Chapter 7
Making Sense of Financial Statements
IN THIS CHAPTER
Spotting interesting trends in the income statement
Kicking the tires of companies by analyzing the balance sheet
Appreciating the importance of tracking cash flow
Finding the lurid details about a company buried in the proxy statement
When you go to the doctor, you end up sharing parts of your body or personal concerns you don’t normally divulge to just anyone. It’s the professional relationship you have with your doctor that makes you feel free to open the kimono, literally and figuratively.
A similar situation exists between investment banks and their clients. Companies commonly share detailed aspects of their business with close financial advisors. It’s part of the relationship between investment banks and companies, and a big reason why the industry is so closely regulated — that information has great value.
But even though companies often share privileged information with investment bankers, investment bankers must do their part to research a company in order to understand it better. And when it comes to getting to know a company, even beyond what the CEO may tell an investment banker, the financial statements are hard to beat.
A company’s financial statements break down exactly how the firm is performing financially, how it got there, what kind of economic condition it’s in and even a little bit about how it’s positioned for the future. Information contained in the financial statements is generally considered to be the base camp from which companies and their investment bankers must start before building more complex financial products and planning for the future.
In this chapter, you find out about the primary financial statements investment bankers pay the most attention to: the income statement, balance sheet, and statement of cash flows. And since the proxy statement is such a treasure-trove of company information, we explore that document, too, from an investment banker’s perspective.
Income Statements
Individual investors are often fixated on the income statement. Every quarter, investors eagerly await earnings season (a roughly three-week period during which major companies report their quarterly results). During earnings season, investors pore over the financial documents released by companies, especially the income statement.
There’s a good reason why investors pay such keen attention to the income statement: The income statement is what tells all interested parties, stock investors, bondholders, employees and, yes, investment bankers, how much the company earned during that quarter.
The income statement’s basic task is to show investors how much the company brought in by selling goods and services, and how much was left in profit after paying expenses.
The income statement adheres to very strict accounting guidelines, called generally accepted accounting principles (GAAP). All companies that trade on U.S. exchanges and file financial statements with the Securities and Exchange Commission (SEC) are required to follow GAAP. By following the same set of accounting rules, investment bankers are able to compare the financial results of different companies against each other.
Although all companies must follow these rules, there is often room for interpretation of these guidelines, and comparing one firm to another may not be an “apples-to-apples” comparison. You can find more on this in Chapter 16.
The income statement is used by investment bankers primarily to
- Gauge the trajectory of the business. By reading the income statement, investment bankers can get a good idea where the company is on the spectrum of the firm’s lifecycle. The income statement, for instance, can show investment bankers if it’s a young company that’s growing rapidly or a lumbering giant that’s hitting the wall and struggling to find new businesses to tap.
- Find out where a company’s objectives lie. If there’s one reason why investment bankers pay close attention to the income statement, it’s because other investors and company management pay close attention to it. If a company’s management, including the CEO, can’t find a way to drive profit higher, their high-paying jobs could be on the line. By scanning the income statement, investment bankers can in short order get a pretty good idea of what problems CEOs must solve in order to hang onto their lucrative jobs.
- Understand the true drivers of the business. Companies are often best known for their higher-profile businesses, but the true driver is something else. The income statement cuts away any preconceived notions about which businesses are most important to a company and gets down to the facts.
Locating the areas of interest to investment bankers
If you’re an accountant or investor, you look at the income statement very differently than an investment banker does. Accountants look for inconsistencies or ways the companies may overstate their profits or appearance of success. Investors examine the income statement for clues on whether the company would likely be a good investment. But investment bankers look at financial statements trying to find ways to approach the companies with ideas of ways to improve results.
This chapter isn’t intended to be a comprehensive primer on the line items on the financial statements. There are entire books dedicated to that topic, and they’re pretty thrilling, as you can imagine. The point of this chapter is to explain the basics of the financial statements and how investment bankers, in particular, examine them. In Chapter 8, you find out how to glean insights from the numbers from the financial statements by turning them into financial ratios. If you’re interested in finding out even more about reading financial statements to discover undervalued investments, here’s our shameless plug for Fundamental Analysis For Dummies, by Matt Krantz ( Wiley), which shows you some of the tricks.
For investment bankers, the focus is on certain line items on the income statement that are the most telling for their purposes, including
- Revenue: Revenue is the amount of total sales that’s being hauled in by a company. Revenue is sometimes called sales or “the top line.” Investment bankers pay very close attention to revenue because it’s a measure of the amount of dollar volume running through the company. Revenue is also the basis for measuring how quickly a company is growing. Companies must follow strict guidelines that determine when they can count a sale as revenue, in a process called revenue recognition.
- Cost of goods sold (COGS): Companies don’t get to keep all their revenue, as hard as they might try. There are costs associated with producing a product or service. Those direct costs include buying raw materials.
- Gross profit: A company’s gross profit is how much is left of revenue after paying COGS. Gross profit is a good indication of how profitable a company’s line of business is before mucking up the analysis with peripheral overhead costs, some of which are more controllable than direct costs are.
- Selling, general, and administrative costs (SG&A): Companies don’t just need to buy raw materials to get a product to market. There are salespeople to pay, not to mention advertising costs and executive paychecks to deal with. These overhead costs are often indirect costs by investment bankers.
- Operating income: A company’s operating income is how much it keeps from revenue after paying both direct and indirect costs. Operating income gives investment bankers a good indication of a company’s profitability, excluding the bite from Uncle Sam in the form of taxes.
- Interest expense: Companies that borrow money from bondholders or other lenders typically need to make periodic interest payments on those loans. The portion of the expenses paid in the current period is shown in the interest expense line item.
- Income taxes: Companies must pay taxes, too. Taxes can be a significant cost for companies, and tax bills may even come into play when making decisions on business moves or where even to physically locate a business. One consideration in mergers, for instance, has to do with managing tax bills.
- Net profit: Investment bankers arrive at the bottom line, or net profit. Net profit tells the investment bankers how much the company earned after subtracting all the costs.
These line items apply to most manufacturing firms and even many service firms like restaurant chains. Financial companies are unique, and the line items on the income statement are read differently.
Tweaking the statement with different assumptions
Unlike many other users of financial statements, investment bankers rarely accept the financial statements at face value. To glean insights about where the business may be headed, and what kinds of financial products the company may need, investment bankers tweak the numbers for their own analysis purposes. All accountants must operate under the same rules, but those rules allow for some maneuvering.
Looking at financials in a new way: Pro-forma results
Investment bankers largely look at financial statements as ancient history. And it’s true that even a quarterly statement may be a month old before it’s filed to the SEC’s EDGAR system (see Chapter 6), and by then, the business may have changed.
Given the backward-looking nature of financial statements, investment bankers try to use information from the past to tell something about the future. That’s the role of so-called pro-forma analysis. In Latin, pro forma means “as a matter of form.” In a pro-forma analysis, Investment bankers take the financial statements, including the income statement, and make hypothetical adjustments to them.
An investment banker thinking about pitching a buyout candidate to a company, for instance, may add that target company’s revenue to the buyer’s revenue on the income statement. By making estimates based on the past income statement, the investment banker can attempt to see how much the deal may add to the purchasing company’s bottom line. Forming these hypothetical financial models can help investment bankers see how proposed changes to the business will likely affect its results.
Finding out all about net operating profit after tax
One of investment bankers’ favorite adjustments to the income statement is net operating profit after tax (NOPAT). NOPAT is a way to look at a company’s profit to remove the distortion of debt and interest costs. NOPAT is calculated as follows:
- NOPAT = Operating Income × (1 – Corporate Tax Rate)
Investment bankers like to look at NOPAT to see how profitable a company is, leaving out the influence of the costs of debt financing. Examining NOPAT gives investment bankers an idea of how much debt a business can theoretically support before the interest payments become too onerous.
Finding investment banking opportunities
The income statement is fertile ground for investment bankers looking for holes in a business that may be filled with some financial products. Part of the magic investment bankers subject the income statement to is based on financial ratios (see Chapter 8). Another technique is comparing a company’s financial statements to the industry (as shown in Chapter 9). But there are opportunities to spot just by glancing at the income statement, including the following:
- Capacity to handle more debt: Investment bankers love finding ways to get companies to take on more debt. Adding debt to a company, or leveraging it, creates different ways for the investment bank to make money, including the selling of the bond offering. When used properly, leverage can also boost a company’s profitability. The income statement, particularly the interest expense line item relative to the company’s net income, can be especially telling when an investment banker is going to suggest a company add more debt.
- Ripe for a boost in growth: When investment bankers see the revenue line either stalling or creeping higher at a snail’s pace, they see opportunity. Investors usually demand that companies generate growth, which can get increasingly difficult as companies get bigger. But when CEOs are looking for a fast and easy way to grow, they may turn to investment bankers for buyout candidates that may help the company get the top line moving higher again.
- Candidates for divestiture: Sluggish growth in net income, even as revenue is expanding, is a possible indication that the company may be involved in a low-margin business. A low-margin business is one that generates substandard levels of net income relative to the revenue it brings in. Sometimes a low-margin business can act as an anchor around a company because it ties up employees and resources, with little payback. Enterprising investment bankers may identify these low-margin businesses as candidates to be sold to another company, to private investors, or even to the public as an initial public offering (IPO) or spin-off. Although these low-margin businesses may be anchors to the company, if operated as stand-alone businesses, by management that focuses on that business, they may become quite profitable. As evidence of that, researchers find that spinoffs perform quite well.
Balance Sheets
The balance sheet is a snapshot in time of the financial health of a company. In its simplest form, the balance sheet is a financial statement that shows all the assets the company owns and all the liabilities that it owes based primarily on historical cost or book value.
Investment bankers with a practiced eye and attention to detail can take a quick glance at a balance sheet and identify a company’s financial strengths and weaknesses. The balance sheet gives investment bankers a look at the resources and liabilities a company has at its disposal, critical information when it comes to pitching financial products to the company.
Finding your way around the key parts
Investment bankers have a unique way of looking at the world, and that view extends to the balance sheet. In this section, you find out the key elements of the balance sheet to investment bankers.
Getting to know the assets
Investment bankers might crack open the balance sheet by first examining what the company has. All the companies’ possessions are listed as assets and placed into understandable groups:
- Cash and cash equivalents: Cold, hard cash — or, as controversial football star Randy Moss put it, “Straight cash, homey.” There’s nothing like it, whether inside your wallet or on the balance sheet of a company. Investment bankers pay particular attention to cash because it’s critical in many corporate maneuvers. Cash equivalents are extremely short-term investments that can be quickly and easily turned into cash.
- Accounts receivable: When companies sell goods and services, they usually don’t get paid right away. Instead, the selling company takes an IOU from the customer for a short time. These IOUs are called accounts receivable on the balance sheet.
- Inventory: Companies that make products can’t manufacture them out of thin air. Companies must buy raw material and other ingredients, which is included in inventory. But the inventory line item also counts the value of products waiting to be sold or in various stages of manufacturing.
- Property, plant, and equipment: Companies often make massive investments in equipment and other facilities to bring their products and services to market. Here investors can find out how much those investments cost the company, minus depreciation (see the next bullet point).
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Accumulated depreciation: When companies buy an asset, whether a machine or building, the passage of time takes a toll on that asset and typically reduces its value. Accountants require the companies to estimate how much value has likely evaporated due to the passage of time, and this is known as depreciation.
Depreciation may be a cost, but it doesn’t cost the company any of its cash. This characteristic is important to remember later in this chapter when you read about the statement of cash flows. - Long-term investments: Assets that companies plan to keep for a while, typically more than a year, are included here. Generally, these investments are stocks, bonds, and real estate.
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Goodwill: Goodwill is one of those assets that investment bankers know have value but have trouble describing. Goodwill is a catchall term to describe assets that have value, but generally aren’t tangible. Goodwill is often associated with copyrights, trademarks, and brand names, for instance.
One of the most common ways for companies to accumulate goodwill is when they buy another company for more than the book value of the company on the balance sheet. The difference is goodwill. - Total assets: Investment bankers tally up the value of all the assets the company controls, and that is the total assets.
Finding out about the liabilities
You have to spend money to make money. That’s just the reality of business. And the bills companies face, or the things they owe, show up in the liabilities section of the balance sheet, which includes the following:
- Accounts payable: Just because a company buys something from another firm doesn’t mean it actually has to pay for it right away. The accounts payable line item measures the sum the company owes.
- Short-term borrowings: Companies can borrow in many different ways. Here, accountants require companies to break out what portion of the debt the company owes is due in less than a year.
- Long-term debt: When companies borrow money that’s not due for more than a year, the total must be tallied up in the long-term debt line item.
- Current portion of long-term debt: A company may have a long-term loan, but part of that loan is to be repaid in less than a year. That portion of the loan due in the short-term must be disclosed here.
- Capital leases: Being a renter can be convenient, even for companies. But some leases come with many strings attached, which put the company on the hook for the obligations of the leased property. Those cases must be documented on the balance sheet.
- Pension and other post-retirement benefits: If you’re like most working Americans, you probably don’t get a pension and have to settle for a 401(k) match. But some older companies still owe retirees pension benefits. And oftentimes, these are especially large obligations.
Understanding the equity
Equity is one of those words in finance that can have many different meanings. In investment banking, the term equity is often used synonymously with stock, for instance. But when talking about the balance sheet, the term equity usually refers to the value of the shareholders’ ownership of the company. Another good way to think of equity in terms of the balance sheet is the difference between assets and liabilities.
Understanding a company’s financial strength
The balance sheet for an investment banker serves a similar role as blood work for a doctor. When you go to the doctor, and blood is drawn, the physician can get a snapshot of your health at the current time. The blood work tells the doctor more about long-term trends or attributes about your health. Similarly, investment bankers use the balance sheet to get a broad view of the health of a company.
If a company just released a hit product, it may be posting huge profits and the income statement may show the numbers of a highly successful company. But not until the company finds a way to extract that profit and put it in the bank or invest it do those riches show up on the balance sheet.
The primary way investment bankers pull apart the financial statements is by using financial ratios (see Chapter 8). But there are ways to glean insights into a company’s financial health just using the balance sheet, which we discuss in the next few sections.
Common sizing analysis
One of the key weapons of investment bankers is the technique of common sizing, a type of financial analysis that measures all the elements of a financial statement relative to the total. When common sizing the balance sheet, all the company’s individual assets are divided by the total assets and each of the individual liabilities are divided by the total assets, too.
This seemingly simple exercise can quickly put a company’s balance sheet into perspective. Table 7-1 is a simple example of common size analysis using Hershey’s 2018 balance sheet. Notice how the common sizing puts the numbers in context.
An investment banker would look at this common size analysis, and several things would immediately jump out. First, notice that nearly 8 percent of the company’s total assets are held in cash. An investment banker may wonder if there might be better uses for that cash than sitting idly collecting interest. Another takeaway is that 60 percent of the company’s assets are tied up in property, plant, and equipment. This indicates that the company is pretty capital intensive, meaning large investments in equipment are needed to compete.
TABLE 7-1 Putting Hershey’s Balance Sheet into Perspective
|
Balance Sheet Line Item |
2018 Value ($ millions) |
Common sized Value |
|
Cash and equivalents |
$588 |
7.6% |
|
Accounts receivable |
$594 |
7.7% |
|
Inventories |
$785 |
10.2% |
|
Property, plant, and equipment |
$4,582 |
59.5% |
|
Goodwill |
$1,801 |
23.4% |
|
Other assets |
$127 |
1.6% |
|
Total assets |
$7,703 |
100% |
|
Accounts payable |
$502 |
6.5% |
|
Short-term debt |
$1,198 |
15.6% |
|
Current portion of long-term debt |
$5.4 |
0.07% |
|
Long-term debt |
$3,254 |
42.2% |
|
Other liabilities |
$185 |
2.4% |
|
Total liabilities |
$6,296 |
81.7% |
|
Total equity |
$1,399 |
18.2% |
Comparing debt to equity
One of the most telling exercises for investment bankers looking at the balance sheet is the relationship between a company’s total debt and its equity. By simply dividing a company’s total liabilities by its total equity, investment bankers can see how leveraged a company is, or how much of the cost of the company’s assets are financed using debt and how much are financed using equity.
Using the preceding Hershey example, investment bankers see that the company relies much more heavily — more than three times more — on borrowings than on equity. Knowing this will help guide the investment bankers offering solutions to the company.
Studying book value
A company’s book value of equity, loosely speaking, is much like a person’s net worth. The book value of equity of a company is a rough estimate of what the company’s collection of assets is worth after paying all its liabilities. The key assumption, here, however, is that assets are liquidated at book value and liabilities are extinguished at book value. In reality, some assets, such as land, may be worth much more than book value, and other assets, such as inventory, may be worth much less than book value. Book value of equity is calculated by subtracting total liabilities and goodwill from a company’s total assets.
Book value is roughly designed to give investors an idea of what a company would be worth if all its assets were liquidated (sold off ). That’s one reason why goodwill is excluded from book value, because goodwill is an intangible asset and can’t be easily sold separately. Some investors look for undervalued companies by looking for where stock prices are below a company’s book value.
Locating pitfalls and opportunities
When individuals meet a financial planner, one of the first things they do is create a net worth statement. The net worth statement outlines all the assets owned and all the liabilities owed by the individual. At just a glance, the financial planner can create a set of priorities for the person to achieve. Similarly, an investment banker can get a quick opinion on a company’s opportunities and deficiencies by looking at the balance sheet, including
-
Opportunity to increase leverage: One of the top tricks of investment banks is helping companies sell debt securities to increase their level of leverage. By deploying more debt, depending on where interest rates are, companies can push their profitability up and appease and please stockholders. When a company uses debt to boost profit, that in turn increases the return on equity invested in the business.
Increased debt can work both ways for a company. Investors may be pleased by the increased returns by using debt, but the change also increases risk. Greater leverage can be dangerous if a company’s cash flow falls and the interest payments turn onerous. That’s why leverage is often referred to as a “double-edged sword.” - Finding uses for cash: A big pile of cash sitting on the balance sheet attracts the attention of investment bankers and makes them salivate like one of Pavlov’s dogs. Especially when interest rates are low, as they were during much of the 2010s, having cash sitting idly by can have a high opportunity cost, meaning companies are missing out on better returns elsewhere. Investment bankers will approach cash-rich companies for possible uses of that cash, including mergers and acquisitions (M&A) activity.
Statement of Cash Flows
Most individual investors dwell on the income statement and, to a lesser degree, the balance sheet. Investors are keenly tuned into how much a company is earning (so they can look for potential stock price growth) and how much cash a company has (eyeing fat dividends).
But investment bankers know the power of a third, often overlooked financial statement: the statement of cash flows. The statement of cash flows is the place where the company tells investors where the dollars are coming and going in the business.
Cash flow is very different from net income. A company may book a sale as revenue, but that cash isn’t received yet. The statement of cash flow concerns itself with cold, hard dollars that find their way into the company.
Seeing why the cash flow statement is so important in deal making
Cash is king in investment banking. Make no mistake about it: The ability of a company to take on more debt or even do a deal often hinges on the business’s cash generation characteristics. Companies with large and stable cash flows are often candidates for investment banking techniques, as the manager of the business attempts to extract greater profit from the company using financial tools.
And keep in mind that although the income statement is important in investment banking analysis, it’s largely a tool designed by accountants. Net income is generated when companies follow a set of rules that accountants say determines the profitability of a firm. The statement of cash flows, on the other hand, is much less subjective. When a company hauls in or spends a dollar, there’s no questioning it. A dollar is a dollar. You can spend dollars — you can’t spend profits!
Investment bankers often focus on the statement of cash flow because it’s seen as being a bit more pure and less tainted by accounting nuances and gimmicks than other financial statements, especially the income statement.
Understanding the key parts of the document
Follow the money! That’s the advice often given to detectives and investigators. And the same can be said to investment bankers. Tracing the movement of cash through a company can tell the investment banker a great deal about the company and its economic feasibility. The cash flow statement is a powerful document that shows investment bankers how the business is a cash-using (or cash-burning) machine. This section gives investment bankers a quick run through the parts of the cash flow worth paying the most attention to.
The statement of cash flows is broken into three distinct areas. Each areas reveals specific information about the type of cash flow.
Cash flows provided from (used by) operating activities
If you want to know how much cash it brought from the business itself, this section is the one for you. Here, you find how much of the company’s profit came from conducting business in cash.
Calculating cash flows provided from operating activities starts with net income, taken right from the income statement. Uses of cash are then deducted from net income, and sources of cash are added back. The most important adjustments to cash flow in the eyes of investment bankers include
- Adding back depreciation and amortization: Net income takes a big hit from an expense that doesn’t cost the company a bit of cash: depreciation. Accountants require companies to deduct from their reported profit the estimated monetary value of wear and tear on equipment. But that wear and tear may never actually cost real cash. Depreciation is added back to net income to come up with net cash flow from operations.
- Stock-based compensation: A big part of a company’s overhead is the money paid to executives. But much of the payment to CEOs and the other executives at the top of the firm is never paid in cash, but in stock-based rewards. Because this pay isn’t in cash, it’s added back to net income.
- Change in accounts receivable: When a company sells goods and services, it often doesn’t collect right away. That sale may be good enough to count as net income, but it’s not enough for cash flow from operations. Accounts receivables are subtracted from net income as a result.
Cash flows provided from (used by) investing activities
You have to use cash to make cash. Companies can often borrow money to make improvements to their facilities, but many times a company taps its cash hoard to add capacity, expand facilities, or build new computer systems.
The starting point for calculating cash flows provided from investing activities is cash flows provided from operating activities (from the preceding section). From there, a number of adjustments are made to show investors how much cash is used or generated not just from the company’s operations, but also its investments. Sources of cash are added back, while uses of cash are subtracted, as follows:
- Capital additions: Periodically, the time comes for companies to put money into assets to make them better or make them last longer. These investments are called capital additions. When such improvements to assets are made using cash, the amount must be subtracted from cash flow.
- Proceeds from sales of property, plant, and equipment: Companies sometimes find that they’re sitting on assets they don’t need or want anymore. When these assets are sold, they’re a boost to cash. In this section, investors adjust their cash flow to reflect the influx of cash from divestitures.
- Business acquisitions: Companies buy other companies for a variety of reasons (see Chapter 4). Whatever the reason for the deal, if the buyout is done using cash, that must be reflected as a use of cash in the cash flow statement.
Cash flows provided from (used by) financing activities
Even the simplest companies typically use cash that’s brought in from outside investors or lenders. Even a 5-year-old opening her first lemonade stand likely got started using a loan to buy lemons and sugar from her parents.
This section of the cash flow statement attempts to help investors see the inputs and outflows of different forms of financing, be it from debt or stock. Digging into this area of the cash flow statement gives investment bankers a clear view of where the company is getting and using cash to pay for its operations. This section includes the following:
-
Increases in debt: When companies borrow, it’s an addition to cash from financing and added to cash flow. Investment bankers can keep an eye on whether companies have been adding to debt if they see increases on this line item in the statement of cash flows.
Companies often distinguish when they add short-term versus long-term debt. Often, when companies restructure, they try to exchange costly debt that matures in a few years, called short-term debt, with longer-term debt that matures in five or more years. This common maneuver, which often taps the resources of investment bankers, is designed to save on current interest expense. - Repayment of long-term debt: When companies pay down debt, they’re using cash. This can be a good move for companies looking to reduce their debt and interest expense.
- Cash dividends paid: Increasingly, investors have urged companies to use their excess cash to pay a periodic cash payment, or dividend. Dividends can be suspended by companies if they hit hard times (unlike interest payments that must be made), but they’re still significant uses of cash.
Calculating free cash flow
As you can see, the statement of cash flow is a very comprehensive financial statement. Literally, every dollar flowing in and out of the company is counted and classified into the proper category.
But investment bankers often mix and match items from the three sections of the cash flow statement to get numbers that are most telling for them. One of the best examples of this kind of adjustment is free cash flow (FCF ). Free cash flow measures the company’s cash flow power from its core operations, after making the necessary improvements to its assets to keep the business running smoothly. Remember: A company that doesn’t invest in keeping up its plant and equipment isn’t going to be in business for the long-term.
Free cash flow isn’t provided to you on the statement of cash flows, so if you want to analyze it, you’ll have to calculate it. Here’s how to calculate free cash flow:
-
Start with net cash flows provided from operating activities.
On the statement of cash flows, the last item in the section, cash flows provided from operating activities is net cash flows from operating activities. This number is net income adjusted for all the uses and sources of cash from the company’s normal operations.
-
Subtract capital additions from net cash from operating activities.
You’ll find capital additions from the cash flows provided by investing activities section of the cash flow statement.
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Analyze the findings.
The free cash flow number gives investment bankers a good look at how much cash the company needs to keep running on an ongoing basis. It’s a good idea to do the same calculation for past periods, too, to see if the company’s cash flow usage is rising or falling over time.
If a company’s free cash flow is negative, alarm bells should go off in your head. Negative free cash flow means the business, as it currently stands, is not economically feasible over the long term. Many Internet companies in the late 1990s and early 2000s, were propped up with easy cash financing from IPOs. But when those firms’ cash hoards disappeared, most of the companies did, too, and along with them the value of investor’s stakes in those firms. Cash burning companies returned to public markets in the late 2010s, including electric car maker, Tesla, and ride-sharing app, Uber Technologies. Time will tell if these companies enjoy a happier ending than the failed Internet dot-coms did.
Proxy Statements
The three primary financial statements are the income statement, balance sheet, and the statement of cash flows. These three documents, when looked at together, give investment bankers an excellent view of the profitability, financial resources, and cash-generating characteristics of any firm.
But there’s another document, which isn’t technically a financial statement, that’s very valuable to investment bankers as well. This document, called the proxy statement (sometimes known by its formal name, DEF 14A), is a bonanza for anyone looking to learn more about the company.
There’s much more to the proxy statement than we have room for in this section. Our goal here is to help you identify the parts of the document of most interest to investment banking.
Learning about the key players in a deal
Real-estate brokers know that the biggest part of doing a real-estate deal is getting to know the people involved. It’s exactly the same when looking to broker deals with companies. Personalities, egos, and relationships play a huge part in just about every deal investment bankers do, including helping along mergers, divestitures, and IPOs.
Because personalities are so important, investment bankers must take the time to get to know the people running the company. An excellent place to get started is the proxy statement, which spells out details about the people of power in a company.
A few of the details about people in a deal you can uncover from the proxy include
- Biographies of the top management: The chief executive officer (CEO), chief financial officer (CFO), and chief operating officer (COO) are the primary points of contact for investment bankers approaching a company. The proxy statement provides complete biographies of these top players. You’ll find details including age, educational background, and tenure at the company. This information can be a good starting point to get to know the players.
- Clues on relationships the top management has at other companies: Most proxy statements divulge some of the personal contacts of the top management, information that can be extremely valuable for investment bankers who know where to look. For instance, the proxy breaks out all the other companies the executive works with, usually as a member of the board of directors. You can be sure the management team member knows these other directors well, which is a way to start the networking process.
- Details about the board of directors: Some CEOs like to act like they own the place, but that’s usually not the case. Typically, with most large companies, which are largely owned by public shareholders, the management team answers to the board of directors (a body of professionals hired by the shareholders to oversee the company’s management team). The proxy spells out who these people are and describes their backgrounds — again, very useful information to the investment banker.
Investment bankers pay close attention to the board members who are part of the finance and risk management committees of a company. These subgroups of the board of directors are responsible for overseeing many of the activities that interest investment bankers the most, including decisions to invest in new facilities or divesting assets.
Identifying the management team’s incentives
The biggest reason for diving in to the proxy statement and looking at the way the executives are paid isn’t to get paycheck envy (although that may be a side-effect of doing so — during 2018, for instance, the median total compensation paid to CEOs of companies in the largest 500 companies by revenue was $12 million, up 25 percent from 2013, according to an Equilar analysis). The reason investment bankers pay such close attention to the way CEOs are paid is to understand what makes them tick, financially.
A deal may make perfect sense based on what the financial statements say, but investment bankers may hit resistance if the deal somehow works against a manager’s personal interests. As Nobel laureate Milton Friedman said, “It is a law of economics that people respond to incentives. That’s just how it is, no way around it.”
For instance, an empirical look at the financial statements may make a great case for divesting a business unit. The business may be a total loser, generating low returns relative to the enormous investments needed to keep the business humming. A sale may bring cash into the company that could be paid as a dividend or plowed into another area of the business that’s more profitable.
But an examination of the CEO’s pay structure may explain why there’s resistance to the deal. For instance, if the CEO’s bonus is based in part on the company’s total revenue hitting a certain size, a divestiture would likely reduce revenue and, in turn, reduce the CEO’s bonus.
There are cases when the company’s management may welcome a deal. It’s pretty typical for the employment contracts of top executives to come with lucrative bonuses when a company is bought out, called golden parachutes. These deals can be worth hundreds of millions of dollars.
Analyzing management pay packages
It’s important to understand that the management of companies are hired hands. The CEO and the rest of the management team are employed by the shareholders of the company to run it in the best way to generate returns for the stakeholders. But the CEO isn’t running the company for fun — he expects to get paid (and paid handsomely) for his time and effort.
Before an investment banker even thinks about approaching a CEO to discuss a deal, it’s imperative to understand the size and nature of the CEO’s pay. And that’s very possible using the proxy.
You can spend quite a bit of time analyzing the proxy, looking for all the ways the management is paid. The best way to see, quickly, how much CEOs are paid is to head to the summary compensation table in the proxy statement. The key portions of a manager’s pay breaks down as follows:
- Salary: This is the annual base pay received by the executive. Typically, the salary received is a relatively small portion of the total pay package. Due to various tax rules, companies try to keep the salary below $1 million.
- Bonuses: Many executives are eligible for added cash payments if they meet certain predetermined performance goals. These bonuses can be quite hefty when executives accomplish the tasks.
- Stock awards: Increasingly, more executives are being granted restricted stock, which are special buckets of company stock that are locked until the executives meet certain preset guidelines for performance.
- Stock options: Stock options in this context are contracts that give the executives the right, but not the obligation, to buy company stock at a preset value sometime in the future. Stock options can become extremely lucrative when a company’s stock rises. Stock options have been losing popularity versus stock awards for CEO pay because there’s a concern that they encourage managers to do anything possible just to push up the stock price in the short term — because the stock options only have value if the price of the shares rises over time. The options are priced using a complex mathematical formula that estimates what the options were worth the day they were given to the executive, or the grant-date value.
- All other compensation: Ever wonder how the other half lives? In this part of the proxy, you get to find out. In this section, the companies spell out all the perks they give CEOs, including the use of the company jet, country club memberships, and private security. These perks, although relatively small in terms of absolute dollars, can be a big deal to executives because they’re some of the sweet part of success.
- Total: All the executives’ forms of pay are summed up here and put into the grand total.