Thinking like an Investor: The key financial metrics

I've quite often come across the phrase "thinking like an investor" in books and here on WSO, "not thinking like an investor" seems to be a fairly recurrent reason cited for getting dinged in a PE interviews. It's quite natural, since it is not something that one can pick up from a banking stint. Thus, it seemed appropriate for me to share a gem of an advice that I received from my fund manager a few months into my current gig (this is my first job and I recently completed a year here).

For private equity investments, there are just 4 financial metrics that are the biggest force behind determining the merits of an investment. Sure, there are countless other external factors, but if these four don't work out, chances are the investment is not worth your time. So if you ever get asked a question along the lines of, "Is this a good investment opportunity?" or "How would you evaluate this company?", make sure that you cover these four metrics.

So what are they? Before jumping into the details, it is important to understand that the single biggest factor that makes or breaks a private equity investment is cash flow. PE investments typically involve taking on a load of debt, so the investor needs to know that the target will be able to repay the principal, service the interest as well as pay any additional cash upside built into the transaction structure. Hence, nothing else is going to matter much if the target cannot generate the requisite cash flow.

The metrics that I'm going to list now are all driven towards getting an idea of what the cash flow would be like. These financial metrics are: Revenue, EBITDA, Capex and Debt. I'm not listing them in the order of importance, but in the order in which they would appear in the all-important Cash Flow Statement.

Revenue: Revenue, of course, is the very source of the cash flow. It gives you the broadest indication of how much and how fast the Company can grow. Here, you only need to understand whether the Company has scope for growing its revenue, and if so, at what rate. Does the Company have an existing market? If it's a manufacturing entity, how much can the revenue grow without incurring additional capex for increasing capacity?

EBITDA & EBITDA Margin: The company's EBITDA margin needs to be high enough to be able to provide a comfortable level of cash from operations and should ideally exhibit a stable upward trend rather than volatility. This is because EBITDA is the very base of the cash flow - no amount of revenue is going to be enough if it's all being lost towards costs. It goes without saying that EBITDA is the most suitable measure for evaluating the commercial profitability of a company.

In both revenue and EBITDA, it's a good idea to evaluate historical and projected CAGR's, which gives you a working indication of the path that the company is on. However, just looking at one without the other is near useless.

Capex: Now that you have sufficient cash flow from operations thanks to a good revenue growth and adequate EBITDA margin, you need to see how much of it will get drained towards capex - whether routine or towards expansion. Generally the PE investor will heavily discourage additional debt post investment, so any future capex requirements will need to be fulfilled by internal accruals. Therefore, you need to get a good idea of future capex requirements and the impact on free cash flow.

Debt: Debt is the most crucial factor that impacts cash flow after EBITDA. If there's too much existing debt, any available free cash flow will go towards servicing the interest and principal payments on that, leaving very less cash for the incoming investor. Therefore, you need to know if leverage ratio of the company is reasonable compared to industry standard. Even if the leverage ratio is high, the investment might still work if the company is generating enough free cash flow to service existing debt and still have a good cash coverage for the new investor.

Whatever cash is left after considering the above is what is available for servicing the PE investor. At the initial stage, there's no need to look into working capital requirements unless they're unusually high as well as volatile. Once you've considered the above four factors, you'll have a solid idea of what sort of cash coverage the investment will have, which is all that a PE investor is generally concerned with.

In case some of you feel, "but these four factors cover everything!", you might want to pick up an annual filing. There's a tonne of additional financial information that you can look into, like cost break-up, capital structure, dividend payments, asset base and so on, but all of this doesn't really provide any value add once you've considered the above.

One popular ratio I've seen quoted on WSO is Return on Investment. But unless you're an equity investor, I don't think a good RoI is going to make much difference if the company is unable to pay it out in cash due to high capex, debt service or a myriad of other reasons. For private equity investments, cash is king.

This rounds up the post and hopefully you've come away with some useful information. If you did and there's enough interest, I might do a follow on post on the intangible drivers involved in private equity investments - matters that an analyst will never think of and cannot factor into a model - relationships. Cash may be king, but after all is said and done, PE investments are a relationship game, at least at the boutique level.

So, let me know your thoughts below!