Before walking through the model, here is a glossary of common accounting and finance terms that will be used throughout this blog series:
Sales/Revenue: Sales or Revenue is the total dollar amount a company has “realized” (received) through the sales of its products and services during a given time period.
Cost of Goods Sold/Cost of Revenue: These are the costs directly associated with producing the company’s products or services, which include the cost of materials used and the labor of making the product or doing the service.
Gross Profit: The profit earned by a company after subtracting the costs directly related to producing its products or services. This can be used as an indicator of the company’s efficiency and for determining gross profit margins.
Selling, General, and Administrative Expenses: These are expenses a company incurs that are required to run the business but not to directly make an individual product or service. Basic examples of this are building rents, utilities, and administrative and sales employee salaries.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA): A common metric for operating cash flow since it reflects the company’s total cash operating costs for producing its products or services. It is also important for comparing companies in the same industry against each other because EBITDA is free from the differences companies have in the “capital structure” (whether a company is funded by stock investment or debt, and the interest expenses that come with debt) or tax rates. If this is not given by the company, it is calculated by taking the company’s reported “EBIT” number and adding back in Depreciation and Amortization. These are added because they are not cash expenses (cash was spent at some point in time, but not on a continuing basis). This is a non-Generally Accepted Accounting Principle measure, but is commonly used by companies and financial analysts.
Depreciation and Amortization: These are two methods for decreasing the value of an asset because it has been partially used. The layperson example of depreciation is of an individual’s car losing value after buying and driving it because the car has been used and is therefore older and potentially more “worn down”. Companies have assets which they depreciate in a similar manner. Amortization is reducing the value of an “intangible asset”. An layperson’s example of this is an “amortizing home loan”, where the loan’s principal value decreases steadily with each mortgage payment. While the house might be an asset, the loan is what is being paid, and financial instruments like loans can be considered “intangible”.
Earnings Before Interest and Taxes (EBIT, also known as Operating Income, Operating Profit, or Operating Earnings): The reason EBIT is also called Operating Income because it is the measure of a company’s profit after all its operational expenses (the SG&A, Depreciation, Amortization, and Cost of Goods Sold) that are part of earning its revenue are subtracted from its revenue. The only expenses left are interest on debt and taxes, which do not directly affect the business’s operations except as final expenses.
Taxes: The taxes applied on a company’s earnings. Typically for basic modeling purposes analysts will use 35% to 45% tax rates, but companies will give more detailed tax expenses or credits in their public filings.
Earnings Before Interest After Taxes (EBIAT): Earnings after taxes is sometimes used as a metric for comparing companies, but less so compared to EBITDA. Taxes are taken out because they are an expense that company’s have little influence on compared to the rest of their business and so are considered not highly relevant when trying to figure out how healthy a business is.
Capital Expenditures (CAPEX): A capital expenditure is an expense used to acquire or improve a company’s assets, such as building new factories and buying equipment. These expenses are made with the intent of growing the business. This is found in a company’s Cash Flow statement.
Current Assets: Current Assets are non-cash assets that can be used or turned into cash within a year, such as Accounts Receivable (payments due from customers to the company) and Inventory. This is found on the Balance Sheet.
Current Liabilities: Current Liabilities are liabilities that need to be paid or settled within a year. This is found on the Balance Sheet.
Net Working Capital (NWC): This is a company’s “Current Assets” minus “Current Liabilities”. This shows how much cash and other liquid assets a company uses to run its operations. One important point is that an increase in NWC is a use of or decrease in available cash because the cash is being turned into assets like inventory used to grow the business. A decrease in NWC is either caused by assets being used up to generate cash or liabilities decreasing, and is therefore an increase or source of cash.
Free Cash Flow (FCF): This is the cash left over after all the expenses of running the business have been removed from revenues. Free Cash Flow is what companies use to grow the business, save for a rainy day, or give money back to shareholders.
Weighted Average Cost of Capital (WACC): Companies are funded by some mix of equity (stock ownership) and debt. Investors who either buy the stock or give the company loans expect some return on their investment. The “cost of capital” is financial jargon for an investor’s expected return. Because stock and debt are have different legal and financial arrangements between the company and investors, they have different costs. A lot of public companies use a combination of stock and debt, so you have to find an average between the cost of stock and the cost of debt to the company. The equation for the Weighted Average Cost of Capital is:
Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
T = corporate tax rate
Tangible Book Value (Per Share) (TBV): Tangible Book Value is the value of the company if it had to sell off all its tangible assets at the value of those assets in its accounting books. “Intangible” assets like trademarks and brand recognition are not included because, in a situation like bankruptcy where a company has to sell all its assets, intangible assets would have no or unpredictable value. If a company supplies its TBV data (which they typically do), it will appear on the Balance Sheet. TBV per share is the company’s TBV divided by the number of shares of stock, telling each shareholder how much of the company’s value his stock is worth.
Terminal Value: The value of the company as an ongoing business. In the context of a DCF model, it’s the value of all the potential future profits outside of the immediate years in your model.
Perpetuity Growth Rate: The annual rate at which the company’s terminal value will grow indefinitely into the future. This is a way to factor into your model the expectation that the company will continue to grow and this growth should be considered when valuing the business. This percentage is rarely more than 3% per year, which is the target for annual growth of the USA economy as a whole.
Enterprise Value: The value for the entire company. The equation for Enterprise Value is: Value of all the common stock (called “market capitalization”) + value of preferred stock (often given to special investors or founders/managers of a company) + value of debts + Minority Interests in Other Business – Cash and cash-like assets.
Next: Starting the DCF Model
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