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• The uses of financial statements
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mergers, and acquisitions discounted cash flow analysis

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 Investment
Banking

by Matthew Krantz
and
Robert R. Johnson, PhD, CFA, CAIA
Investment Banking For Dummies®
Published by: John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, www.wiley.com
Copyright © 2014 by John Wiley & Sons, Inc., Hoboken, New Jersey
Published simultaneously in Canada
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Library of Congress Control Number: 2013954075
ISBN 978-1-118-61577-5 (pbk); ISBN 978-1-118-61570-6 (ebk); ISBN 978-1-118-61571-3 (ebk);
ISBN 978-1-118-61588-1 (ebk)
Manufactured in the United States of America
10 9 8 7 6 5 4 3 2 1
 Contents at a Glance
Introduction................................................................. 1
Part I: Getting Started with Investment Banking............. 5
Chapter 1: Introducing Investment Banking.................................................................... 7
Chapter 2: The Purpose of Investment Banking: What Investment Bankers Do...... 23
Chapter 3: How Investment Bankers Sell Companies.................................................. 43
Chapter 4: How Investment Banking Is Used in Mergers and Acquisitions.............. 61
Chapter 5: How Investment Banking Is Used in Leveraged Buyouts......................... 79

Part II: Digging In: Performing Investment Banking...... 93

Chapter 6: Finding the Data: Documents and Reports................................................. 95
Chapter 7: Making Sense of Financial Statements...................................................... 113
Chapter 8: Perfecting the Financial Ratios for Investment Banking......................... 133
Chapter 9: Sizing Up the Industry................................................................................. 151
Chapter 10: Understanding Stocks and Focusing on Past Transactions................. 169
Chapter 11: Applying Investment Banking to Fixed Income..................................... 183

Part III: Taking Investment Banking to the Next Level....201

Chapter 12: Doing a Discounted Free Cash Flow Analysis........................................ 203
Chapter 13: Structuring a Leveraged Buyout.............................................................. 223
Chapter 14: Determining the Strength of a Company’s Return on Equity............... 237

Part IV: Applying Investment Banking....................... 253

Chapter 15: Knowing the Rules..................................................................................... 255
Chapter 16: Seeing How Some Companies Lie, Cheat, and Steal
Their Way to the Top................................................................................................... 269
Chapter 17: Understanding Alternative Investments and Asset Management....... 289
Chapter 18: Trying Your Hand at Investment Banking with a Case Study.............. 303

Part V: The Part of Tens............................................ 315

Chapter 19: Ten of the Biggest Debacles in Investment Banking History............... 317
Chapter 20: Ten Ways to Improve a Discounted Cash Flow Analysis...................... 325
Chapter 21: Ten (Or So) of the Best Online Resources for Investment Bankers....... 333

Appendix: Where Investment Banking Came From....... 341

Index....................................................................... 349
 Table of Contents
Introduction.................................................................. 1
About This Book............................................................................................... 1
Foolish Assumptions........................................................................................ 3
Icons Used in This Book.................................................................................. 3
Beyond the Book.............................................................................................. 4
Where to Go from Here.................................................................................... 4

Part I: Getting Started with Investment Banking............. 5

Chapter 1: Introducing Investment Banking. . . . . . . . . . . . . . . . . . . . . . . . 7
What Investment Banking Is............................................................................ 8
The role investment banking plays...................................................... 8
How investment banking differs from ­traditional banking.............. 10
The services investment banks provide............................................ 11
How investment banks are organized................................................ 12
The current lay of the investment banking land............................... 14
Types of investment banking operations.......................................... 15
How investment banks get paid.......................................................... 15
How Investment Banking Is Done................................................................. 17
Finding the financial statements......................................................... 17
Understanding the importance of financial statements
and ratios.......................................................................................... 18
Zeroing in on past transactions.......................................................... 18
Seeing the value of fixed income........................................................ 19
Turning Into an Investment Banking Pro..................................................... 19
Putting the discounted cash flow analysis to work.......................... 19
Seeing how leverage becomes a force in investment banking........ 20
Pinpointing buyout targets.................................................................. 20
Putting Investment Banking to Work........................................................... 21
Staying in compliance with the rules................................................. 21
Looking beyond the published financial statements....................... 21
Making adjustments to financial statements for
comparability.................................................................................... 22

Chapter 2: The Purpose of Investment Banking:

What Investment Bankers Do. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Putting the For-Sale Sign on Corporate America........................................ 24
Mergers and acquisitions.................................................................... 25
Leveraged buyouts............................................................................... 28
Private business sales.......................................................................... 30
Initial public offerings.......................................................................... 32
vi Investment Banking For Dummies

Helping Investors Decide Whether to Buy or Sell...................................... 36

The importance of research................................................................ 36
What do the analysts do?.................................................................... 37
Digging Into the Role of the Trading Desk................................................... 38
Why investment banks are into trading............................................. 39
How investment banks turn pennies into billions............................ 40
The type of analysis used in trading ­operations.............................. 41

Chapter 3: How Investment Bankers Sell Companies . . . . . . . . . . . . . . 43

Getting Companies Ready for Sale on Public Markets............................... 44
Meeting the requirements to make an IPO happen.......................... 45
Writing the prospectus........................................................................ 47
Supporting the IPO: Making success last........................................... 51
Seeing What Sell-Side Analysts Do............................................................... 53
The goals of the sell-side analyst........................................................ 53
What investors look to sell-side analysts for.................................... 54
Spreading the word: Disseminating ­sell-side research.................... 55
Examining a Sample Research Report......................................................... 56
What to look for in the document....................................................... 56
The main sections of a research report............................................. 57
Ways to look beyond the “buy” or “sell”........................................... 59

Chapter 4: How Investment Banking Is Used in Mergers

and Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Come Here Often? The Basics of Mergers and Acquisitions..................... 61
Kinds of mergers................................................................................... 62
Why companies merge instead of simply growing
organically.......................................................................................... 63
Firms that make attractive acquisition targets................................. 66
How companies identify firms to merge with................................... 67
The nature of the merger: Friendly or hostile?................................. 68
Tools Used to Analyze the M&A Deal.......................................................... 71
The role of the buy-side M&A advisor............................................... 71
The role of the sell-side M&A advisor................................................ 74
Why Many M&A Deals Go Wrong................................................................. 75
Misplaced incentives............................................................................ 75
Faulty analysis....................................................................................... 76
Overstated synergies........................................................................... 77
Culture wars.......................................................................................... 77
The winner’s curse: Overpaying......................................................... 78

Chapter 5: How Investment Banking Is Used

in Leveraged Buyouts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
In This Corner: Introducing the Players...................................................... 80
Investment banks.................................................................................. 81
Big institutions...................................................................................... 82
 Table of Contents vii
Management.......................................................................................... 83
Stock and bond investors.................................................................... 84
Aiming for the Right Targets in a Leveraged Buyout................................. 85
Identifying companies that can work in a leveraged buyout.......... 85
Appreciating the power of cash flow................................................. 87
Coming to terms with the return analysis: Internal
rate of return...................................................................................... 88
Finding the Exit............................................................................................... 90
Setting a target for exit in time............................................................ 90
Considering how the exit will happen................................................ 90

Part II: Digging In: Performing Investment Banking....... 93

Chapter 6: Finding the Data: Documents and Reports . . . . . . . . . . . . . . 95
Finding What You Need on the Securities and
Exchange Commission’s Website............................................................. 96
What types of information you can find............................................ 96
The key types of documents............................................................... 97
How to use EDGAR to pinpoint information...................................... 98
Getting Data in a Format You Can Work With.......................................... 103
Assembling the tools you need......................................................... 103
Importing financial information into Excel...................................... 105
Getting in tune with interactive data................................................ 106
Paying Attention to the Non-Financial Information.................................. 107
Monitoring news streams for investment banking ideas............... 107
Quickly processing information with aggregators......................... 109
Doing research on the key players in a deal................................... 111

Chapter 7: Making Sense of Financial Statements. . . . . . . . . . . . . . . . 113

Income Statements....................................................................................... 114
Locating the areas of interest to ­investment bankers................... 116
Tweaking the statement with different assumptions..................... 117
Finding investment banking opportunities..................................... 118
Balance Sheets.............................................................................................. 119
Finding your way around the key parts........................................... 120
Understanding a company’s financial strength.............................. 122
Locating pitfalls and opportunities.................................................. 124
Statement of Cash Flows.............................................................................. 124
Seeing why the cash flow statement is so important
in deal making.................................................................................. 125
Understanding the key parts of the document............................... 125
Calculating free cash flow.................................................................. 128
Proxy Statements.......................................................................................... 128
Learning about the key players in a deal......................................... 129
Identifying the management team’s incentives.............................. 130
Analyzing management pay packages.............................................. 131
viii Investment Banking For Dummies

Chapter 8: Perfecting the Financial Ratios for

Investment Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
Valuation Multiples: Assessing How Much the Company Is Worth....... 134
Investors’ favorite valuation tool: P/E ratio.................................... 134
Going old school with price-to-book................................................ 135
Putting a price on profitability.......................................................... 136
Liquidity Multiples: Checking Companies’ Staying Power...................... 138
Deciphering debt to equity................................................................ 139
Getting up to speed with the quick ratio......................................... 140
Interpreting interest coverage.......................................................... 140
Profitability Ratios: Seeing How a Company’s Bottom
Line Measures Up..................................................................................... 141
Why gross margin isn’t so gross after all........................................ 142
Income from continuing operations: Looking at
profit with a keen eye..................................................................... 142
Keying into profits with net margin.................................................. 143
Efficiency Ratios: Knowing How Well the Company Is
Using Investors’ Money............................................................................ 144
Finding out about return on assets.................................................. 145
Digging into return on capital........................................................... 146
Uncovering company secrets with return on equity..................... 148
Calculating a company’s growth rate............................................... 148

Chapter 9: Sizing Up the Industry. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

Performing an Industry Analysis................................................................ 152
Understanding why industry analysis is important....................... 152
Creating a comparison universe....................................................... 153
Adjusting the industry comparison universe.................................. 157
Unearthing Company Trends and Common sizing
the Financial Statements.......................................................................... 158
Comparing growth rates.................................................................... 158
Comparing leverage............................................................................ 161
Comparing various profit margins................................................... 162
Seeing How a Company Stacks Up: Comparing the Key Ratios.............. 164
Sizing up valuation.............................................................................. 164
Comparing total debt-to-equity......................................................... 167
Sizing up companies on their efficiency.......................................... 167
Industry ratios..................................................................................... 168

Chapter 10: Understanding Stocks and Focusing on

Past Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
Introducing Stock......................................................................................... 170
Characteristics of stock..................................................................... 170
Types of stock..................................................................................... 172
Understanding stock pricing............................................................. 173
 Table of Contents ix
Finding Past Transactions........................................................................... 174
Tracking the stock market................................................................. 174
Studying private deals........................................................................ 174
Looking at pre-IPO marketplaces...................................................... 176
Examining buyouts............................................................................. 176
Analyzing Past Transactions....................................................................... 177
Knowing what the market will bear.................................................. 177
Knowing when the market is distorted............................................ 178
Tabulating key ratios for past deals................................................. 179
Understanding the pitfalls................................................................. 182

Chapter 11: Applying Investment Banking to Fixed Income. . . . . . . . 183

Introducing Bonds........................................................................................ 184
Identifying the Various Types of Bonds.................................................... 186
Convertible bonds.............................................................................. 187
Callable bonds..................................................................................... 187
Puttable bonds.................................................................................... 187
Floating-rate bonds............................................................................. 187
Zero-coupon bonds............................................................................ 188
Knowing Their Place: The Position of Bondholders................................ 188
Understanding Bond Pricing....................................................................... 190
Introducing the concept of present value....................................... 190
Relating yield to maturity and price................................................. 193
Playing the spread: How different factors affect bond prices...... 194
Considering bond sensitivity to changes in interest rates............ 195
Tracking the Bond Market........................................................................... 198
Debt or Equity: How a Company Chooses................................................. 200

Part III: Taking Investment Banking to the Next Level...... 201

Chapter 12: Doing a Discounted Free Cash Flow Analysis . . . . . . . . . 203
Gearing Up for Discounted Free Cash Flow............................................... 204
Computing free cash flow.................................................................. 206
Forecasting free cash flow................................................................. 207
Calculating the Weighted Average Cost of Capital................................... 208
Understanding why the weighted average cost of
capital is so important.................................................................... 209
Measuring the cost of debt and equity............................................ 210
Understanding the capital asset pricing model.............................. 213
Going for Terminal Value............................................................................. 216
Knowing the perpetuity growth formula......................................... 216
Applying the constant growth formula............................................ 217
Applying the two-stage growth model............................................. 217
Stress-testing the results................................................................... 219
Valuing a Share of Stock.............................................................................. 220
x Investment Banking For Dummies

Chapter 13: Structuring a Leveraged Buyout . . . . . . . . . . . . . . . . . . . . . 223

Seeing How Leveraged Buyouts Are Structured....................................... 224
The types of financing........................................................................ 224
Understanding seniority and maturity............................................. 230
Building a Leveraged Buyout Model.......................................................... 231
Creating a pro forma model.............................................................. 232
Deciding on methods of financing.................................................... 233
Seeing how the results work out....................................................... 234
The importance of taxes in a leveraged buyout............................. 235
What can go right and what can go wrong...................................... 235

Chapter 14: Determining the Strength of a Company’s

Return on Equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
Understanding the Importance of Return on Equity................................ 238
What return on equity shows............................................................ 239
Pros and cons of return on equity versus other
profitability measures.................................................................... 241
How return on equity can help guide an investment
banking deal..................................................................................... 244
Using a DuPont Analysis.............................................................................. 244
The three-factor DuPont method...................................................... 245
The five-factor DuPont method......................................................... 247
Interpreting the Results............................................................................... 249
Cola wars............................................................................................. 249
What the numbers mean.................................................................... 250
Looking past the numbers for insight.............................................. 251
Telling companies how to react to the numbers............................ 251

Part IV: Applying Investment Banking........................ 253

Chapter 15: Knowing the Rules. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
The History of Regulation of Investment Banking.................................... 255
The goals of investment banking regulation................................... 256
Why the rules of today are the result of days past........................ 256
How regulations have shaped the investment
banking industry............................................................................. 256
The Ins and Outs of Modern Investment Banking Rules......................... 258
The types of rules imposed on investment banking...................... 258
How investment banking rules changed after the
financial crisis.................................................................................. 261
The Rules on Analysts.................................................................................. 263
Why rules were needed...................................................................... 263
The not-so-delicate balancing act analysts play............................. 264
What disclosure and compliance are required............................... 265
Why Simply Making Rules Isn’t Enough..................................................... 267
 Table of Contents xi
Chapter 16: Seeing How Some Companies Lie, Cheat,
and Steal Their Way to the Top . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
Did You Really Sell That? When Companies Aggressively
Report Revenue......................................................................................... 270
Don’t let the sun go down on me...................................................... 271
The truth?............................................................................................ 272
Lucy, You Got Some ’Splainin’ to Do: When Companies Understate
Their Expenses.......................................................................................... 274
What a waste....................................................................................... 274
Crazy like a fox.................................................................................... 275
Missed It by That Much: When Companies Overstate
Their Financial Position........................................................................... 276
Those pesky pensions: The epidemic of firms understating
pension liabilities............................................................................ 276
We are the world................................................................................. 280
Keeping Investors Off-Balance.................................................................... 281
Enron’s special purpose.................................................................... 282
A mountain of a scandal..................................................................... 284
Swap meet............................................................................................ 286
What Should an Investment Banker Do?................................................... 287

Chapter 17: Understanding Alternative Investments and

Asset Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
Knowing Your Alternatives......................................................................... 289
Hedge funds......................................................................................... 290
Venture capital.................................................................................... 292
Commodities....................................................................................... 293
Real estate........................................................................................... 295
Digging Into Asset Management................................................................. 296
Attracting investors to asset management...................................... 296
Creating asset management tools..................................................... 297
Managing Potential Conflicts with Clients................................................. 299
How asset management can cause conflicts................................... 299
How to eliminate and manage conflicts........................................... 301

Chapter 18: Trying Your Hand at Investment Banking

with a Case Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
Setting the Scene.......................................................................................... 303
The acquirer........................................................................................ 304
The target............................................................................................ 304
Considering the Options.............................................................................. 305
Identifying the options....................................................................... 305
Looking at financing........................................................................... 306
Creating the Analysis................................................................................... 307
An analysis of the financial statements........................................... 307
xii Investment Banking For Dummies

Structuring a Deal......................................................................................... 310

Form of acquisition............................................................................. 311
Creating pro forma statements......................................................... 311
Success or Failure......................................................................................... 314

Part V: The Part of Tens............................................. 315

Chapter 19: Ten of the Biggest Debacles in Investment
Banking History. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
The Dot-Com Boom and Bust...................................................................... 318
Tainted Research Scandals......................................................................... 319
Enron and the Accounting Scams............................................................... 319
The Mortgage Debacle and Collapse of Lehman...................................... 320
The Flash Crash............................................................................................ 321
The London Whale at JPMorgan and Barings Bank................................. 321
Long-Term Capital Management................................................................. 322
Bankruptcy in Jefferson County, Alabama................................................ 323
IPO Allocations with CSFB........................................................................... 323
Bad Mergers and Acquisitions Like AOL Time Warner........................... 324

Chapter 20: Ten Ways to Improve a Discounted

Cash Flow Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
Financial Analysis Isn’t Physics.................................................................. 325
Show Your Sensitive Side............................................................................ 326
Monte Carlo Isn’t Just for High Rollers...................................................... 327
What Can Go Wrong Will Go Wrong........................................................... 327
It’s Tough to Make Predictions, Especially about the Future................. 328
The Investor of Today Doesn’t Profit from Yesterday’s Growth............ 329
Garbage In, Garbage Out.............................................................................. 330
Rates Are Falling — It’s a Better Deal!........................................................ 330
Read Your Putt from Several Angles.......................................................... 331
The Weighting Is the Hardest Part............................................................. 332

Chapter 21: Ten (Or So) of the Best Online Resources

for Investment Bankers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
Bloomberg..................................................................................................... 333
Reuters........................................................................................................... 334
Standard & Poor’s......................................................................................... 335
Renaissance Capital and IPOScoop.com................................................... 335
The Securities and Exchange Commission............................................... 336
Moody’s......................................................................................................... 336
 Table of Contents xiii
FreeStockCharts.com................................................................................... 337
Index Fund Advisors.................................................................................... 337
Morningstar................................................................................................... 338
Bureau of Labor Statistics........................................................................... 338
Department of Commerce........................................................................... 339
Federal Reserve............................................................................................ 339
Trefis.............................................................................................................. 340

Appendix: Where Investment Banking Came From........ 341

Index........................................................................ 349