Thinking like an Investor: The key financial metrics

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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!

Comments (40)

 
Feb 6, 2014 - 10:49am

I'm a bit confused about the explanation for debt - in a standard buyout scenario, won't you be retiring the existing debt on the balance sheet and recapitalizing at your targeted D/E ratio (or whatever the banks and mezz lenders will allow)?

"For I am a sinner in the hands of an angry God. Bloody Mary full of vodka, blessed are you among cocktails. Pray for me now and at the hour of my death, which I hope is soon. Amen."
 
Feb 6, 2014 - 1:56pm

I don't agree with EBITDA margins as a metric, especially when your valuations are generally relative to EBITDA. The fact that one company has a 20% margin while another has an 80% margin tells you nothing about which one is the better investment.

Debt is also irrelevant from a PE perspective since you'll be putting your own capital structure on the business. If someone answered debt levels to a question of "how would you evaluate this business" or "is this a good investment" that would be an instant ding.

 
Feb 7, 2014 - 1:45am

I rather strongly disagree with using operating margin as the base for valuing the business. For instance, take a retail franchising business. The stores would be operating at a very good margin, but a bulk of the expenses would be concentrated at the hub and still be classified as "non-operating" expenses. There are a lot of major expenses which fall below the operating margin line, and can ultimately drag the overall margin down. That's why I prefer EBITDA, which is your profit after all business expenses.

I'll be happy to hear counter arguments to the above point, it'll be interesting to see if there's a flaw in my logic.

Move along, nothing to see here.
 
Feb 6, 2014 - 2:15pm

@abcdefghij

EBITDA margin is going to be a significant driver of cash flow, so this is going to be an important metric to evaluate when it comes to assessing potential returns. Assuming this is a standard highly levered buyout scenario, you are only going to see attractive profits (or any profits at all) if you can quickly delever and exit. Alternatively, you can lever up for a dividend recap, but you're still eventually going to have to deal with the debt. I'm unsure of why you think existing debt is irrelevant for PE- you do realize that every dollar you spend refinancing the debt is a dollar that's not going to go towards purchasing the equity of the company? High existing debt limits the leverage you can apply and limits potential returns.

 
Feb 6, 2014 - 2:25pm

Tri_Optimum:

@abcdefghij

EBITDA margin is going to be a significant driver of cash flow, so this is going to be an important metric to evaluate when it comes to assessing potential returns. Assuming this is a standard highly levered buyout scenario, you are only going to see attractive profits (or any profits at all) if you can quickly delever and exit. Alternatively, you can lever up for a dividend recap, but you're still eventually going to have to deal with the debt. I'm unsure of why you think existing debt is irrelevant for PE- you do realize that every dollar you spend refinancing the debt is a dollar that's not going to go towards purchasing the equity of the company? High existing debt limits the leverage you can apply and limits potential returns.

EBITDA margin is not a driver of your returns. If I pay 8x EBITDA for a 20% margin business and for an 80% margin business, I still get the same returns all else being equal. If anything I would probably prefer the 20% EBITDA margin business from a PE standpoint.

Existing debt does nothing to "limit the leverage you can apply". You need to review your basic LBO mechanics.

ROIC is probably the single best standalone metric for evaluating investment opportunities, whether for PE or hedge funds.

 
Feb 6, 2014 - 2:46pm

abcdefghij:

Existing debt does nothing to "limit the leverage you can apply". You need to review your basic LBO mechanics.

Thank you for sanity.

"For I am a sinner in the hands of an angry God. Bloody Mary full of vodka, blessed are you among cocktails. Pray for me now and at the hour of my death, which I hope is soon. Amen."
 
Feb 6, 2014 - 2:50pm

Tri_Optimum:
High existing debt limits the leverage you can apply and limits potential returns.

This is simply wrong. If a Company is levered to the hilt, it shouldn't change the EV of a Company. If you spend $100mm acquiring a company ($50mm debt, $50mm equity) and the Company has $90mm in debt on the balance sheet before closing - the creditors will get paid out on their $90mm, the existing equity holders will get the additional $10mm. You will own 100% of the equity at a $50mm equity valuation, and there will be a brand spanking new $50mm of debt on the BS.

"For I am a sinner in the hands of an angry God. Bloody Mary full of vodka, blessed are you among cocktails. Pray for me now and at the hour of my death, which I hope is soon. Amen."
 
Feb 7, 2014 - 1:48pm

I think on a theoretical basis you are right, but I cannot say I agree with that in practice.

Companies are not always valued at their theoretical EV and companies are not always run in a manner that drives the highest valuation. I think that is especially true for public companies that are valued on a mix of metrics (not just EV / EBITDA).

For instance, if a public company is currently levered at 2x EBITDA but has a growth, risk and cash flow profile supporting 5x leverage they could be undervalued on the public equity markets (there will be a diverse investor base investing on who knows what type of methodology). A private equity firm could come in, increase leverage and subsequently increase equity returns. This would be impossible to do if the company is already very levered.

Also, as has been mentioned elsewhere on this thread, if a company is highly levered there could be significant breakage costs associated with restructuring the capital structure.

 
Feb 6, 2014 - 3:42pm

I'm generally replying since the quote/reply buttons aren't working for me now. To Duff, mechanically, yes, I was wrong - thanks for correcting me. However, while I agree now with the general premise of what I've read from checking the board (i.e. preexisting debt shouldn't matter for an LBO investor), there is a potential issue with breakage cost for blowing up the existing capital structure if the company is highly levered (i.e. 5.0x +), so I wouldn't say that it would be irrelevant in all situations. I still disagree with the issue of EBITDA margin (not one of the points you made, Duff), however - you need stable, solid EBITDA margin to generate stable, solid cash flow. Take oil jobbers, for example – they might have (artificially) high revenues due to fuel prices, but they typically have very low margins and thus tight cash flow.

Good points to consider. Here's the link to thread I mentioned earlier:
//www.wallstreetoasis.com/forums/leverage-relevance-for-lbo-target

 
Feb 6, 2014 - 9:33pm

IMO ROIC is the most important metric for PE and HF investors. From a PE perspective it helps you understand the value of each $ of capital the company invests throughout your holding period. ROIC incorporates how capital intensive a project is and the associated time to pay this back (incorporating revenue ramp and profit margins).

EBITDA margins / EBITDA – CapEx margins matter when you're evaluating a business because they help you understand a company's ability to make interest payments. Basically this can limit the leverage a business can sustain, which limits the purchase price a sponsor is willing to pay for an asset. Another great thing that matters about margins are that they dictate the amount of profit that comes in with each incremental dollar in sales. Margins are also indicative of upside / downside potential to margins over the sponsor ownership period.

 
Feb 6, 2014 - 10:32pm

Value Investor:

IMO ROIC is the most important metric for PE and HF investors. From a PE perspective it helps you understand the value of each $ of capital the company invests throughout your holding period. ROIC incorporates how capital intensive a project is and the associated time to pay this back (incorporating revenue ramp and profit margins).

EBITDA margins / EBITDA – CapEx margins matter when you're evaluating a business because they help you understand a company's ability to make interest payments. Basically this can limit the leverage a business can sustain, which limits the purchase price a sponsor is willing to pay for an asset. Another great thing that matters about margins are that they dictate the amount of profit that comes in with each incremental dollar in sales. Margins are also indicative of upside / downside potential to margins over the sponsor ownership period.


Also I feel like people generally give 1% of Revenue growth the same credit across companies with various margins when that is flawed. If you have 80% margins, 1% of growth will transcribe to greater EBITDA growth than at a 20% margin business. Margins can also tell you the extent of barriers to entry or pricing power relative to other peers.
 
Feb 7, 2014 - 12:24am

HarvardOrBust:

Value Investor:

IMO ROIC is the most important metric for PE and HF investors. From a PE perspective it helps you understand the value of each $ of capital the company invests throughout your holding period. ROIC incorporates how capital intensive a project is and the associated time to pay this back (incorporating revenue ramp and profit margins).

EBITDA margins / EBITDA – CapEx margins matter when you're evaluating a business because they help you understand a company's ability to make interest payments. Basically this can limit the leverage a business can sustain, which limits the purchase price a sponsor is willing to pay for an asset. Another great thing that matters about margins are that they dictate the amount of profit that comes in with each incremental dollar in sales. Margins are also indicative of upside / downside potential to margins over the sponsor ownership period.

Also I feel like people generally give 1% of Revenue growth the same credit across companies with various margins when that is flawed. If you have 80% margins, 1% of growth will transcribe to greater EBITDA growth than at a 20% margin business. Margins can also tell you the extent of barriers to entry or pricing power relative to other peers.

Yeah, the important (value adding) metric is growth in free cash flow, not revenue, although that's harder to project.

 
Feb 7, 2014 - 1:24am

Thank you for your replies, everyone. You've raised some interesting points that I'll be happy to address.

Regarding considering debt as an important metric, @"duffmt6", @"bonobochimp", @Tri_Optimum:

The point regarding existing debt not being one of the key factors would be correct in a pure LBO, since you're going to buy it out anyways. But I strongly believe that we're moving away from pure LBO's to structured transactions, comprising debt, mezz and equity, with debt/mezz being the predominant components. In fact, in my region, traditional LBO's are non-existent and structured deals are hugely prevalent. In such deals, a small proportion of the investment goes towards equity stake in the Company.

In such structured investments, it is common for the PE investor to leave some debt on the balance sheet, with the expectations of repaying it over a few years down the line. This makes it crucial to know how much debt is already existing and a flexible assumption of how much will continue to exist, thereby impacting free cash flow available to the investor in the future.

Apologies, I should've made the point about structured PE investments clearer. Hope this clears up my reasoning.

Move along, nothing to see here.
 
Feb 7, 2014 - 1:36am

Regarding considering EBITDA/ROIC as an important metric, @"abcdefghij", @"BatMasterson", @"value investor", @"HarvardOrBust":

The use of EBITDA here is not driven towards determining the value of the business, or to a certain extent, even profitability. I have not considered valuation anywhere in my post, the reason for which I will explain later. As for profitability, like someone mentioned above, it isn't going to make much difference if the target is earning 20% margins in a 40% industry standard.

I'm using EBITDA solely because it is the very base of the cash flow - it is where you derive your residual free cash flow from after accounting for all business expenses. That's what makes EBITDA so crucial - it's importance for determining cash flow, not it's relevance on profitability.

Along the same lines, ROIC: Even if the the Company has a great ROIC, which I agree indicates that it is a profitable company, ROIC indicates nothing about the cash flow. What if the company is at the peak of it's manufacturing capacity? Sure it has a great profitability, but it's cash flow will all get drained towards additional capex.

As you can see, I seem to be obsessed with cash flow - which is what I mentioned right before diving into each of the metrics. For PE investors, generally cash flow is what determined the profitability of the investment, which is all you are ultimately concerned with (not profitability of the Company).

Move along, nothing to see here.
 
Feb 7, 2014 - 1:55am

Lastly, regarding valuation of a business for a PE investment:

In a pure LBO, I don't even know how current valuation of the business is going to have any impact on your investment, since you'll be only buying out existing debt.

Even otherwise, as far as PE investments are concerned, anyone who is in the industry will tell you that over 80% of the time, the fund manager has a target valuation in mind and it's your job to see if that valuation works, and if it doesn't, see if you can make it work. So instead of valuing a business and negotiating from there, the fund manager will already have a number in his mind and you have to see if at that number, the company will have enough cash flow to make it work. It's twisted, but I believe that's a realistic representation of what's going on everywhere.

Further, even in structured PE investments, the equity portion of the investment (amount invested in equity vis-a-vis total size of investment) is very small. So while considering the required initial equity stake, the fund manager generally leaves scope for upward or downward negotiation by ~5%, which can then be adjusted based on how well the overall investment size works.

I'm not sure if I'm being clear enough in this explanation, feel free to let me know if you have any comments.

Move along, nothing to see here.
 
Feb 7, 2014 - 3:45am

IMO only 2 things matter - quality growth and capital efficiency (i.e cash flow generation). A good investment would give me returns through growth and by generating cash flow.

EBITDA margin as many have pointed out is highly irrelevant. RoIC or ROCE is the right metric, along with growth. Growth needs to be understood at a unit level so the quality of growth is sustainable (volume, price). I usually do a simple EBITDA/(Gross Block + Net Working capital) to calculate RoCE. It is the closest metric to assess capital efficiency.

For capex intensive companies EBITDA-Capex would be the simple metric

 
Best Response
Feb 7, 2014 - 4:33am

A lot of people here are mistaking the use of EBITDA in my post as a factor for determining profitability. It is not. Fundamentally a PE investor couldn't care less whether the EBITDA margin, or for that matter, any profit margin, is 2% or 20%. What matters is the amount of EBITDA, which gives the first indication of cash availability.

I'll make this point clearer in the post later when I get a chance.

As for your other points - revenue growth and capex - already covered in the post. And cash generation is what the entire post is about.

Move along, nothing to see here.
 
Feb 7, 2014 - 9:33am

EBITDA margin does matter, particularly for a PE investor: If you have very low margins, it is more likely that EBITDA is highly volatile, given that a certain portion of the cost base will be fixed. High margins give you more of a cushion, all other things being equal. Also, high EBITDA margins typically speak to competitive advantage, though they are not the best metric for this.

More generally, I feel this post is a bit misleading. When people say not thinking like an investor, they often mean too much focus on the metrics (typical of bankers) and not enough vision for why it could be a great deal. Knowing the cash flow of a target tells you nothing about whether it will be a good deal. Because everyone else will also know it and it will be reflected in the price. An investor needs to think about developing an angle to win: can we partner with mgmt, can we take cost out, drive international expansion etc.

 
Feb 7, 2014 - 10:24am

PZ87:

More generally, I feel this post is a bit misleading. When people say not thinking like an investor, they often mean too much focus on the metrics (typical of bankers) and not enough vision for why it could be a great deal. Knowing the cash flow of a target tells you nothing about whether it will be a good deal. Because everyone else will also know it and it will be reflected in the price. An investor needs to think about developing an angle to win: can we partner with mgmt, can we take cost out, drive international expansion etc.

Appreciate your comments. Please allow me to point you to the title of this post: Thinking like an investor: The key financial metrics.

If you drill down to the nuts and bolts, 90% of post-investment operational improvements will be driven towards improving cash flow. It's not going to help an LBO investor much if he helps improve the brand name, but it will if he improves working capital cycles, because it will improve the cash flow.

I'll focus on the other intangible factors like management and relationships in coming posts, as mentioned in the closing para.

Move along, nothing to see here.
 
Feb 7, 2014 - 2:23pm

PZ87:

EBITDA margin does matter, particularly for a PE investor: If you have very low margins, it is more likely that EBITDA is highly volatile, given that a certain portion of the cost base will be fixed. High margins give you more of a cushion, all other things being equal. Also, high EBITDA margins typically speak to competitive advantage, though they are not the best metric for this.

More generally, I feel this post is a bit misleading. When people say not thinking like an investor, they often mean too much focus on the metrics (typical of bankers) and not enough vision for why it could be a great deal. Knowing the cash flow of a target tells you nothing about whether it will be a good deal. Because everyone else will also know it and it will be reflected in the price. An investor needs to think about developing an angle to win: can we partner with mgmt, can we take cost out, drive international expansion etc.

Also consider operating leverage which I think of as the relative level of fixed vs. variable costs in a company's cost structure. Lots of fixed = more whippy, higher risk / reward, lots of variable = more stable, lower risk / reward.

Operating margin can be important if you believe there is a cost cutting case. For example if you can prove the CEO is highly overpaid, e.g. near identical peers operate at better margins simply because their CEOs are paid market, you can make a case that you can unlock some significant EBITDA by hiring a new CEO. Or if the company lags its peers in profitability, but you can show how a supply chain shakeup could improve margins over the forecast, by all means incorporate it.

if you like it then you shoulda put a banana on it
 
Feb 8, 2014 - 1:22pm

margins should matter because high margins means you keep more of your topline growth, and topline growth takes capital, so technically your capital efficiency / roi will improve.

On the other hand, low margins means there's room for margin expansion which can drive up your exit valuation.

so ebitda margin can be good low or high but it really depends if it's a flip or grow with the company style purchase.

 
Feb 9, 2014 - 12:58am

@couchy, @dukebanker12:

Christ, you guys like to hit a point home. To quote my own OP,

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. It goes without saying that EBITDA is the most suitable measure for evaluating the commercial profitability of a company.

I'm not discounting the importance of EBITDA. In the comments when I said that it couldn't matter less to a PE investor whether the margins are 2% or 20%, I was trying to make a point in context of cash flow requirements. Suppose hypothetically there is an industry where the benchmark margin itself is 2%, but typically has low to negligible debt, what are you gonna do then? Avoid that industry entirely? Dream up ways to materialize that "scope for improvement"? You're not management consultants and only certain PE investors are operational investors.

What I'm trying to say is that if a 2% margin still leaves a lot of cash flow with the company, the 2% margin alone doesn't indicate that it's a bad business or a bad investment. Any fool with half a brain can realize that all else being equal, a 20% margin is better than 2%. But when the low hanging fruits dry up, you gotta bring your expectations down a notch and eat some of the fouler smelling fruit.

I have this nagging feeling that most of the people here haven't been involved in distressed investments.

Move along, nothing to see here.
 
Feb 24, 2014 - 5:11am

To put in context my views on EBITDA margins, most infrastructure assets (toll roads, ports, power plants) have very high EBITDA margins (north of 50%) given low opex, but RoCEs are almost always in the 10-15% range given tariff structures.

As a general PE investor (not an infra fund or a distressed fund) my priority would be to generate a 25% IRR or its equivalent (3x my money). In a 15% RoCE business you will always need additional rounds of capital within your investment horizon of 5-6 years thereby ensuring your stake is diluted down. So even if EBITDA grows 3x, your stake value will grow less than 3x.

Unless a business generates atleast 20% RoCE it's highly unlikely you will get your threshold returns without a major dose of luck in the debt markets.

I prefer focusing on gross margins to EBITDA margins though since gross margins give you a real sense of value the firm adds in its industry's value chain. A software reseller would make 10-15% gross margins against a true enterprise software business which would enjoy GMs north of 80%. EBITDA margins have too much noise built in.

 
Aug 23, 2018 - 2:51pm

OP the comment on debt is retarded. pre-transaction capital structure has no impact on returns (bar call premiums) as new cap structure is put in place. even if all debt is rolled over it is a source of funding and will reduce equity cheque in the same manner that raising new debt will

I sold some shares, but on a net basis, significantly increased my ownership. Jeffrey Skilling
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