Chapter 9
IN THIS CHAPTER
Creating a comparison set of peers for industry analysis
Seeing how companies differ from one another in key areas
Comparing and contrasting companies’ growth and other metrics
Measuring differences of companies’ profitability and valuation
Understanding why investment banking requires knowledge of the complete industry
The theory of relativity is a mind-blowing concept from Albert Einstein that says, among other things, that space and time are best understood in context to each other. The importance of comparison isn’t just heady science.
Consider what happens in a classroom. If a student gets an A on a paper, she may be overjoyed until she finds out that all the other students got A’s, too. Her A isn’t as meaningful when, in context, it’s not all that unusual. The dreaded “bell curve” is a way to separate the average students from the truly exceptional ones.
The importance of comparison doesn’t stop in the classroom. Even the super-rich understand this principle. What’s the fun of having a 50-foot yacht when someone else at the country club has a 100-foot one?
The same theory of relativity applies to investment banking, especially when it comes to studying the financial statements and financial ratios. As you see in Chapter 8, although many insights can be gleaned from the financial statements, much of the deeper analysis requires putting the data into context. And the best way to really size up a company’s financials is to compare them against similar companies.
Industry analysis is the technique investment bankers use to put financials and financial ratios into perspective. In this chapter, you learn the tricks of the investment banking trade when it comes to sizing up companies’ financial results to get deep insights into companies and the industries they operate in.
It’s not enough for investment bankers to dive into the financials of the company they’re interested in. Sure, digging into that one company’s financial statements and ratios is a critical first step to understanding its profitability, efficiency, and valuation.
But imagine you’ve created a beautiful spreadsheet that crunches down the company’s gross profit margin, return on assets, and price-to-book. Now what? Those numbers are helpful when compared with previous years at the company, but in isolation there’s only so much investment bankers can glean from them.
Investment bankers know that understanding a company and its financial situation requires an industry analysis. Taking a broader look at a company’s performance shows investment bankers where a company is especially weak or strong, giving clues of what financial overhauls or tweaks might be needed.
“It’s all relative,” is a common cliché but one that’s especially true when it comes to financial analysis. Financial ratios can vary wildly based on the industry a company is in.
Investment bankers can use industry analysis to help them in several key areas, including the following:
Before you can start doing some serious analysis of the industry, you have to define what the industry is and who the big players in it are. The first part of an investment banker’s industry analysis is to define which companies are to be included in the universe.
Picking the correct companies to include in the comparison universe is important since the mix can have a big sway on the conclusions reached. Putting companies into categories used to be more difficult, but the development of classification systems and the decreased role of hard-to-classify conglomerates has made the job much easier.
There are several ways that investment bankers are able to generate their universes to compare with. Building the list takes quite a bit of research and may require you to consider different companies, and perhaps toss them out of the universe if you decide they’re not applicable.
Finding all the players in an industry may seem overwhelming, but much of the work may be done for you.
There’s a massive industry organization system called the Global Industry Classification Standard (GICS), which groups companies much like zoologists have a way of organizing similar animals. Just as animals are placed into a genus and species, companies are put into sectors and industry groups. GICS was developed by investment professional firms Morgan Stanley Capital International (MSCI) and Standard & Poor’s to assist in the analysis of companies. In other words, all their work makes your job a bit easier. You can take a look at the entire GICS structure at www.msci.com/products/indices/sector/gics/gics_structure.html
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There are 11 sectors, or main groupings that categorize all the major areas of businesses. Those 11 sectors are then broken down into 24 industry groups. And those 24 industry groups break down into 69 industries.
It may help to see a summarized version of the breakdown of sectors and industry groups, as in Table 9-1.
TABLE 9-1 The 11 Sectors
Sector |
Select Industry Groups |
Select Industries |
Energy |
Energy |
Energy Equipment and Services, Oil, Gas, and Consumable Fuels |
Materials |
Materials |
Chemicals, Construction Materials, Containers and Packaging |
Industrials |
Capital Goods |
Aerospace and Defense, Building Products |
Commercial and Professional Services |
Professional services | |
Transportation |
Airlines, Road and Rail | |
Consumer Discretionary |
Automobiles and Components |
Auto Components, Automobiles |
Consumer Durables and Apparel |
Household Durables, Leisure Equipment | |
Retailing |
Distributors, Internet and Catalog Retailers | |
Consumer Staples |
Food, Beverage, and Tobacco |
Beverages, Food Products |
Household and Personal Products |
Personal Products | |
Healthcare |
Healthcare Equipment and Services |
Healthcare Equipment and Supplies |
Pharmaceuticals, Biotechnology, and Life Sciences |
Biotechnology, Life Sciences and Services | |
Financials |
Banks |
Commercial Banks, Thrifts and Mortgage Finance |
Diversified Financials |
Diversified Financial Services, Consumer Finance, Capital Markets | |
Information Technology |
Software and Services |
Internet Software and Services, IT Services |
Technology Hardware and Equipment |
Communications Equipment, Computers and Peripherals | |
Communication Services |
Telecommunication Services |
Diversified Telecommunication Services, Wireless Telecommunication Services, Media, Entertainment |
Utilities |
Utilities |
Electric Utilities, Gas Utilities, Water Utilities |
Real Estate |
Real Estate Management and Development |
Source: MSCI, S&P Global Market Intelligence
Here’s an example: Let’s say you wanted to look into the investment banking industry. (Imagine that, given the book you’re reading right now!) It turns out that the Investment Banking and Brokerage sub-industry is a member of the Capital Markets industry. The Capital Markets industry is a part of the Diversified Financials industry group, which is part of the Financials sector.
When you figure out which sector and industry group the company you’re studying belongs in, you can get a good start on your industry universe. For instance, imagine that you’re preparing an analysis of tech giant IBM. You may be tempted to compare it with other tech giants Microsoft and Apple. And it’s true, IBM is part of the Information Technology sector, as are Microsoft and Apple. But IBM is in the Software and Services industry group and the IT Consulting industry. IBM gets most of its revenue from consulting, not from selling hardware or operating systems. IBM’s peers in the IT Consulting industry includes firms like Accenture, Cognizant Technology, and Infosys.
If anyone knows who a company’s competitors are, it’s the company’s management team. Companies in the same industry are intensely competitive with one another. And you can be sure they know which companies are trying to steal business from them.
IBM, for instance, gives great detail about its competitors for each of its major business units in its regulatory filings. IBM lists Accenture, Capgemini, DXC Technology, Fujitsu, and Alphabet (Google) as rivals to its Global Business Services consulting segment. IBM lists computer service firm SAP, Microsoft, and Oracle as competitors in its Cognitive Solutions unit. Big Blue, IBM, even lists Cisco Systems as a rival for its lending unit, called Global Financing.
If there’s one area in which CEOs don’t want to slip behind their competition, it’s their own pay. Each year, companies’ boards of directors determine how much to pay the CEO and other top management. It’s a much-watched process that many investors pay attention to. But more important to investment bankers than the amount being doled out to the CEO is the process used to determine the pay. Companies pay close attention to the other companies in the industry, and in the process, they do much of the industry analysis for investment bankers.
At this point, you’ve discovered how to take a good first crack at creating an industry comparison universe. Creating the initial list using the GICS or even the list of competitors from the company’s CEO compensation list is a great starting point. You can even combine these approaches to come up with a master list.
But depending on the analysis you plan to do, you’ll need to winnow the list down a bit. There are times when certain companies may technically be rivals, but in reality, the companies aren’t really comparable. You’ll want to toss these outlier companies out of your industry comparison universe. A company may not be an appropriate peer for investment banking analysis when that company is
Astrologers know there’s only so much you can learn by gazing at just one star in a telescope. Part of the true mystery of the heavens is answered by knowing how the stars have changed over time, as well as how they behave in relation to each other.
Studying companies may not be as galactic as star gazing, but insightful investment bankers know that it also requires putting financial results into context. Investment bankers traditionally look to put financial statements into perspective by
Serious investment bankers don’t just look at one year’s financial statements. For in-depth analysis of financials, investment bankers rely on several years of financial data, which are the raw ingredients of trend analysis, in which analysts try to see whether key indicators of the company’s performance are on the upswing or headed downward. And to take this trend data to the next level, investment bankers are looking for ways to compare with related companies’ trends as well.
Percentage Change = ([New Number – Old Number] / Old Number) × 100
Let’s use a basic example: Imagine a corn plant was 10 inches tall before a farmer poured a bucket of fertilizer on it. After two weeks, the plant grew to be 18 inches tall. Here’s how much the plant grew:
Percentage Change = ([18 – 10] / 10) × 100 = 80%
This formula is critical when measuring trends.
Instead of stepping you through the theoretical ways that trend analysis may aid the investment banker, it’s prudent to take a real example. It’s an old example — but a relevant one — because enough time has passed so we can see how everything turned out.
Perhaps you recall that, in 2013, Michael Dell expressed interest in taking his computer company, Dell Computer, private in a leveraged buyout. News reports indicated that Dell’s revenue growth was slowing relative to the industry and that being private would allow the company to make investments needed to remain competitive. (Investment in new equipment and expansion is called capital expenditures).
An investment banker would use trend data to quantify this financial story. The first step would be to get Dell’s revenue and capital expenses for several years, both of which are available from Dell’s income statement and statement of cash flow from the company’s latest 10-K filing. If you need a refresher course on how to access the 10-K, flip back to Chapter 6. To save you time, Table 9-2 is a presentation of several years of Dell’s revenue and capital spending.
TABLE 9-2 Dell’s Revenue and Capital Spending
|
Fiscal 2013 ($ millions) |
Fiscal 2012 ($ millions) |
Fiscal 2011 ($ millions) |
Revenue |
56,940 |
62,071 |
61,494 |
Capital expenditures |
513 |
675 |
444 |
Source: Dell 10-K filing for fiscal 2013, ending February 1, 2013
Table 9-2 looks pretty, but at its face, you can’t glean much trend information until you convert the absolute numbers into percentage changes. And when you do the math, you generate a table like the one in Table 9-3.
TABLE 9-3 Dell’s Revenue and Capital-Spending Trends
|
Fiscal 2013 (% change) |
Fiscal 2012 (% change) |
Revenue |
–8.3 |
0.9 |
Capital expenditures |
–24 |
52 |
Now the Dell story becomes crystal clear and quantified. Revenue did fall off 8.3 percent in fiscal 2013, certainly not a positive development. But even more alarmingly, the company cut back its capital expenditures by 24 percent. That’s a disturbing trend because technology companies rely on innovation and new products for revenue growth in future years. At this point, investment bankers can begin to see the problem that Dell is trying to address.
Before investment bankers can jump to any conclusions about what they’ve seen in the trends, it’s important to measure those trends against other companies. After all, maybe Dell’s 8.3 percent decline in revenue is actually less severe than that reported by other tech companies. And perhaps, the rest of the industry is cutting back in capital spending, so a 24 percent reduction isn’t all that unusual. Knowing this would put the trend data in a much different light.
TABLE 9-4 Computer Hardware Trends
|
Revenue Change Comparable 2013 Period (% change) |
Capital Expenditures Change in Comparable 2013 Period (% change) |
Apple |
18.8 |
89.3 |
Hewlett-Packard |
–5.0 |
–23.1 |
NCR |
7.7 |
44.4 |
Source: Company filings (Apple 12-month period ended March 2013; Hewlett-Packard 12-month period ended January 31, 2013; NCR 12-month period ended March 2013)
Sizing up Dell’s results, it’s clear the company was in danger of falling behind the investments being made by other computer hardware companies, Apple and NCR. But it’s interesting to note that Dell’s closest direct rival, Hewlett-Packard, was similarly pulling back on its capital expenditures in light of declining revenue. Investment bankers can use this industry analysis to draw deeper conclusions.
Dell took the plunge in October 2013 and went private. It was a radical move because the company had been a publicly traded stock for 25 years. Dell was a widely held stock as it was a member of the Standard & Poor’s 500. But that all ended in 2013 after Dell said it would exit the Nasdaq exchange in a $24.4 billion leveraged buyout deal. Michael Dell himself plus private investors, aided with a loan from Microsoft, bought the company. The thinking was this: As a private company, Dell wouldn’t be subject to short-term financial goals to appease shareholders. Dell could make costly investments in its business to reinvigorate — if not save — itself.
The company remained private for about five years. Management evaluated every aspect of the company, with the luxury of escaping the relentless scrutiny of the public markets and quarterly profit demands. Massive layoffs, restructurings, and investment in faster growing areas of technology helped Dell reduce reliance on the slower growing personal computer industry.
It took years, but Dell reemerged in 2018. The company returned to public markets by first buying a competitor, EMC, in 2016. That move put Dell at the top of the fast-growing computer storage industry. EMC also owned a majority share of cloud-computing company VMware. Dell took its time fixing its core business and integrating EMC. And then on December 28, 2018, Dell went public by buying the rest of VMware, which was public. The company used VMware’s public stock listing, changed the name to Dell Technologies, and put the symbol back to DELL.
Did the complicated move work? So far, it appears so. Not only did Dell survive (albeit in a different form), it’s growing again. And it has dramatically boosted its capital expenditures, shown in Table 9-5, which it needs to do to stay competitive.
TABLE 9-5 The New Dell’s Revenue and Capital-Spending Trends
|
Fiscal 2019 ($ Millions) |
Change From Fiscal 2015 |
Revenue |
$90,621 |
67% |
Capital expenditures |
$1,229 |
157% |
The balance sheet is where companies list out all the assets it owns and the liabilities it owes. Examining the balance sheet by itself can be a valuable exercise. One of the best uses of the balance sheet is finding out how much debt a company has, or how leveraged a company is. Leverage can magnify profits during the good times but spell major financial troubles if the company slows down or if interest rates rise.
The true power of the balance sheet, though, shines through when using the financial statement to compare the financial resources of a company with that of its peers. But here’s the problem: How do you compare the assets and liabilities of different companies that may be in the same industry but are of dramatically different sizes? If a company has a total load of debt of $1.9 billion, is that high, low, or average compared with the industry?
Using a real example, it’s easier to see how common sizing works. Hershey, the giant food company, showed a breakdown of its liabilities (refer to Table 7-1). That table showed that in 2018, the food company’s short-term debt is equal to 15.6 percent of its total assets, the current portion of the company’s long-term debt is equal to just 0.07 percent of total assets, and long-term debt has reached 42.2 percent of assets. That information is very useful to the investment banker because it shows the company is largely counting on debt that doesn’t come due for more than a year. (Keep in mind that while short-term debt, the current portion of long-term debt, and long-term debt are among Hershey’s biggest liabilities, there are others, so the percentages don’t add to 100 percent.)
But the investment banker may want to take things a step further by common sizing the balance sheets of rivals, creating a table like the one shown in Table 9-6.
TABLE 9-6 Comparing Balance Sheets
Competitor |
Short-Term Debt as % of Total Assets |
Current Portion of Long-Term Debt as % of Total Assets |
Long-Term Debt as % of Total Assets |
Mondelez |
5.1 |
4.8 |
20.0 |
General Mills |
4.9 |
4.6 |
38.6 |
Hershey |
15.6 |
0.07 |
42.2 |
Source: S&P Global Market Intelligence, based on packaged foods and meats industry as of December 2018 for Mondelez, May 2019 for General Mills
The common sizing industry analysis shows the investment banker that Hershey has more of its liabilities held in the form of long-term debt, showing the company seems to be trying to take advantage of low interest rates.
Comparisons are also important to investment bankers trying to gauge how profitable companies are. And again, common sizing is a tool that investment bankers can use to rank and compare a company’s profit-producing power.
To show the power of common sizing with the income statement, you can try it out using the airline industry. The airline industry is known for its often tight profit margins and cutthroat competition. To dig deeper, you can common size the income statement of Delta Air Lines and then see how that matches up to the industry. Notice how after Delta’s income statement is common sized in Table 9-7, you get a keen look into the company’s profitability and where its biggest expenses lie.
TABLE 9-7 Common Sizing Delta’s 2012 Income Statement
Income Statement Item |
Absolute 2012 Amount ($ millions) |
Common Sized (% of revenue) |
Total revenue |
44,438 |
100 |
Cost of goods sold |
33,039 |
74.3 |
Gross profit |
11,399 |
25.7 |
Selling, general, and administrative expenses |
1,941 |
4.4 |
Operating income |
5,406 |
12.2 |
Net income |
3,935 |
8.9 |
Source: Delta Air Lines, S&P Global Market Intelligence
The common sizing analysis of Delta Airlines confirms that the airline is definitely a relative low net margin business. The company earned just 8.9¢ of every dollar of revenue in 2018 as net income. A vast majority of the company’s revenue is chewed up by the company’s cost of goods sold, which includes jet fuel. It’s important to note, though, that this is actually an improvement. Back in 2012, the company’s net profit was just 3 percent of revenue.
But to understand how Delta stacks up, it’s important to common size the income statements of its rivals, to create a chart like the one in Table 9-8.
TABLE 9-8 Common Sizing Delta’s Rivals
|
Gross Profit % of 2018 revenue |
Operating Income % of 2018 Revenue |
Net Income % of 2018 Revenue |
United Airlines |
32.4 |
9.1 |
5.2 |
Southwest Airlines |
32.3 |
14.4 |
11.2 |
Delta Air Lines |
25.7 |
12.2 |
8.9 |
Source: S&P Global Market Intelligence
The common sizing analysis of the companies in the airlines industry definitely shows how the industry has little control over its direct costs, such as jet fuel. The gross profit as a percentage of revenue is pretty consistent in the mid-20 to low-30 percent range. Where the airlines have the most power to control costs is in overhead costs. This information is helpful for investment bankers because they may look for financial products to help airlines boost their profitability.
How do investment bankers know if the annual bonus they got was big? There’s an old saw on Wall Street that says you got a good bonus as long as it’s bigger than the one the person sitting next to you got.
That’s a flippant way to look at pay, but that way of thinking spans beyond the cubicles in the investment bank’s high-rise to the way that companies’ financials are analyzed. Companies’ financial results, especially when synthesized and looked at as financial ratios, can’t be fully understood in isolation. Investment bankers must compare companies’ financial ratios with the financial ratios at other firms in the industry. Such comparisons give investment bankers deeper insights into how a company is performing outside the ups and downs of the industry.
Valuation (the process of putting a price tag on a company) is one area where most investors appreciate the value of comparison. In Chapter 8, we fill you in on the value of financial valuation ratios, including the price-to-earnings (P/E) ratio and the enterprise value–to–EBITDA (EV/EBITDA) ratio.
The P/E ratio tells you how much investors are paying for a claim to $1 of a company’s earnings. When it comes to valuation ratios, the P/E is certainly one of the most famous because many people use it as a benchmark to tell them if a stock is relatively cheap or expensive.
The trouble is, though, that the P/E doesn’t tell you much by itself. The ratio is most valuable when compared to that of similar companies or even the entire stock market. Keep in mind, too, that P/E ratios rise and fall as stock prices fluctuate and earnings change.
TABLE 9-9 S&P 500’s P/E through Time
Date |
Operating P/E (Trailing) |
December 31, 2018 |
16.5 |
December 31, 2017 |
21.5 |
December 31, 2011 |
13.0 |
December 31, 2010 |
15.0 |
December 31, 2000 |
23.5 |
December 31, 1990 |
14.6 |
Source: S&P Dow Jones Indices
The P/E is a helpful benchmark of company’s value in large part due to simplicity. If you have access to a computer and financial websites, you can get a company’s P/E pretty quickly. But investment bankers usually dig deeper, using EV/EBITDA, where EV is enterprise value and EBITDA is earnings before interest, taxes, depreciation, and amortization. You can read more about what these measures are and what they tell you in Chapter 8.
But for now, know that EV/EBITDA is best appreciated when used to look at a valuation of a company compared with its peers. Calculating EV/EBITDA requires a calculation using data, pulled from the financial statements, like what you see in Table 9-10.
TABLE 9-10 Calculating EV/EBITDA for Hershey in 2018
Data Point |
Financial Statement Line Item ($ millions) |
Market value |
22,487.2 |
Cash and short-term investments |
823.79 |
Total debt and minority interest |
4,706.23 |
Total revenue |
7,791.1 |
Cost of goods sold |
4,198.2 |
Selling, general, and administrative (SG&A) |
1,797.4 |
Depreciation and amortization |
0 |
Source: S&P Global Market Intelligence as of December 31, 2018
The first task for the investment banker is to calculate enterprise value. Using the formula in Chapter 8, you know the following:
Enterprise Value = Market Value – Cash and Short-Term Investments + Total Debt and Minority Interest
Referring to Table 9-10, you can find all the data you need to plug into the formula to find:
Enterprise Value = $22,487.2 – $823.79 + $4,706.23 = $26,369 million
Take a deep breath. You’re halfway there. Now it’s time to calculate EBITDA. The formulas for EBITDA is as follows:
EBITDA = Total Revenue – Cost of Goods Sold – Selling, General, and Administrative + Depreciation and Amortization
Again, inputting the data from Table 9-10, you find:
EBITDA = $7,791.1 – 4,198.2 – 1,797.4 + 0 = $1,795.5 million
Last, you divide enterprise value by EBITDA to find that Hershey had an EV/EBITDA ratio as of December 31, 2018, of 14.7. But what does that mean? To find out, you perform the same calculation with other firms in the packaged foods and meats industry and you find something like you see in Table 9-11.
TABLE 9-11 Comparing EV/EBITDA
Competitor |
EV/EBITDA |
Mondelez |
14.7 |
General Mills |
11.0 |
Source: S&P Capital IQ as of Dec. 31, 2012
Comparing Hershey’s EV/EBITDA to select peers in its industry shows that investors are willing to pay a greater premium for shares of Hershey over General Mills. But the valuation is on par with that of Mondelez. This is important information for the investment bankers to consider when evaluating options for perhaps issuing stock or conducting a merger.
Managing a company’s mix of debt and equity financing is a big part of what investment bankers do for their clients. Learning to size up a company’s total debt-to-equity ratio is a key part of understanding its capital structure (the mix of the sources of funds a company uses to operate itself). Chapter 8 shows how to calculate and analyze debt-to-equity ratios. But it’s important, too, to see how the debt-to-equity ratio can vary greatly among companies, as you can see in Table 9-12.
TABLE 9-12 Comparing Total Debt-to-Equity
Company |
Total Debt-to-Equity in 2018 |
Hershey |
316.8% |
Mondelez |
72.8% |
General Mills |
183% |
Source: S&P Capital IQ, data for December 31, 2018, except through May 2019 for General Mills due to fiscal year
Investment bankers can see, at a quick glance, that Hershey is much more dependent on debt than its peers, relative to equity financing. It’s a reminder that Hershey will be more interested in investment banking products that may help it manage its leverage.
Efficiency ratios help investors, and investment bankers, see how well management is handling the cash entrusted to it by its investors and bondholders. For this reason, efficiency ratios, such as return on equity can be somewhat of a report card to judge management. You can find out everything there is to know about return on equity (ROE) in Chapter 14.
But just remember that before being critical of management, using ROE, you have to put this ratio into context. Some industries generate higher returns than others and some businesses require larger investments in plants and equipment. It’s natural for some industries to have higher returns on equity.
If you notice anything in reading this chapter, it’s that there’s practically no end to the ways investment bankers can study and pick apart a company. You can dig deep into the financial statements and off-the-shelf financial ratios like P/E and EV/EBITDA. But investment bankers with deep industry insights often follow financial measures that are more closely tied to the specific industry. Many industries have key benchmarks that are particularly useful to them.
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