Strategic Capital Group Workshop #1: Investment Fundamentals

Agenda

Introduction to USIT & SCG Creating a Company Financial Statements Raising Capital Exercise and Closing

Meet the USIT Shirt Company

Currently run out of Parker’s dad’s garage, we are providers low cost, awful quality t-shirts to any suckers who will buy them.

The Business + Key Terms

We sell t-shirts for $20 each, and on sell 100 per year The $2,000 of sales we make each year is referred to as

revenue Price x Volume = Revenue

We pay Parker’s little brother $2 per shirt to assemble and $3 per shirt for the input materials.

This $5 per shirt of costs are referred to as

cost of goods sold

, or the direct costs of the inputs and labor that goes into the product

Cost per unit x Volume = Cost of Goods Sold

The Business + Key Terms

Benedikt, the CEO, who does not actually make the products, gets paid a fixed $500 salary per year.

The $500 paid to him is referred to as an

operating expense

Operating expenses are not the same as cost of goods sold because they reflect costs uninvolved in production

Now how to we represent the state of the business?

The Income Statement

Revenue -COGS Gross Profit -Operating Expenses Net Income $2,000 500 $1,500 500 $1,000 • • • Tells us how much the business sold and what it cost to sell the products, all the way down to the leftover profit.

Typically shows the state of the business for a year or a quarter of a year Important to know how profitable the business is

The Income Statement

Key terms: Gross Profit Margin = Gross Profit Revenue $1,500 $2,000 = 75% Net Margin = Net Income Revenue $1,000 $2,000 = 50% After paying off all expenses and costs, 50% of every dollar of sales will be left over as profit. As this percentage increases, the amount of costs per dollar of sales are declining and the business is becoming more cost efficient

The Business + Key Terms

Parker contributed $500 of cash when the business first started Benedikt loaned the business $500 dollars $200 was used to buy a t-shirt making machine.

The Balance Sheet

Assets What you own

=

Liabilities What you owe

+

Equity What’s contributed and left over Cash Machinery $200 Loan from Ben $500 Contributed Capital $500

Sanity Check #1

• We’ve had an introduction to two financial statements (forms that describe a business’s condition) – Balance Sheet – tells us about the resources of the business and how they were funded – Income Statement – tells us how much we sold and how much we spent during a period

Expanding

A sudden fad for overpaying for cheap shirts has developed, meaning demand for USIT Co.’s shirts has skyrocketed.

Making t-shirts out of Parker’s dad’s garage is no longer enough, and we need to expand.

In order to expand, we need to buy more buildings, more machines, and more inventory.

To get more assets, we need more capital!

Options for Raising Capital – “Financing”

Debt (liabilities) Equity • • • • Types of debt: Loans – offers of money now Face Value – the amount of money • return of capital and interest later on Bonds – a loan that can trade before the loan is due back exchanges Key Terms: • • Types of Equity: • • Common stock – the traditional stock, or shares of a company that a company puts its stock for sale to any investor through a stock ownership of a company and claims on voting rights and profits Preferred Stock – stock that has no payments to investors voting right, but has guaranteed payments from a pool of profits

So which do we choose?

Debt Equity • • •

Advantages

Your creditors (loaners) have no control over the company Easy to raise Good tax implications •

Disadvantages

You are legally required to pay interest and principal or risk bankruptcy •

Advantages

You have no obligation to pay anyone. Investors are not guaranteed distributions • •

Disadvantages

You are essentially selling control of your company. If you sell more than 51%, your decisions can be vetoed Potential for hostile investors

…and how do we do it?

Step 1: Find an investment banker Step 2: Have your investment banker overwork his junior bankers to figure out what your company is worth, then find people to invest in your newly issued securities Step 3: Figure out how much money you need to raise, then sell that proportion of your company (if equity)

Sanity Check #2

• We’ve talked about the two ways to raise capital: – Debt – loans with obligatory interest payments – Equity – stock with no obligation to pay, but gives away voting rights

USIT Co.’s Capital Decision

Debt • • $10M of “senior” bonds at a 5% interest rate $10M of “junior” bonds at a 10% interest rate Equity • $50M of proceeds from issuing 1M shares of stock related to a 25% stake in the company How much money in total did we receive?

What was the stock price we issued at?

How much is the total equity of the company worth?

Stock price is arbitrary!

It’s important to note that the company chooses the stock price it wants to issue at. We could have issued: 10 million shares @ $5 per share 100 million shares @ $.50 per share 1 share @ $50 million per share Either way, we still receive $50 million dollars in proceeds

Implications

After raising publicly-traded stock, you are considered a public company. Every quarter and at year end, you file an annual report with various financial statements and notes called a 10-K

or 10-Q

A quick update on what our new balance sheet looks like, post-financing

Assets:

Cash Machines $70,000,800 $ 200 $70,001,000

Liabilities:

Loans Bonds Payable $ 500 $20,000,000

Equity:

Common Stock $50,000,000 Contributed Capital$ 500 $70,001,000

Let’s fast forward a year…

The Income Statement

Revenue -COGS $100,000,000 (40,000,000) Gross Profit $60,000,000 -Operating Expenses (50,000,000) Net Income $10,000,000 Stock price at issuance: $50 per share Number of shares: 1 million Earnings Per Share $10.00

EPS = Net Income (earnings) Shares of stock outstanding Literally…how much your company earns per each share

Valuation

Finance is the process of raising capital for a business, but in order to know the appropriate amount of capital to raise and how much it will cost, we need to

value

a company Investors and bankers have several tools to value a company, but first…

Valuation

Your exotic friend asks you to go buy this fruit you’ve never seen for him, but to not spend too much for him.

The fruit is only sold by one vendor and costs $5 per pound, but you have no idea if that’s a good price. What do you do?

You compare it to other things that are like it, namely, other fruit! You can refine your search further by comparing to other fruit that look and taste like it.

The same concept can apply to companies:

T-shirt Co T-shirt Co Price = $50.00 per share Price = $5.00 per share

Which is the cheaper investment?

What about if we look at EPS?

T-shirt Co T-shirt Co EPS = $10.00 per share EPS = $3.00 per share

USIT seems to pay out more per share…

P/E- The Price to Earnings Ratio

Share price is not enough!

P/E: how much does one dollar of this company’s earnings cost?

Price (the amount you pay) USIT P/E = Earnings per share (how much the firm makes) = Price (the amount you pay) SCG P/E = Earnings per share (how much the firm makes) = $50.00

$10.00

$5.00

$2.00

= 5x = 2.5x

Become The Investor

So now which is the cheaper investment?

5x 2.5x

Remember: P/E ratios are a measurement of how much you pay per dollar of earnings

The answer is… there isn’t one.

• • Widely varying interpretations of P/E – High P/E – investors value the earnings more, willing to pay more • Could mean optimism – Low P/E – cheaper earnings, better deal Note: This is all relative – We are comparing to similar companies – “Cheap-er”, “costli-er”

Valuation

• • Relative valuation is just one of the ways we value a company and has its advantages and disadvantages. Later during the year we will discuss different ways to value a company and will flesh out further how to use these tools.

Sanity Check #3

• • We’ve learned about the P/E multiple We’ve compared two companies and decided which to invest in

Exercise

• Which of the following companies would you buy? Why?

Company Price Shares Assets Revenue Profit Margin P/E P/B P/S USIT SCG UCF Nike Average $4.00 $7.57 $82.53 $67.73 10,000,000 5,000,000 1,000,000 2,000,000 $40.46 4500000 $11,000,000 $12,000,000 $19,800,000 $8,000,000 $100,000,000 $125,000,000 $228,000,000 $48,000,000 $33,300,000 $48,000,000 $49,500,000 $35,700,000 33.3% 38.4% 21.7% 74.4% $12,700,000 $125,250,000 $41,625,000 41.9% 1.20

0.79

1.67

3.79

1.86

3.64

3.15

4.17

16.93

0.40

0.30

0.36

2.82

6.97

0.97