash you put into the deal was only $10,000.
- [29:26]
B
So $5,500 divided by $10,000 is a 55% return on equity.
- [29:31]
C
Boom.
- [29:31]
B
That's insane. I didn't become a better landlord. The building didn't become more valuable or generate more rent. I simply used debt to artificially amplify the returns on my small sliver of equity.
- [29:43]
C
And this is the exact mechanics of a leveraged buyout or an LBO used by private equity firms. They buy a company, load its balance sheet up with mass amounts of debt to pay for the acquisition, and then use the company's own cash flows to slowly pay down the debt, which wildly amplifies their eventual return on equity.
- [29:59]
B
But there's a dark side to this magic trick. It's very dark because if a recession hits and a few tenants move out of my commercial building, maybe my rental income drops from $10,000 down to $4,000.
- [30:09]
C
Yep.
- [30:09]
B
Now, if I had paid all cash, my ROE would just drop to 4%. It's a bummer, but I survive. I just make less money. But because I use leverage, I still owe the bank their $4,500 in interest, no matter what.
- [30:20]
C
And your income is only $4,000.
- [30:22]
B
All right, I am underwater. I'm losing $500 a year.
- [30:25]
C
And this is where leverage amplifies your losses. You will quickly burn through your cash reserves. And if you can't make the interest payment, the bank forecloses. Your $10,000 in equity is wiped out instantly. You lose everything.
- [30:37]
B
Which raises the critical question for analysts evaluating a company. How do you know when a company has crossed that line from smart efficient leverage to existential catastrophic risk?
- [30:48]
C
Right. Where is the cliff exactly?
- [30:51]
B
The sources highlight three critical debt ratios used to evaluate firm risk. Here, the interest coverage ratio, leverage net debt to EBITDA and debt to ebitda. Let's start with the interest coverage ratio. How do investment bankers interpret this for their clients?
- [31:05]
C
The interest coverage ratio is EBIT earnings before interest and taxes divided by the company's interest expense. It basically tells you how many times over a company's operating profit could pay its interest bill. It is a direct measure of a company's margin of safety.
- [31:19]
B
So if a software company generates, say $50 million in EBIT and their debt requires $10 million in interest payments a year, their coverage ratio is 5x.
- [31:28]
C
Yes, and that is a very healthy ratio. It means that even if a new competitor enters the market and slashes the software company's operating profits in half, down to $25 million, they still have more than enough operating income to easily service their debt.
- [31:43]
B
They can survive the shock.
- [31:44]
C
They can survive.
- [31:46]
B
But what if a private equity firm does a leveraged buyout and loads that software company up with so much debt that the interest payment Suddenly jumps to $40 million a year?
- [31:55]
C
Well, now the EBIT is $50 million and the interest is $40 million. The coverage ratio plummets to 1.25x. That company is now walking on a financial tightrope. We call it operating in the sweat zone.
- [32:09]
B
This Quetzone. I love that.
- [32:10]
C
Because you are constantly sweating a minor supply chain hiccup. A slight miss in quarterly sales, or most dangerously, a decision by the Federal Reserve to raise interest rates on their variable rate debt could push their interest expense higher than their operating profit and default becomes imminent.
- [32:26]
B
That perfectly explains the danger of the interest payment. But what about the total size of the mountain of debt itself? This brings us to debt to ebitda. We established earlier that EBITDA is the proxy for raw operating cash flow. So total debt divided by ebitda, what is that telling the analyst?
- [32:44]
C
It tells you how many years it would take for the company to pay off its entire debt load using just its current operating cash flow, assuming they paid zero interest and spent zero money on capital expenditures.
- [32:55]
B
Okay, so If a company has $200 million in total debt and $50 million in EBITDA, the ratio is 4x exactly.4
- [33:02]
C
years to pay it off in a perfect world.
- [33:05]
B
And how do investment bankers view these specific thresholds? Is Forex good or bad?
- [33:10]
C
It really depends on the industry. But there are general rules of thumb. A debt to ebitda ratio of 1x to 2x is generally considered very healthy, very conservative. 3x to 4x is typical for a stable mature company with highly predictable cash flows. Think of a utility company or a well established consumer staples brand. But Once you push past 5x6 or 7x, you are entering highly leveraged high risk territory.
- [33:33]
B
So in the M and A world, if you are advising a corporate buyer and you look at a target company with a 7x debt to EBITDA ratio, that massive debt is essentially a radioactive deal breaker.
- [33:46]
C
Oh, absolutely. It's a huge red flag. The buyer will either demand that the seller pay down that debt before the acquisition closes, or they will dramatically lower the purchase price to compensate for the massive risk they are absorbing. Identifying these toxic leverage ratios is a fundamental skill tested heavily on the Series 79 exam.
- [34:06]
B
Okay, let's take a breath and recap our journey so far. We have successfully completed the three step framework. We checked the pulse with liquidity metrics, ensuring the company won't go bankrupt by Friday.
- [34:17]
C
Yep.
- [34:17]
B
We measured the engine with profitability metrics, stripping out accounting illusions using ebitda. And we assess the risk with leverage ratios, making sure the debt load won't collapse the company.
- [34:26]
C
We have gathered all the raw ingredients. We understand the mechanics of the operation inside and out. Now it is time for the grand
- [34:33]
B
finale, Section five, the final price tag. Valuation.
- [34:38]
C
The big one.
- [34:38]
B
How do we actually synthesize liquidity, profitability and risk into a single dollar amount? What does this company actually worth?
- [34:47]
C
Valuation is where the science of accounting meets the art of forecasting. It really is an art form. The sources drop a mountain of metrics on us here. So let's start by establishing the baseline vocabulary. We need to distinguish between market capitalization, equity value and enterprise value.
- [35:03]
B
Okay, market cap is the easy one. That's the number you see scrolling on the news ticker every night. It's simply the current stock price multiplied by the total number of outstanding shares.
- [35:14]
C
Right.
- [35:15]
B
So if a company has 10 million shares and the stock is trading at $50 a share, the market cap is $500 million. It's what the public equity markets say the company is worth. Right. This exact second.
- [35:27]
C
But market cap only tells you the value of the equity. It does not tell an acquirer what it actually costs to take over the entire business. For that, we need enterprise value or ev.
- [35:38]
B
Let's use another real estate analogy to explain this, because I think it helps ground it. Let's say you want to buy a house. You negotiate a price with the seller for the equity in the home. $200,000.
- [35:47]
C
Okay.
- [35:47]
B
But the house comes with a $300,000 mortgage that's tied to the property, which you have to assume when you buy it. The true cost to you, the acquirer, isn't $200,000. It's the equity plus the debt you're taking on. So it's $500,000.
- [36:04]
C
That is exactly how enterprise value works. EV is the market cap plus the company's total debt. But there's one more step that people forget. What if, when you buy that house, you open a safe in the basement and find $50,000 in cash just sitting there?
- [36:19]
B
Oh, well, that cash effectively acts as a rebate on my purchase price. I can use it immediately.
- [36:23]
C
Exactly. So the full formula for enterprise value is market cap plus debt minus cash and cash equivalents.
- [36:29]
B
Ah. It is the comprehensive debt inclusive cash adjusted takeover price of the entire corporate entity. Because if I buy the company, I acquire their cash, which gives me a discount, but I have to pay off their debt, which makes the acquisition more expensive.
- [36:43]
C
This is why enterprise value is the absolute foundational metric for M and A analysis. Once we know the ev, we can start applying valuation multiples.
- [36:51]
B
Right? Multiple.
- [36:52]
C
Now, multiples are a form of relative valuation. They don't tell you absolute intrinsic value. They just tell you if company A is cheaper or more expensive than company B based on a specific metric.
- [37:05]
B
The most famous multiple, like the grandfather of them all, is the P E ratio or price to earnings. It's the price of one share of stock divided by the earnings per share.
- [37:15]
A
Right.
- [37:15]
B
If a Stock trades at $100 and it generates $5 of earnings per share, the P E multiple is 20.
- [37:21]
C
Put simply, a P E of 20 means investors are willing to pay $20 today for the right to receive $1 of the company's current annual profit. It measures how expensive the earnings are.
- [37:32]
B
Now, the sources mentioned forward PE versus LTM. LTM stands for last 12 months. It's backward looking. Uses the profits the company already reported
- [37:41]
C
in the past, which is factual but inherently flawed.
- [37:43]
B
Because it's the past.
- [37:44]
C
Right. The stock market is a forward looking discounting mechanism. You don't buy a stock for what the company did yesterday. You buy it for what it will do tomorrow. Therefore, forward. Pe, which divides the current price by analyst estimates of next year's earnings is usually a much more relevant multiple for investors.
- [38:00]
B
But PE has a massive blind spot, doesn't it? It completely ignores growth.
- [38:04]
C
It does.
- [38:05]
B
If I look at a mature utility company, it might have a PE of 10. If I look at a high flying tech software company, it might have a P E of 50. The novice investor looks at that and says the tech company is five times more expensive. I should buy the cheap utility stock. But that might be a terrible decision. Right.
- [38:23]
C
That is exactly where the PEG ratio comes in. PEG stands for price Earnings to growth. It takes the PE ratio and divides it by the company's expected annual earnings growth rate.
- [38:33]
B
Oh, I see. Let's run the math on our utility and tech companies. The utility has a PE of 10, but it's only growing its earnings at maybe 2% a year. 10 divided by 2 gives us a PEG ratio. 5.
- [38:44]
C
Okay. Pega 5.
- [38:45]
B
The tech company has a massive P E of 50, but it is growing its earnings at an explosive 50% a year. 50 divided by 50 gives us a PEG ratio of 1.
- [38:54]
C
And a lower PEG ratio generally indicates a better value. So mathematically, once you actually adjust for the trajectory of growth, the expensive tech stock is actually a significantly better bargain than the cheap utility stock. The PEG ratio equalizes them.
- [39:07]
B
That is incredibly useful. We also have other multiples for specific situations listed here. PB Price to book value compares the market cap to the accounting value of the company's net assets, which is heavily
- [39:20]
C
used when valuing banks and financial institutions whose balance sheets are mostly liquid assets anyway.
- [39:25]
B
And then we have PS Price to sales. Why do we need to compare price to sales revenue? Why not just use earnings?
- [39:32]
C
Because early stage hyper growth tech companies, think of the Ubers or Amazons of the world in their first decade are often deliberately running at massive losses.
- [39:40]
B
Right. They are burning cash.
- [39:41]
C
Exactly. They are spending every divine they make on customer acquisition and R and D just to capture market share. Because they have negative earnings, calculating a P E ratio is mathematically impossible. You can't divide by a negative number and get a meaningful multiple. So analysts use price to sales to gauge how the market is valuing their top line revenue growth.
- [40:02]
B
But if there is one valuation multiple that rules them all. One multiple that is universally tested on the series 79 and endlessly debated in boardrooms. It is evident. Enterprise value divided by ebitda.
- [40:13]
C
The holy grail of multiples.
- [40:15]
B
Right. We established earlier that enterprise value is the true cost of acquiring the business, regardless of how its equity or debt is currently structured. And we established that EBITDA is the raw operating cash flow of the business, regardless of its tax bracket or historical depreciation.
- [40:32]
C
So when you put them together, EBITDA
- [40:34]
B
is the ultimate pure comparison. It compares the capital structure neutral price of the firm to the capital structure neutral cash flow of the firm. It is the great equalizer.
- [40:45]
C
It really is. You can use it to compare a heavily indebted German manufacturing company with fully depreciated assets against a debt free American startup with brand new factories and actually get a mathematically sound relative valuation.
- [40:58]
B
That's amazing.
- [40:59]
C
It is, but I really want to stress the word relative. Multiples just tell you if a stock is cheap compared to its peers. But what if the entire industry is currently trapped in a massive irrational market bubble?
- [41:10]
B
Oh, like the dot com bubble?
- [41:12]
C
Exactly. Comparing multiples might just tell you which stock is the least overvalued in a sea of wildly overvalued stocks. It doesn't tell you what it's actually worth.
- [41:22]
B
So to find the absolute intrinsic value of a company, what it is fundamentally worth, regardless of what the stock market thinks on any given Tuesday, we have to leave multiples behind entirely. We have to build a discounted cash flow model, or dcf.
- [41:36]
C
The dcf. It is the absolute pinnacle of financial modeling. It is mathematically complex, but philosophically, it is built on one simple premise. The value of any business today is simply the sum of all the cash it will ever produce in the future, discounted back to today's value.
- [41:52]
B
Okay. I want to try and simplify the concept of the DCF for beginners without losing the nuance. I like to think of a DCF model as trying to price a time traveling atm.
- [42:01]
C
A time traveling atm. Okay, let's hear it.
- [42:03]
B
Let's say I offer to sell you a magic atm. I find a rock solid contract guaranteeing that this atm will spit out exactly $10,000 in free cash flow every single year for the next 10 years. That is $100,000 in total cash. My question is, what is the maximum amount you would pay me for that ATM today?
- [42:20]
C
Well, a novice might say $100,000, but anyone who understands finance knows you would pay significantly less than that.
- [42:27]
B
Right. Because of the fundamental concept of the time value of money, a dollar in your hand today is fundamentally worth more than a dollar promised to you 10 years from now.
- [42:37]
C
Exactly. And there are two main reasons for this. The first is opportunity cost.
- [42:41]
B
Meaning what else I could do with the money.
- [42:43]
C
Right. If I have $10,000 today. I can invest it in risk free government bonds yielding 5%. In 10 years, that $10,000 will have grown significantly due to compound interest. If I have to wait 10 years for your ATM to give me that final $10,000, I have lost a decade of investment returns.
- [43:02]
B
And the second reason?
- [43:03]
C
Inflation. A dollar in 10 years will simply buy fewer goods than a dollar today. It loses purchasing power.
- [43:09]
B
And I'd add a third reason. Risk. What if the ATM breaks in year five? What if you go bankrupt and void the contract? A promise of future cash always, always carries a risk of default.
- [43:20]
C
Therefore, you must discount those future cash flows. You project out the future cash flows, year one, year two, year three, and you apply a mathematical discount rate to shrink them back to their net present value.
- [43:31]
B
And here is where the DCF transitions from simple logic into intense, highly debated corporate finance. What exactly is that discount rate? Our sources point to the cost of capital, and specifically wacc, the weighted average cost of capital.
- [43:48]
C
WACC is basically the minimum return that a company's investors, both debt holders and equity holders, demand for providing capital to the business. It is a blended rate.
- [43:58]
B
Let's break WACC down. The cost of debt part is relatively easy to find, right? You just look at the interest rate the company is currently paying on its corporate bonds. If they issue bonds at 6%, their cost of debt is roughly 6%, minus the tax shield. Since interest payments are tax deductible.
- [44:14]
C
Right. That's the easy part.
- [44:15]
B
But the cost of equity is much harder. Shareholders don't have a guaranteed interest rate printed on their stock certificates. So how do analysts calculate the return that equity investors demand?
- [44:24]
C
They use the capital asset pricing model, or capm. And CAPM relies heavily on a metric called beta.
- [44:30]
B
Beta. Okay, what's that?
- [44:32]
C
Beta measures a specific stock's historical volatility relative to the overall stock market. The market as a whole always has a beta of exactly 1.0.
- [44:41]
B
So if a massive stable consumer goods company like a toothpaste manufacturer moves less violently than the market, maybe its stock only goes up 0.5%. When the market goes up 1%, its beta is 0.5. Is a low volatility, lower risk stock.
- [44:56]
C
Correct. And conversely, a high growth speculative biotech firm might swing wildly. If the market drops 1%, the biotech stock might crash 2%. Its beta is 2.0. It's highly volatile.
- [45:08]
B
And in finance, risk and reward are intrinsically linked. Because the biotech stock is riskier, higher equity investors naturally demand a much higher percentage return to justify buying it. In the first place, that higher demanded return means a higher cost of equity,
- [45:20]
C
which in turn drives up the company's overall wacc. And here is the crucial mechanical link in the dcf, a higher WACC means a higher discount rate. When you apply a higher discount rate to those future cash flows, their present value shrinks dramatically.
- [45:36]
B
So the math systematically penalizes the valuation of the company for the uncertainty and volatility of its future.
- [45:42]
C
Exactly.
- [45:43]
B
I love the elegance of that structure. I have to push back here. I really do go for it. I see analysts present these massive DCF models with decimal point precision, declaring a stock is intrinsically worth exactly $64. But the entire model requires us to forecast revenues five or 10 years into the future. It requires us to calculate WACC, which relies on historical beta to predict future volatility. Aren't metrics like WACC and terminal value just sophisticated guesswork dressed up in a tuxedo of complex math?
- [46:15]
C
That is the most honest and arguably the most accurate critique of the DCF model you can make. The math is absolute, yes, but the inputs are 4. Fundamentally subjective valuation is an art governed by scientific parameters. I mean, a tiny, seemingly innocuous tweak by an analyst, say, changing the terminal growth rate from 2% to 0.5% or shifting the WACC by just 50 basis points can swing the final enterprise value of a multi billion dollar company by hundreds of millions of dollars.
- [46:43]
B
It feels like if an investment banker really wants to justify a high purchase price to close a deal and get their commission, they can just subtly tweak the WACC downward until the spreadsheet produces the exact number they want.
- [46:55]
C
Which absolutely does happen. And it's exactly why understanding the assumptions behind the model is way more important than the final number it spits out. As an investor or as a buyer, you must stress test the wacc. You must ask, what if the analyst's growth projections are just wrong?
- [47:11]
B
Speaking of growth projections, our sources explicitly highlight the need to calculate simple company growth rates using kgr, the compound annual growth rate. How does KGR differ from just taking a simple average of a company's past growth?
- [47:24]
C
A simple average can be mathematically deceptive due to the compounding effect. Let me give you an example. Let's say A startup has $100 in revenue. In year one, revenue grows by 100% to $200.
- [47:35]
B
It's incredible growth.
- [47:36]
C
But then in year two, revenue drops by 50% back to $100.
- [47:40]
B
Okay, so if you take a simple average of those two growth rates, positive 100% and negative 50%. The average is a positive 25% growth rate.
- [47:49]
C
Right. But look at the actual money. The revenue started at $100 and ended at $100. The actual growth over the two years was absolutely zero.
- [47:59]
B
The average is lying to us.
- [48:00]
C
It is. This is exactly why analysts use ctr. The compound annual growth rate calculates the exact steady percentage the company would have needed to grow every single year to get from the beginning value to the ending value, smoothing out all the volatility. In our example, the CAGR would correctly calculate as 0%. It is the standard mathematically sound metric for expressing historical growth and projecting it into a DCF model that clears that up perfectly. Now, the sources also list dividend models under valuation. The ddm, which is the dividend discount model, the dividend payout ratio, and the dividend yield. The dividend discount model is essentially a variation of the dcf. But instead of projecting the company's entire free cash flow, you operate under the assumption that the only cash flow that actually matters to a minority shareholder is the dividend check they receive in the mail.
- [48:47]
B
Okay, so you project the future dividends the company will pay out and discount those back to present value using the cost of equity.
- [48:54]
C
Exactly.
- [48:55]
B
But this model seems incredibly limiting. You can't use a DDM to value Google or Amazon because they don't historically pay significant mature dividends.
- [49:05]
C
You're right, you can't. The DDM is primarily used for highly mature, slow growth, stable cash cow companies. Think of massive utility conglomerates, real estate investment trusts, or legacy telecommunications firms. For these companies, the primary return to the investor is the dividend yield rather than explosive stock price appreciation.
- [49:24]
B
And the dividend payout ratio?
- [49:26]
C
That's just the percentage of net income paid out as dividends. It helps analysts judge if that dividend is actually sustainable. If a company's payout ratio is 95%, any slight drop in profits will force them to cut the dividend. And when a mature company cuts its dividend, the stock price usually plummets.
- [49:44]
B
Right. Okay. Finally, we reach the ultimate application of all these valuation metrics. The sources list M and a specific analysis. Accretion, dilution, and some of the parts. When a massive merger is announced on cnbc, the first question analysts always ask is, is this deal accretive or dilutive?
- [50:02]
C
Yep. The most important question on day one.
- [50:04]
B
Let's demystify this. What do those terms actually mean mechanically?
- [50:07]
C
Let's set up a scenario. Company A, a massive software conglomerate, decides to buy Company B, a smaller, innovative rival. Company A doesn't want to Use its precious cash reserves. So it decides to pay for the acquisition using its own stock.
- [50:20]
B
Okay, so Company A issues millions of brand new shares of its own stock and hands them over to the owners of Company B as payment.
- [50:26]
C
Exactly. Now, before the deal, let's say Company A had 100 shares outstanding and generated $100 in total profit. Their earnings per share, or EPS, was exactly $1.
- [50:38]
B
By issuing new shares to buy Company B, they are increasing their total share count. They are taking the corporate pie and slicing it into smaller pieces. Let's say they issue 20 new shares. Now they have 120 shares outstanding.
- [50:51]
C
That is the dilution aspect. But Company B isn't just an empty shell. Company B brings its own profit to the table. Let's say company B generates $30 in profit. So the new combined mega company generates $130 in total profit.
- [51:04]
B
Now we recalculate the new EPS. We take the $130 in combined profit and divide it by the new total of 120 shares. The new EPS is $8.08.
- [51:13]
C
And there you go. Because the new EPS of $1 8 is higher than the original EPS of $1, this merger is accretive. Even though the pie was sliced into smaller pieces, the total size of the pie grew so much that every individual slice actually got larger. The acquisition made the shareholders of Company A mathematically richer on day one.
- [51:31]
B
But what if Company A drastically overpaid for Company B? What if they had to issue 50 new shares just to get the deal done?
- [51:38]
C
Let's run the math. Combined profit is still $130, but now there are 150 total shares outstanding. $130 divided by 150 gives you an EPS of C dollars $0.86. The EPS dropped from a dollar down to $0.86. The deal is dilutive.
- [51:56]
B
Wow.
- [51:56]
C
The new earnings Company B brought in were not enough to offset the massive number of new shares issued.
- [52:02]
B
So why would a CEO ever agree to a dilutive deal? I mean, why would shareholders vote for an acquisition that instantly lowers their earnings per share?
- [52:09]
C
Usually, management argues for synergies.
- [52:12]
B
Ah, synergies. The magic word.
- [52:14]
C
Always. They claim that by combining the companies, they can fire duplicate staff, close overlapping factories, and cross sell products, which will boost future profits enough to make the deal accretive in year two or year three.
- [52:25]
B
Do investors actually buy that?
- [52:27]
C
Wall street is deeply skeptical of synergy promises. If an M and A deal is highly dilutive on day one, institutional investors will typically punish the acquiring company's stock price the exact moment the Deal's announced accretion dilution analysis is the ultimate immediate stress test of an M and a transaction's viability.
- [52:47]
B
And what about some of the parts analysis? When is that used?
- [52:50]
C
It is used primarily for massive conglomerates, companies that operate in multiple wildly different industries. Imagine a corporate giant that owns a legacy slow growth shipping business, but also owns a fast growing high margin cloud computing subsidiary.
- [53:06]
B
If you try to value that entire company as a single entity using a blended P E ratio, you just get a mess. The slow shipping business drags down the valuation of the cloud computing business precisely.
- [53:18]
C
So analysts perform a sum of the parts valuation. They isolate the shipping division and value it using a low evapd multiple comparable to other shipping companies. Then they isolate the cloud division and value it using a high revenue multiple comparable to other tech startups. Then they simply add the two valuations
- [53:33]
B
together and very often they discover that the sum of the parts is actually significantly higher than the current enterprise value of the conglomerate. Meaning the market is undervaluing the hidden gem.
- [53:44]
C
Exactly. And this is the trigger for activist investors. They will buy up stock in the conglomerate and publicly demand that management spin off or sell the cloud computing division to unlock that trapped shareholder value. It is the ultimate corporate restructuring play.
- [54:01]
B
Well, we have covered an absolutely monumental amount of ground today. We took a dense stack of financial ratios and built a really logical interconnected framework. We started at the foundation with step one, the pulse check, navigating working capital, distinguishing the current ratio from the asset test and examining how the cash collection cycle can turn a retailer into a bank.
- [54:21]
C
We then explored how accounting choices, specifically the LIFO and FIFO inventory methods, can drastically shift a company's financial narrative, sacrificing reported profit just to preserve cash from the irs.
- [54:33]
B
We moved right into step two, the profitability engine. Tracing the waterfall from gross margin down to net income. And really unpacking why EBITDA is the capital structure neutral, great equalizer for comparing operational cash flow across industries.
- [54:47]
C
And we stress tested the framework in step three with leverage, utilizing the interest coverage ratio and debt to EBITDA multiples to determine if a company is brilliantly maximizing its return on on equity or dangerously dancing on the edge of a default.
- [55:01]
B
And finally, we synthesized all of those raw ingredients into valuation, defining enterprise value, contextualizing multiples like the PEG ratio, projecting the future through the discounted cash flow model in wacc and evaluating the ultimate success of M and A deals through accretion and dilution analysis.
- [55:18]
C
Honestly, for anyone studying for the series 79 or anyone managing a Series portfolio. I really hope the fog is lifted the next time you read financial news about a multi billion dollar merger or review a stock pitch, just remember that these metrics are not just dry abstract math. They are the actual vocabulary used to negotiate corporate reality. When analysts argue over a WACC discount rate or an EV Bitna multiple, they aren't just doing arithmetic. They are vigorously debating the future risk and the ultimate potential of human enterprise.
- [55:46]
B
Which perfectly brings me back to our opening thought. We started by looking at a company that was highly profitable on paper, but filing for bankruptcy in reality. We've seen how choosing LIFO over FIFO can vanish millions in profit. We've seen how focusing on EBITDA can hide rusting delivery trucks. We've seen how tweaking a DCF terminal growth rate can conjure billions of dollars in valuation out of thin air. It forces you to ask a somewhat philosophical question. How objective is financial truth really? When we look at a balance sheet and an income statement, are we actually measuring absolute physical reality or are we just reading a highly regulated, mathematically complex, fiercely negotiated story?
- [56:29]
C
That tension between the math and the story is the ultimate question of corporate finance and figuring out which is which is exactly what makes a great analyst.
- [56:36]
B
Thanks for diving deep with us today. Keep questioning the numbers and we'll see you next time.