- Jan 9
- 8 min read
Updated: Apr 21
I recently finished lecturing a couple of corporate finance and financial modeling courses curated for working professionals. The most common feedback was either that the pace was too fast or it was challenging to keep up with the accounting math. Coming from an engineering background where math is like an innate skillset, I try to keep the logic as simple as possible.
Looking back, sometimes I wished someone had shared these with me earlier right from the start when I embarked on my investment banking career. In case you are looking for a plain layman's explanation, this article effectively summarizes everything you need to know about investment banking and corporate finance:
(1) Decision-making
All of corporate finance effectively comes down to decision making. And when it comes to decision making, there are essentially two questions to ask:
- To invest or not to invest?
- Where is the money coming from?
(2) Investing decisions
The decision to invest is all about cost-benefit i.e. do the future benefits of doing this outweigh the costs of mobilising capital?
Valuation (NPV) and returns (IRR) are the main yardsticks of how companies evaluate an investment. NPV (Net Present Value) measures the value of an asset based on its future cash flows, while IRR (Internal Rate of Return) gives the return on an investment based on an initial outlay and a future cash payout.
However, one cannot make sense of the value of an asset or business without first considering where the money is coming from, which leads us to the next point.
(3) Financing decisions
There are only two ways you can fund a business--equity or debt.
Lenders care about profits only to the extent it affects their ability to receive a repayment on the debt, but for equity investors profits are really what matters.
Both equity and debt have strings attached. Equity requires you to share any future profits in the business. Debt requires you to ensure that the investment is made whole with an agreed fixed payment of sorts.
Unlike equity, debt prioritizes wealth preservation. To do so, lenders will ask for all sorts of comfort and security over what businesses can offer to ensure that their capital will not be jeopardized. The banks call this collateral. They will also create boundaries around what borrowers can do and cannot do. These are called "red lines" or financial covenants. Crossing the lines gives the bank the right to ask for an early repayment on the debt.
Using the analogy of a queue, debt holders stand in front and equity holders stand behind. Because of where they stand in queue, equity is almost always more costly than debt. This is a simple risk-reward logic and are also the irrefutable rules of the financial markets i.e.
If I stand further behind the queue, I expect a bigger payout.
NPV and IRR—the decision making tools in corporate finance—therefore involves weighing the cost of capital against the potential returns of investing in a certain project.
(4) Relativity
Nearly all of business valuation involves some form of comparison.
Interest rates set by central banks all over the world are a widely accepted benchmark for a rate of return on capital with minimum risk.
Therefore, any premium above the benchmark rate comes from how financing institutions are perceiving risk i.e. there is no reason why an investor would put their money on the line for a business if there was a similar and less risky alternative elsewhere.
In other cases, rates of return are used to also drive and influence policy making. For example the widely accepted long-term target inflation rate of 2% came about from a meeting of central banks in New Zealand dating back to 1988[1]. According to one person, “The figure was plucked out of the air to influence the public’s expectations”.
To quote Eugene Fama[2]:
“I’d compare stock pickers to astrologers, but I don’t want to bad-mouth the astrologers.”
Everyone who makes a living in finance thinks they know it all. But there are no correct answers, only comparisons which arise from differing points of views.
(5) Storytelling
According to archaeologists, cave paintings that date thousands of years ago indicate storytelling was an important aspect of how humans communicate and evolve. Listening to stories causes the brain to release oxytocin which is associated with empathy and cooperation.
People are drawn to stories because they can relate to them.
Stories shape our beliefs, and beliefs drives decision making. Therefore, for what it’s worth, story telling has become an important part of finance. The narrative helps investors make up their minds about whether a business is good or bad[3].
Since no one can accurately predict how things in the future are going to turn out, history becomes a convenient fallback, society rewards good storytellers, and people being humans, do love to listen to a good story.
(6) Simplicity
Finance doesn't need to be complicated.
Even stuff such as financial modeling and complex structures such as leverage buyouts (LBOs) isn't as complicated as bankers make them out to be.
Take for instance, LBOs are the equivalent of buying a house on a mortgage--the bulk of the purchase is typically funded with a huge bank loan comprising between 60-80% of the property price. The difference lies in how the debt is serviced.
With buying a house, the cash flows come from rental income. In a LBO, cash flows come from operating the business. Assuming the value of the asset remains the same, the value of ownership (equity) naturally increases as debt gets paid down, enabling the home owner (or equity holder) to realize its return on investment. That’s all there is to it.
When you think about it, a lot of what goes on in corporate finance are actually very relatable to what we do in daily life.
It pays to remember that most of what we learn about how financial markets work and and business valuation were originated from the West, largely because the US and the dollar led the charge on how capital is being raised since the history of corporate finance as we know it.
Since then, a number of things have changed. The world became more globalized, investors at all levels have better access and knowledge to putting money to work, information is now more pervasive with technology and social media. There is also a huge supply of capital seeking new avenues for returns.
A number of global events that took place over the last few decades had also dramatically shaped the way we apply the frameworks of corporate finance such as estimating growth, calculating risk premiums, deriving cost of capital and using valuation multiples.
As a practitioner, it is important to take these nuances into our approach when looking at businesses. Here are some real life examples:
One billion people.
How do you forecast cash flows in the world’s fastest growing economy?
In early 2000, China opened up, embarking on huge market reforms that put it on the global economic map. It became one of the hottest investment destination and everyone wanted a piece of the pie. I was fortunate to have witnessed first hand how businesses had successfully produced insanely affordable smartphones, put them in the hands of even the poorest people and connecting everyone in the country.
China also leapfrogged the entire credit card economy, going from cash to cashless transactions. Putting the two together meant that one billion people now had the power to spend on just about anything at the convenience of their fingertips.
Double digit growth is not out-performance, it is the norm.
If you truly understand and appreciate this, trying to project cash flows and using DCF in China at that point of time will fiercely challenge your understanding of local market dynamics and the assumptions around growth rates to derive the value of a Chinese company.
“Mature market” risk premium.
Given the state of world affairs, are countries such as the US still a “mature market”?
The financial crisis in 2008 that kicked off the collapse of Lehman Brothers and subsequently the dissolution of pure-play investment banks, also led to the over-printing of money in the US. Since then, liquidity has been the go-to playbook for solving any financial crisis.
For a long time now, the US market has always been positioned as the baseline for what constitutes a mature market, along with other high-performing financial capitals of the world.
Today, whether the US will continue to honor its USD 30+ trillion debt obligations will not only test the strength of the US dollar and the credibility of its treasury bonds, but ultimately also our textbook definition of what makes up a “mature and stable market”.
If the LIBOR, the London Interbank Offered Rate (which at one point of time had been used as the benchmark for setting interest rates all over the world) can be abolished[4], we must accept the very possibility that our understanding of what defines a stable market return could already be outdated.
AT1 bonds.
Geopolitics continue to have a big influence on financial markets, so does debt still stand in front of equity?
The default on the now defunct Credit Suisse’s AT1 bonds in early 2023 also raises disturbing questions on our conventional understanding of how debt and equity works. For example, is debt financing really less risky when an important strategic shareholder owns part of a business?
When countries start to weaponize economic and financial policy through bailouts, tariffs and sanctions, do companies and investors continue to apply the weighted average cost of capital ("WACC") to quantify and justify their decisions?
Exorbitant valuation multiples
Investors are paying exorbitant multiples for AI companies.
Elsewhere in the world, an investor is paying 100 times on sales for Zhipu, a large-model AI company that recently debuted on the HK exchange but has no earnings yet. There is no decent financial model that could justify a company being valued at 100x sales. But as Lee Kai Fu[5] once said of the AI bubble in these companies,
“If you believe there is 2x, 3x, 5x growth for the next three years, it is going to justify that valuation at some point. The bubble is merely that it has gotten ahead of itself, not the likelihood of growth in the future.”
The all-time historical high of a price-to-sales ratio for the S&P 500 and the NASDAQ was approximately 3.4x and 7x respectively. Even tech darling Nvidia only touched 30-40x at its recent peak. That makes it highly irrational to think that any business could be valued at 100x price-to-sales. Put that into your model.
———
There are no correct answers to the questions above.
One thing that is for sure is that there are definitely are a lot more events taking place in the world that has transformed the way we look at businesses. In short, the rules that we used to learn in books, the rules that govern how financial markets supposedly work, are different from what happens in the real world, and it will continue to stay that way.
Finance teaches us that value - especially intrinsic value - is the sum of the present value of all future cash flows. Reality however often tells another story.
It is necessary to still know how the math works on paper, but acknowledging and understanding this difference is perhaps the most important lesson in corporate finance.
[1] "Of Kiwis and Currencies: How a 2% Inflation Target Became Global Economic Gospel" - The New York Times.
[2] Lunch with Eugene Fama - The Financial Times.
[3] In my opinion, relying on IRRs, MOCs and DPIs to assess and determine the performance of a company or a fund manager violates one of the cardinal rules of investing: History is not the best indicator of the future. Also, good bankers do not always make good investors, good investors do not always make good operators of businesses and managing capital is fundamentally different from running a business. An investor is only as good as his last trade.
[4] In 2012, it was first discovered that banks were colluding to manipulate the benchmark interest rates to profit from trading and mask the troubles that banks were facing following the 2008 financial crisis. It was fully phased out in the middle of 2023.
[5] "Sinovation Ventures Lee Kai Fu on The China-US AI Race" - Bloomberg.
