Queen's Capital Primer

1
QUEEN’S CAPITAL PRIMER
MONEY
NEVER
SLEEPS

Accounting for Finance ... 3
Mergers & Acquisitions ... 12
Three Statement Models ... 16

Comparables and Precedents ... 20
DCF (Discounted Cash Flow) ... 23
NAV (Net Asset Value) ... 27
Technical Analysis ... 33
Oil & Gas ... 37
REITS ... 43
FIGS ... 45
Metals & Mining ... 56
How to Deliver a Great Pitch ... 64
TABLE OF CONTENTS

ACCOUNTING FOR FINANCE
Equity
When a company needs to raise capital, it looks at two primary sources: equity financing
and debt financing. Equity financing is when a company issues stocks (or shares) in
either a primary offering or secondary offerings. Before a company is taken public, its
management team decides on the maximum number of shares that they will be willing to
issue. These shares are referred to as authorized shares.
However, just because a company is able to issue a certain number of shares does not
mean that it actually will. Typically, a company would keep a portion of its total shares
in its own treasury. The company could then use these shares for additional offerings to
raise capital. One reason an investor might want to know how many authorized shares a
company has is to analyze the potential for stock dilution. Dilution reduces a stockholder’s
share of ownership and voting power in a company and reduces a stock’s earnings per
share when new stock is issued.
The number of authorized shares that is sold to and held by the shareholders of a company,
regardless of whether they are insiders, institutional investors, or the general public is
called the issued shares. If a share has been issued and has not been reacquired by the
corporation, it is referred to as outstanding shares. These shares are actively traded in
the stock market and are commonly used in fundamental analysis to calculate ratios (i.e.
Earnings per share). Outstanding shares can further be categorized as “restricted” or
part of the “float”. Restricted shares cannot be bought or sold unless authorized by the
SEC and are commonly given to insiders as part of their salaries or as additional benefits.
Denoting the greatest proportion of stocks trading on exchanges, the float consists of
regular shares that we hear and read about on the news. When a company IPOs, a large
portion of its shares is restricted to decrease the likelihood of a rapid selloff immediately
after going public. A term that often appears with the float is the “short interest”. Short
interest serves as a market sentiment indicator of a company’s performance. It represents
the number of shares that have been sold short by investors but have yet to be covered or
closed out. This figure is often expressed as a number or a percentage (percentage being
number of uncovered short shares divided by the total number of outstanding shares).
When a company reacquires outstanding shares, it is increasing its treasury stock.
Treasury stock is the difference between the number of issued shares and the number
of outstanding shares. If a company does not decide to buyback shares, its outstanding
shares should equal its issued shares. Oftentimes, when a company is doing well, it would
buyback shares. Having treasury stock would increase ownership rights and help ward
off any hostile takeover bids. Similarly, a company could give stock options and warrants
to attract or retain high skilled employees. These are contracts given to employees as a
form of compensation, giving the holder the right to purchase shares from the company’s
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Authorized Shares
The maximum number
of shares a company is
willing to issue
Issued Shares
Number of authorized
shares that is sold
to and held by the
shareholders of a
company.
Outstanding Shares
Issued shares that have
not be reacquired by the
issuing corporation.
Treasury Stock
Stocks which are bought
back by the issuing
company.

4Accounting for Finance
treasury at a specific price within a certain time frame. When employees exercise stock
options and warrants, a company’s treasury stock decreases while its outstanding shares
increase.
Debt
Debtholders, or bondholders, are classified as those individuals that finance a company
through debt. In the event that a company liquidates, it must pay its bondholders first
before it pays its shareholders. As such, it is often cited that bondholders pose fewer risks
than equity shareholders; however, as you will discover, this is not always the case.
Debt is further categorized as either senior debt or subordinate debt – both of which
represent its namesake. Senior debtholders have the highest rights to a company’s assets
in the event of bankruptcy. Their capital is also commonly secured by collateral; under
the terms of a secured loan, the lender can seize the collateral used to guarantee the loan
if the borrower defaults. Examples of senior debtholders include bondholders as well as
banks that have issued a revolving line of credit. With this added safety comes a price:
lower interest payments. Subordinate debt is simply debt that ranks lower than senior
debt with regards to claims on assets or earnings. Because subordinate debt is more risky,
it entails higher interest payments.
Bonds are further classified as either being investment grade or junk status. These are
colloquial terms given to fixed-income securities representing their riskiness. Anything
with a BBB rating or above by credit rating facility, Standard and Poor’s, is considered to
be investment grade while anything lower is a junk bond. In accordance to its level of risk,
junk bonds either offer much higher yields than investment grade bonds or are traded at a
significant discount to par value. Companies issuing these types of bonds are seeking out
speculative investors and often have less than stellar credit ratings.
The reason why it is important to understand stocks and debt is because shareholders and
debtholdersarebothfinancialstakeholdersofacompany,andarecompensateddifferently.
On a company’s income statement, the line item: net interest expense, represents the
payments on interest that a company makes, which are then paid to debtholders. Net
interest expense is calculated by subtracting interest capitalized and interest income from
interest incurred.
Calculating Net Interest Expense
Senior Debt
Borrowed money that
a company must repay
first if it goes out of
business.
Subordinate Debt
A loan or security that
ranks below other
loans or securities with
regard to claims on
assets or earning

Interest incurred is the total amount of interest paid by a business on funds it has borrowed;
interest capitalized (an asset) is an account that holds the suitable amount of funds meant
to pay off upcoming interest payments; interest income is any income earned on amounts
that it had lent out or invested.
A loan’s principal payment is not included on the income statement because it does not
represent a company’s operating business. Rather, it is a line item in the balance sheet;
the principal payment is a reduction of a liability, such as a note payable. This payment
will also be a cash outflow on the statement of cash flows and is also paid to debtholders.
After interest is paid and debt is repaid, the rest of the company’s earnings belong to equity
shareholders. Below is a complete breakdown of how a company’s revenue transforms to
earnings for debtholders as well as earnings for equity shareholders.
The total cash flow for the fiscal year belongs to equity shareholders. This will increase the
cash positions, which then increases the retained earnings account as an adjusting entry.
When a company declares cash dividends, it would credit an expense called dividends
payable and debit retained earnings. Then, when it pays the dividend, it would debit
dividends payable and credit cash. The term, retained earnings, represents a company’s
cumulative net income (from the date of incorporation to the current balance sheet
date). Due to the nature of double-entry accrual accounting, retained earnings do not
represent surplus cash available to a company. It’s important to understand that a large
credit balance in retained earnings does not necessarily mean a corporation has a large
cash balance. To determine the amount of cash, one must look at the Cash account in the
current asset section of the balance sheet. (For example, a public utility may have a huge
retained earnings balance, but it has reinvested those earnings in a new, expensive power
plant. Hence, it has relatively little cash in relationship to its retained earnings balance.)
The retained earnings account is simply an adjusting account that changes depending on
Income Statement Who is Affected?
Revenue Both
COGS Both
Expenses Both
EBIT Both
Interest Expense Debtholders
Taxes Both
Net Income Both
Cash Flow from
Operations
Net Income Both
Add: Non Cash Expenses Both
Cash Flow from Investing
Capital Expenditure Both
Cash Flow from
Financing
Less: Loans Repaid Debtholders
Cash Flow for Fiscal Year
Ended Dec 31, 2015
Equity Shareholders
Earnings Impact Breakdown

how a company has managed its profits (i.e. whether it has distributed them as dividends
or reinvested them in the business). When reinvested, those retained earnings are
reflected as increases to assets (which could include cash) or reductions to liabilities on
the balance sheet.
Shareholders Equity
Below are the items that a corporation is required to report on its balance sheet in the
stockholder’s equity section. We will discuss them in the order they would appear on a
balance sheet:
1. Paid-in Capital (also referred to as Contributed Capital)
2. Retained Earnings
3. Treasury Stock
4. Accumulated Other Comprehensive Income
Capital stock is a term that encompasses both common stock and preferred stock. “Paid-
in” capital (or “contributed” capital) is that section of stockholders’ equity that reports the
amount a corporation received when it issued its shares of stock. State laws often require
that a corporation is to record and report separately the par amount of issued shares from
the amount received that was greater than the par amount. The par amount is credited to
Common Stock. The actual amount received for the stock minus the par value is credited
to Paid-in Capital in Excess of Par Value.
To illustrate, let’s assume that a corporation’s common stock has a par value of $0.10 per
share. The par value is essentially the stated value of the common stock. By law, each
corporation’s stocks need to have an intrinsic value, but the impact of the value bears no
economic significance. On March 10, 2014, one share of stock is issued for $13.00. (The
$13 amount is the fair market value based on supply and demand for the stock.) The
accountant makes a journal entry to record the issuance of one share of stock along with
the corporation’s receipt of the money (note that the “Common Stock” account reflects
the par value of $0.10 per share):
Capital Stock
The common and
preferred stock a
company is authorized
to issue, according to
their corporate charter.
Fair Market Value
Price at which a
knowledgeable, willing,
and competent buyer
is willing to buy from a
willing seller

Retained earnings have already been discussed. Together, with paid-in capital, they
represent the basic two line items under shareholders equity.
Recall that a company also has treasury stock. When a company chooses to buyback
outstanding shares, its treasury stock account increases. This is often a sign of financial
prosperity because it means that a company believes that the market price of its shares is
too low and is willing to purchase those shares at the current price. When a company buys
back shares, the number of shares in the market becomes less diluted. This means that
whatever shares you possess are worth more and will generate a higher EPS. Conversely,
when a company’s stock options and warrants are exercised, its treasury stock decreases.
A company can also sell its treasury stock in the open market, increasing cash while
decreasing treasury stock. Treasury stock is a contra-shareholders equity; increases in
treasury stock (i.e. purchasing shares in the market) decrease shareholders equity while
decreases in treasury stock (selling stock to the open market) increase shareholders
equity.
Below is an entry for buying 100 shares of company stock from the open market for $20 a
share. This transaction then decreases Common Stock (since the number of outstanding
shares decreases), which decreases shareholders equity. Again, this balances out the
equation: A = L + OE.
Treasury Stock
Stocks which are bought
back by the issuing
company.

Accumulated Other Comprehensive Income (AOCI) refers to income not reported as net
income on a corporation’s income statement. These items involve things such as foreign
currency transactions, hedges, pension liabilities, and unrealized gains and losses on
certain investments.
Stock Splits and Stock Dividends
When corporations grow too large and their share prices rise too high, it may consider a
stock split. The purpose of stock splits is to make the shares of a company more easily
tradable for retail investors. A 2 for 1 stock split means that a company transforms one
existing share into two new shares worth half the price. This doubles the total number of
outstanding shares and decreases figures such as EPS. However, the corporation’s assets,
liabilities, and shareholder’s equity remain the same as before the stock split. The only
account balance that does change with a stock split is the par value of each share under
paid-in capital. If a stock previously was trading at $80 and had a par value of $1, its new
trading price would be $40 and its par value would be halved to $0.50.
A stock dividend does not involve cash. Rather, it is the distribution of more shares of the
corporation’s stock. If the board of directors of a company approve a 10% stock dividend,
each shareholder will receive one additional share for every 10 shares they own. Since
every stockholder received additional shares, and since the corporation is no better off
after the stock dividend, the value of each share should decrease. In other words, since
the corporation is the same before and after the stock dividend, the total market value
of the corporation remains the same. Because there are 10% more shares outstanding,
however, each share should drop in value. With each stockholder receiving a percentage
of the additional shares and the market value of each share decreasing in value, each
stockholder should end up with the same total market value as before the stock dividend.
(If this reminds you of a stock split, you are very perceptive. A stockholder of 100 shares
would end up with 150 shares whether it were a 50% stock dividend or a 3-for-2 stock
split.)

Stock splits and stock dividends generally perform the same functions. It is important to
note that stock dividends are not issued to compensate equity shareholders unlike cash
dividends.
Cash-Basis Accounting and Accrual Based Accounting
Cash-basis accounting is where transactions are only recorded once cash is actually
exchanged between parties. Under this accounting standard, revenue for sales on credit
is only recorded on the income statement once the customer pays the full amount. With
purchases of direct materials on credit, the company only bills its Cost of Goods Sold
account once it actually pays its supplier. Alternatively, accrual based accounting instructs
companies to record all transactions in the books when they occur, even if no cash changes
hands. Both GAAP and IFRS mandate that companies use the accrual based accounting
standards. Furthermore, under GAAP, companies are required to publish their income
statements with absorption costing principles. The significant implication with this is
that fixed overhead is traced to the COGS account rather than allocated as an operating
expense. This means that a company’s overall fixed costs are divided by the total number
of products a company produces but are only recorded per the number of units sold under
COGS. This will be a misrepresentation of the true cost of the goods sold and will increase
EBIT. The company’s net income will then be overstated for the current fiscal period. As
such, it is important to always check a company’s inventory account to see if there exists
a large number of finished goods ready for sale.
Apples to Apples
The concept of comparing apples to apples is often used to describe financial ratios. It
means that the stakeholders affected by the numerator of the metric should be the same
as the stakeholders affected by the denominator of the metric. Therefore, the numerator
and denominator must measure value the same way. Below are acceptable ratios and
unacceptable ratios.
Ratios that work
EV/EBITDA
EV/Revenue
Price/Earnings (a.k.a. Price/net income)
Reasoning
Enterprise value represents the value of the entire firm.
EBITDA goes to all stakeholders
Same as above; revenue goes to all stakeholder
Price is equity shareholder specific; earnings (or net
income) is after interest expense, so is given to
equity shareholders.

Ratios that don’t work
EV/Earnings
Price/Revenue
Price/EBITDA
Reasoning
Earnings is specific to equity shareholders since interest
expense is deducted
Price or market capitalization is representative of equity
while revenue is for both equity and debt
EBITDA is before interest expense. Similar to above, it goes
to ALL stakeholders
In general, EV/EBITDA is a better metric to use than price/earnings for several reasons
1. P/E is specific to the equity portion of a company whereas EV/EBITDA looks at
debt as well (which is very important because oftentimes, companies finance operations
with both equity and debt)
2. A company’s net income is the first line item in its statement of cash flows. There
is a cash outflow when a company needs to repay the principals of loans. As such, this is
a decrease to the amount of cash that is available to equity shareholders. This is a factor
that is dependent on the capital structure of the company (if the company has a lot of
debt, it would obviously have to repay more of that debt).
3. The Modigliani-Miller theorem states that there are two propositions used to
evaluate the cost of unlevered firms and levered firms. Keep in mind that a levered firm is
one that has financed operations with both equity and debt whereas an unlevered firm has
not financed its operations through debt.
The Modigliani-Miller Theorum
Proposition 1: The value of an unlevered firm equals the value of a levered firm. The cost of a company that is levered
should in theory be equal to the cost of a company that is unlevered because the cash flows of the firm would not
change; therefore, the value won’t change. In other words, the enterprise value of the two firms would be identical
Proposition 2:

Re is the cost of equity, Rd is the cost of debt, and D/E is the debt to equity ratio. From this equation, it is apparent
that the cost of levered equity is more expensive than the cost of unlevered equity. This is intuitive because investors
expect higher returns from companies with debt (assumption of higher risk) than those without debt. This influences
the P/E ratio because price to earnings is highly dependent on leverage. The more debt a company has, the more
returns shareholders expect on their equity, which would mean a higher cost of equity. This would decrease the
price they are willing to pay for the company’s stock, decreasing P/E. As such, in the event that a company is able to
finance operations cheaply with debt (which is fortuitous for shareholders), its shareholders will still pay less for the
company.

Debt/Equity Ratio and the Enterprise Ratio
BreakingIntoWallStreet.com has great resources for the debt/equity ratio as well as the
enterprise ratio. Do check this video out. Speed up the video to 1.25x if you feel that the
speaker is talking too slowly.
The Debt/ Equity Ratio and Enterprise Value
How Equity Value & Enterprise Value Change in M&A Deals

MERGERS & ACQUISITIONS
The Main Idea
Oneplusonemakesthree:thisequationisthespecialalchemyofamergeroranacquisition.
The key principle behind buying a company is to create shareholder value over and above
that of the sum of the two companies. Two companies together are more valuable than
two separate companies - at least, that’s the reasoning behind M&A.
Thisrationaleisparticularlyalluringtocompanieswhentimesaretough.Strongcompanies
will act to buy other companies to create a more competitive, cost-efficient company. The
companies will come together hoping to gain a greater market share or to achieve greater
efficiency. Because of these potential benefits, target companies will often agree to be
purchased when they know they cannot survive alone.
Distinction between Mergers and Acquisitions
Although they are often uttered in the same breath and used as though they were
synonymous, the terms merger and acquisition mean slightly different things.
When one company takes over another and clearly established itself as the new owner,
the purchase is called an acquisition. From a legal point of view, the target company ceases
to exist, the buyer “swallows” the business and the buyer’s stock continues to be traded.
In the pure sense of the term, a merger happens when two firms, often of about the same
size, agree to go forward as a single new company rather than remain separately owned
and operated. This kind of action is more precisely referred to as a “merger of equals.”
Both companies’ stocks are surrendered and new company stock is issued in its place. For
example, both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and
a new company, DaimlerChrysler, was created.
In practice, however, actual mergers of equals don’t happen very often. Usually, one
company will buy another and, as part of the deal’s terms, simply allow the acquired firm
to proclaim that the action is a merger of equals, even if it’s technically an acquisition.
Being bought out often carries negative connotations, therefore, by describing the deal as
a merger, deal makers and top managers try to make the takeover more palatable.
A purchase deal will also be called a merger when both CEOs agree that joining together
is in the best interest of both of their companies. But when the deal is unfriendly - that
is, when the target company does not want to be purchased - it is always regarded as an
acquisition.
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13Mergers & Acquisitions
Whetherapurchaseisconsideredamergeroranacquisitionreallydependsonwhetherthe
purchase is friendly or hostile and how it is announced. In other words, the real difference
lies in how the purchase is communicated to and received by the target company’s board
of directors, employees and shareholders.
Synergy
Synergy is the magic force that allows for enhanced cost efficiencies of the new business.
Synergy takes the form of revenue enhancement and cost savings. By merging, the
companies hope to benefit from the following:
• Staff reductions - As every employee knows, mergers tend to mean job losses.
Consider all the money saved from reducing the number of staff members from
accounting, marketing and other departments. Job cuts will also include the former
CEO, who typically leaves with a compensation package.
• Economies of scale - Yes, size matters. Whether it’s purchasing stationery or a new
corporate IT system, a bigger company placing the orders can save more on costs.
Mergers also translate into improved purchasing power to buy equipment or office
supplies - when placing larger orders, companies have a greater ability to negotiate
prices with their suppliers.
• Acquiring new technology - To stay competitive, companies need to stay on top of
technological developments and their business applications. By buying a smaller
company with unique technologies, a large company can maintain or develop a
competitive edge.
• Improved market reach and industry visibility - Companies buy companies to
reach new markets and grow revenues and earnings. A merge may expand two
companies’ marketing and distribution, giving them new sales opportunities. A
merger can also improve a company’s standing in the investment community:
bigger firms often have an easier time raising capital than smaller ones.
That said, achieving synergy is easier said than done - it is not automatically realized once
two companies merge. Sure, there ought to be economies of scale when two businesses
are combined, but sometimes a merger does just the opposite. In many cases, one and
one add up to less than two.
Sadly, synergy opportunities may exist only in the minds of the corporate leaders and the
deal makers. Where there is no value to be created, the CEO and investment bankers - who
have much to gain from a successful M&A deal - will try to create an image of enhanced
value. The market, however, eventually sees through this and penalizes the company by
assigning it a discounted share price. We’ll talk more about why M&A may fail in a later
section of this tutorial.

Varieties of Mergers
From the perspective of business structures, there is a whole host of different mergers.
Here are a few types, distinguished by the relationship between the two companies that
are merging:
• Horizontal merger - Two companies that are in direct competition and share the
same product lines and markets.
• Vertical merger - A customer and company or a supplier and company. Think of a
cone supplier merging with an ice cream maker.
• Market-extension merger - Two companies that sell the same products in different
markets.
• Product-extension merger - Two companies selling different but related products in
the same market.
• Conglomeration - Two companies that have no common business areas.
There are two types of mergers that are distinguished by how the merger is financed. Each
has certain implications for the companies involved and for investors:
• Purchase Mergers - As the name suggests, this kind of merger occurs when one
company purchases another. The purchase is made with cash or through the issue
of some kind of debt instrument; the sale is taxable.
Acquiring companies often prefer this type of merger because it can provide them
with a tax benefit. Acquired assets can be written-up to the actual purchase price,
and the difference between the book value and the purchase price of the assets
can depreciate annually, reducing taxes payable by the acquiring company. We will
discuss this further in part four of this tutorial.
• Consolidation Mergers - With this merger, a brand new company is formed and
both companies are bought and combined under the new entity. The tax terms are
the same as those of a purchase merger.

Acquisitions
As you can see, an acquisition may be only slightly different from a merger. In fact, it may
be different in name only. Like mergers, acquisitions are actions through which companies
seek economies of scale, efficiencies and enhanced market visibility. Unlike all mergers,
all acquisitions involve one firm purchasing another - there is no exchange of stock or
consolidation as a new company. Acquisitions are often congenial, and all parties feel
satisfied with the deal. Other times, acquisitions are more hostile.
In an acquisition, as in some of the merger deals we discuss above, a company can buy
anothercompanywithcash,stockoracombinationofthetwo.Anotherpossibility,whichis
common in smaller deals, is for one company to acquire all the assets of another company.
Company X buys all of Company Y’s assets for cash, which means that Company Y will
have only cash (and debt, if they had debt before). Of course, Company Y becomes merely
a shell and will eventually liquidate or enter another area of business.
Another type of acquisition is a reverse merger, a deal that enables a private company to
get publicly listed in a relatively short time period. A reverse merger occurs when a private
company that has strong prospects and is eager to raise capital buys a publicly listed
shell company, usually one with no business and limited assets. The private company
reverse merges into the public company, and together they become an entirely new public
corporation with tradable shares.
Regardless of their category or structure, all mergers and acquisitions have one common
goal: they are all meant to create synergy that makes the value of the combined companies
greater than the sum of the two parts. The success of a merger or acquisition depends on
whether this synergy is achieved.

THREE STATEMENT MODELS
This week’s lesson will cover the three core financial statements (balance sheet, income
statement, cash flow statement) and how they are related to one another. As you will
see, changes in any of the statements above will also have an impact on the others. How
these changes are carried through is knowledge that you will be expected to know both in
practice as well as in interviews.
Financial Reporting Overview
Financial reporting, in essence, is used to communicate the financial performance of a
company to its various stakeholder groups. It is used by management to arrive at strategic
decisions and by external users (e.g. investors, creditors) to make judgements with respect
to company value and competitiveness.
There are three underlying accounting principles in the preparation of financial statements:
1. Going concern: the entity will remain in business for the foreseeable future
2. Revenue recognition: revenues are recorded in the accounting period during which
they are earned
3. Matching principle: expenses shuld be matched with the revenue that they helped
to generate
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17Three Statement Models
Balance Sheet
The balance sheet provides an overview of the company owns (assets), owes (liabilities),
and the value of the business to its equity holders (shareholder’s equity).
Assets: Economic resources that are expected to produce economic benefits for their
owner
• Short Term: cash, marketable securities, accounts receivable, notes receivable,
inventory, prepaid expenses
• Long Term: investments, fixed assets, other assets, intangible assets
Liabilities: Obligations the company has to outside parties. Liabilities represent others’
rights to the company’s money or services. Examples include bank loans, debts to suppliers
and debts to employees.
• Current: bank indebtedness, accounts payable, wages payable, accrued liabilities,
notes payable, unearned revenues, dividends payable, current portion of long term debt,
current portion of capital lease obligation
• Long Term: notes payable, long term debt, deferred income tax liability, pension
fund liability, long term capital lease obligation
Shareholders’ equity: The value of a business to its owners after all of its obligations have
been met. This net worth belongs to the owners. Shareholders’ equity generally reflects
the amount of capital the owners have invested, plus any profits generated that were
subsequently reinvested in the company.
• Common stock, preferred stock, treasury stock (contra-equity accounting),
retained earnings, paid in capital (premium paid by investors over and above par-value:
typically for preferred shares)

Income Statement
The income statement measures a company’s financial performance over a specific
accounting period. Financial performance is assessed by giving a summary of how the
business incurs its revenues and expenses through both operating and non-operating
activities.
Revenue: total sales (revenues) during the accounting period. Remember these sales are
net of returns, allowances and discounts.
Cost of Goods Sold (COGS): the direct costs that are related to the product or rendered
service sold and recorded during the accounting period
Operating Expenses: all other expenses that are not included in COGS but are related to
the operation of the business during the specified accounting period
Other Revenues & Expenses: all non-operating revenues and expenses (interest earned
on cash or interest paid on loans)
Income Taxes: provision for income tax
Revenue – COGS = Gross Profit – Operating Expenses = Operating Income +/- Other
Income or Expense +/- Extraordinary Gain or Loss – Interest Expense = Net Profit Before
Taxes – Tax = Net Income
Examples of Non-Recurring Items (Non-Operating Gains/Losses)
• Income/expense from discontinued operations: shutdown of one or more division/
operation
• Extraordinary items: unusual, one-time gains/losses e.g. environmental remediation
• Cumulative effect of accounting changes: changes in accounting policies/estimations
• Other unusual or infrequent items

Cash Flow Statement
Note: This is a general overview, and the cash flow statement will be explained in greater
depth later on. The statement of cash flow reports the impact of a firm’s operating,
investing and financial activities on cash flows over an accounting period.
Operating Activities: CFO is cash flow that arises from normal operations such as
revenues and cash operating expenses net of taxes
Cash Inflow
• Revenue from sale
• Interest revenue (debt instruments)
• Dividends (equity ownership)
Cash Outflow
• Payment to suppliers
• Payment to employees
• Payment to government/lenders
• Payment for other expenses
InvestingActivities:cashflowthatarisesfrominvestmentactivitiessuchastheacquisition
or disposition of current and fixed assets.
Cash Inflow
• Sale of PP&E (property, plant, and equipment)
• Sale of debt/equity securities (read: of other companies)
• Collection of principal on loans
Cash Outflow
• Purchase of PP&E
• Purchase of debt/equity securities (read: of other companies)
• Lending to other entities
Financing Activities: cash flow that arises from raising (or decreasing) cash through the
issuance (or retraction) of additional shares, or through short-term or long-term debt for
the company’s operations
Cash Inflow
• Issuance of equity securities
• Issuance of debt securities
Cash Outflow
• Dividends to shareholders
• Redemption of long term debt
• Redemption of capital stock

COMPARABLE TABLES &
PRECEDENTS
The comparable valuation approach has the general idea that an equity’s value should
resemble other companies operating within the same industry. By retrieving the
differences in value between firms of the same class, one is able to determine whether or
not a company is overvalued or undervalued.
There are 2 main comparable analysis approaches.
• Common Market Multiples
• Precedent transactions
4
Comparable Tables
PROS
Widely available data
Ease of communication amongst market participants
Ability to develop a benchmark value for multiples
Assesses market assumptions of fundamental
characteristics in pre-existing valuations
CONS
Influenced by temporary market conditions or non-
fundamental factors
Not useful when there are few or no comparable
companies
Can be difficult to find relevant companies for
multiple reasons
Not as reliable when compared companies are thinly
traded

21Comparables and Precedents
Common Market Multiples
Selecting the peer group:
When selecting the companies that will be used in your comparable analysis it is vital
to select companies in similar industries and fundamental characteristics. These could
include geographic locations, debt structure, market capitalization, etc.
Selecting the multiples used:
There are two types of multiples used, equity multiples and operating multiples. Operating
multiples utilize Enterprise value as the numerator and Equity multiples utilize price as
the numerator. It is important to include at least one of each type in your analysis. Typical
multiples include the following:
Operating Multiples
EV/Sales: Enterprise value divided by the sales/revenue of the company
EV/EBITDA: Enterprise value divided by earnings before interest, taxes, depreciation, and
amortization
Note: Operating multiples ignore leverage such as debt and commonly ignore depreciation
and amortization. Investment bankers and private equity investors commonly use them.
Equity Multiples
P/E: Price of the company divided by the earnings per share, or market capitalization over
earnings.
P/B: Price of the company divided by the book value per share ( simply put, book value =
total assets- total liabilities)
P/Levered Cash Flow: Price of the company over the levered cash flow of a company
Note: Equity multiples ignore the cash flow to debt holders, they are commonly used by
equity analysts and investment bankers.
When to use price/sales multiples?
• Companies with negative earnings
• Highly volatile earnings
• Abnormally low or high earnings
• Fast growing companies with no or negative earnings
The advantage of using this multiple is the general stability and lower accounting distortion

22Comparables and Precedents
with sales numbers. Sales may be manipulated in other ways though. P/S does not take in
to account the profitability of firms though ex. Low profit margins.
When to use Price/Book multiples?
• Financial service companies (balance sheets composed of liquid assets that
approximate market values)
• Companies with no earnings
• Highly variable earnings or not expected to continue as a concern

DCF (Discounted Cash Flow)
Discounted Cash Flow Analysis
The comparable and precedent transaction methods explained previously are a great
measure of external value. The DCF model allows one to analyze the intrinsic value of a
company. The discounted cash flow tries to work out the value of a company today, based
on projections of how much money it’s going to make in the future.
DCF analysis requires you to think through the factors that affect a company, such as
future sales growth and profit margins. It also makes you consider the discount rate, which
depends on a risk-free interest rate, the company’s costs of capital and the risk its stock
faces.
Forecasting period:
The first step to the DCF is determining how long you want to project the cash flows
for. The best way to do this is to determine the business life cycle of the company you
are analyzing. Usually people project for 5 or 10 years. A more mature staged company
such as an airline would be projected for 10 years while a volatile earlier staged consumer
company would be forecasted for 5 years. This is because one can more easily predict
cash flows from a business that has had steady and consistent cash flows rather than
initial high growth at the start of the business.
Growth Rate of Revenues:
This is a key part of the model as it drives the value of the company when all future cash
flows are discounted back. It is important to keep your forecasting for topline growth
realistic. What has the company been growing at for the past 5 years? Does it have a
defensive market position? How much market share does it own? How much is the
industry it operates in growing on average? A combination of all these factors will allow
you to state your assumptions and provide a realistic revenue projection.
Note: The DCF is full of assumptions and should not be used alone. You can EASILY
manipulate the numbers by small increments to completely change a valuation.
5

24DCF (Discounted Cash Flow)
Calculating Unlevered Free Cash Flow (UFCF):
For each year you want to find the UFCF available before present valuing each year. To do
this you must first find present day’s FCF with the following equation…
EBIT – Taxes + Depreciation & Amortization – CAPEX – Increase in Net Working Capital
UFCF shows how much cash is on hand to pay for operations before other financial
obligations are taken into account. I won’t delve too deep on UFCF but it basically allows
you to see how much cash flow can be used to provide shareholder value in terms of
dividends, share buy backs, and positive NPV projects.
Projecting UFCF:
Since you already projected your revenue, you can project each segment that influences
your free cash flow.
Most likely your tax rate will stay consistent throughout the 5 or 10 years therefore it will
be around 25% of your Earnings before interest and taxes.
CAPEX will change depending on how competitive the market place is and how desperate
the company is in need for new assets or innovation.
Working capital typically increases as sales revenues grow, so a bigger investment of
inventory and receivables will be needed to match The Widget Company’s revenue growth.
Calculating the Discount Rate:
To discount your cash flows, investors commonly use the Weighted Average Cost of
Capital.
WACC = Cost of Equity * equity value / (equity value + debt value) + Cost of Debt * debt value
/(equity value + debt value) * (1-tax rate )
To calculate the cost of equity, you would utilize the Capital asset pricing model (CAPM).
Cost of Equity = Risk Free Rate + Beta (Return on Market Portfolio – Risk Free Rate)
The risk free rate can be obtained by using the return of a 10 year T-bill. The Beta will be
reported. The Return on Market Portfolio is usually a % around 10-15 % depending on
what you are looking at.

The cost of debt can be found using two ways:
1) If the firm has bonds outstanding, and the bonds are traded, the yield to maturity on a
long-term, straight (no special features) bond can be used as the interest rate.
2) If the firm is rated, use the rating and a typical default spread on bonds with that rating
to estimate the cost of debt.
The weightings of equity and debt can just be found on Capital IQ or if you wanted to
calculate it by hand, for equity value you can find the value of shares outstanding over the
value of those same shares plus the value of all debt in the company. And for the weight
of debt you can replace the value of shares outstanding in the numerator with the value
of debt.
Discounting your cash flows:
Now that you have projected UFCF for 5 or 10 years with a set discount rate, its time to
discount them all back to get your NPV. This is classic time value of money from here on.
Use the following equation to bring all your future cash flows back.
Terminal Values:
We present valued all the cash flows, but we didn’t consider that we projected only for 5
or 10 years. A company will operate for longer than that time frame assuming it is does not
go under therefore we must consider cash flows in perpetuity or as an exit multiple. You
can use the Gordon Growth Method for cash flows in perpetuity (forever).
Terminal Value = Final Projected Year Cash Flow X (1+Long-Term Cash Flow Growth Rate) /
(Discount Rate – Long-Term Cash Flow Growth Rate)
For the multiple method you can assume a EV/EBITDA that has grown over the past years.
You must be able to justify this multiple. You then would multiply the multiple by your
forecasted EBITDA number in your last year.
Whichever terminal value you decide to choose, you must then discount the number back
either 5 or 10 years depending on how long you chose to project.
Now you must then sum all your present valued cash flows and the present value of your
terminal value. This will get you an ending enterprise value. This doesn’t allow you to get
the price target of the stock though. So you must convert this enterprise value to an equity
value. (Highlighted in the NAV section of this manual).

Your end product should look something like this. Don’t forget, you can always break down
each line in your model if you would like. Modeling is just basic adding and subtracting
with many assumptions. It’s how you justify those assumptions that makes it an art.
DCF Example

NAV (Net Asset Value)
NAV modelling is a type of financial modelling that is primarily performed on companies
that use assets as the primary driver for revenue. REITs (property), oil and gas (reserves),
as well as investment trusts (capital) all generate 90-95% of their revenue through
their respective assets. A company’s net asset value by definition is the total value of
its assets less the total value of its liabilities – or the company’s equity. One would then
divide this figure by the total number of shares the company has to derive its net asset
value per share. This is the asset value that each share represents in the same way the
price-earnings ratio measures the profit per share. Keep in mind that NAV per share is not
the same as a regular share price because regular shares fall under common stock while
shareholders equity includes common stock, retained earnings, preferred stock, treasury,
etc. Furthermore, calculating a company’s NAV is a bit trickier than just finding its equity
value – one must also take into account the company’s future cash flows.
In short, a NAV model values a company based on two things;
(1) Its current balance sheet (your typical assets less liabilities) and
(2) its capitalized income generation from wholly owned properties and assets.
Capitalized income is calculated much more rigorously compared to estimating future cash
flows in DCFs because each individual asset’s revenue generating capability is traceable.
What I mean by this is that assets have a certain maximum output (when all productive
resources are being utilized) that is measurable and this measurement is translated into
the NAV model. Whereas a DCF is based on assumptions, a NAV model is based on actual
output levels and revenue generated per individual asset, making it more realistic and more
accurate. It is thus, the preferred choice of valuation for the aforementioned industries.
Take an upstream oil producer for example. The price of a barrel of oil is market driven.
An oilrig can only extract a certain number of barrels of oil per day based on factors
external to the company (i.e. the richness of the land it is drilling on). These numbers
are predetermined and cannot be manipulated. Logically, it would make sense that the
company’s revenue per day is simply the product of its daily production and the price per
barrel of oil. Furthermore, its costs would simply be its fixed expenses plus the per unit
cost of producing one barrel of oil multiplied by the number of barrels produced. By coming
up with a company’s future production along with future prices and costs, one would be
able to calculate the company’s cash flows monthly or yearly. Just like in DCFs, you would
then discount these values and sum them up to find the net present value. However, with
companies that use NAV models, they typically have finite resources – meaning that their
assets will eventually deplete or depreciate (with the rare exception of REITs). Once all
of a company’s revenue generating assets/resources are exhausted, it would cease to be
able to generate cash flows and would thus, liquidate whatever non-revenue generating
6

28
assets it still possesses (this includes things like land, patents, insurance, etc.). The sum of
the liquidated parts along with the total lifetime cash flows that the company generated –
discounted to the present – would be a company’s enterprise value. Then, by adding back
cash and subtracting debt, minority interest, and preferred stock, one would come up with
a fair equity valuation for the company.
The reason why REITs are different is that the value of property does not depreciate. If
anything, it oftentimes appreciates in price. However, the future appreciation of property
tends to be very speculative so companies often just report property at the present value.
It is important to note that in a NAV valuation, you assume that the company is not going to
expand and purchase additional revenue generating assets. This is because the purchasing
of additional assets and whatever value those assets can generate is very speculative and
NAV models tend to refrain from using any hypothetical numbers. As previously stated,
each industry that uses NAV valuation has a very obvious asset driver. These asset drivers
generate cash flows based on already established prices and costs. Since all of these
asset drivers are different in nature, there is no universal NAV template that satisfies all
industries. Each NAV model would look different depending on the industry, but will be
based on the same underlying principles. Shown below is a NAV model for an oil and gas
company.
NAV Model Example
The above is part A of a NAV model I made for the company: Seven Generations Energy. I projected cash flows from
2015 to 2027, or until the company depleted all of its current reserves. I separated the model into a few categories:
prices, reserves, production, and production growth rate.

29NAV (Net Asset Value)
Prices: I found the prices of the company’s production mix each year by taking the
commodity prices found on futures indexes. This is a very conservative way of projecting
future prices and you can definitely use your own predictions for the prices. However,
emphasizing the theme of consistency and realism, I tend to refrain from making my own
predictions and instead use market-established prices (since Seven Gen could always buy
the oil futures).
Reserves: The total reserves of an O&G company can be found in its latest quarterly report
or corporate presentation. The reserves are then divided by commodity: condensate + oil
+ NGLS (all liquids), and natural gas. I then converted the two into the same equivalent
unit (mboe or million barrels of energy equivalents), since one Mmbl equals one mboe
and 5.8 MMcfs of natural gas equals one mboe. The total starting reserves in 2015 is thus,
788.6 million boe. Each year, this value depletes by the total amount of resources that the
company drills (produces) until it reaches zero in 2027.
Production: Annual production can be found on a company’s quarterly report as well as
corporate presentation. They oftentimes give production in per day figures as a range (i.e.
50, 000 – 55, 000 boe per day) and to be conservative, it is best to use the lower number.
Sometimes, if a company is very diligent, it will tell you how it came to these numbers by
supplying you with the production of each individual well and rig. Great companies are
transparent and will reveal information such as the IRR (internal rates of return) of specific
assets, which can be extrapolated to figure out annual production. Annual production
obviously changes year over year and can either increase (if the company is in its expansion
stage) or decrease (if the company is in decline). Note that an O&G company’s production
increases not because it purchases additional land (remember that NAV valuations are a
function of the company’s current assets) but rather because it is developing some of its
undeveloped land. Newer companies (such as Seven Gen) tend to have vast amounts of
undeveloped basins of oil and natural gas awaiting development.
Production Growth Rate: Production growth rates are probably the single figure that
you would have to estimate based on the information provided to you in the company’s
statements and reports. Oftentimes, a company would give you their own predictions
(which tend to be good), and you could also project growth by comparing the company to
the historical growth of similar companies. Keep in mind that the growth of the company
in this case is not through the purchase of more reserves. Thus, the asset driver remains
constant; we are still obeying all the rules of NAV modelling; production simply increases
at the cost of capital expenditure (which I presume is included in the model as subtracted
debt ~~ shown later below)

30
At one point, a company would realistically be unable to grow anymore and would decline.
For Seven Gen, I thought that this point would be around the year 2022 (this is dependent
on your discretion) and I had the company scaling back production by roughly 1% per year.
Revenue: After projecting future prices as well as future production, projecting revenues is
easy. It is simply the multiplication of the two. Obviously, the revenue changes every year,
increasing in the growth stage and declining in the maturity stage.
Expenses: The main expenses for an O&G company include operating costs and
transportation costs. The per boe figure is shown in the pink boxes and can be found on
the company’s quarterly reports. Multiply these unit costs by the annual production to
find the total annual costs. The other key variable expense is royalties. This is specific to oil
and gas and the reason why it is separate is because of the sliding royalty rate. This means
that when oil and gas prices are higher, companies need to pay a greater percentage of
revenue in royalties. The percentage in this case is 13.7%. Operating netback is simply the
O&G specific term used to describe the per unit profit of a boe (revenue per unit less per
unit expenses). Operating netback after tax represents the company’s total annual cash
flows. You would then discount these cash flows to find the company’s enterprise value.
Note: The additional cost information found under the Costs & Royalties (% of Price)
subheading and is not pertinent to the calculation of the NAV.
Discount Rate: The standard discount rate for oil and gas companies is 10%. To find a
more specific discount rate or for a different industry, find the WACC of similar companies
by using the CAPM to find the cost of equity and use the company’s 10 year bond as the
cost of debt. For the CAPM calculation, don’t forget to perform the levered to unlevered
beta transition – which is unlevered beta = average levered beta of peers / (1+((1-tax rate)
x (debt/equity))), and find the industry average equity risk premium.
Part B of the NAV model is shown above. Here, I projected revenues and subtracted expenses to calculate operating
netback. Next, I subtracted tax to find the total after tax valuation of the company’s revenue generating assets.

31NAV (Net Asset Value)
Test
Part C (shown above), is the final step of the NAV model. Before converting from the enterprise value to the equity
value, add in the value of non-revenue generating assets and discount them to the present. For Seven Gen, this includes
the value of their undeveloped land. This land is the land available to the company after all of its reserves are depleted
and can be sold for some money. Keep in mind that you should discount the value of the land to the present.
Next, to convert from an enterprise value to an equity value, add back cash, and subtract debt, preferred equity, and
minority interest. Divide this number by the total number of diluted shares outstanding to find the share price. This
share price is oftentimes more accurate than the one given to you by a DCF valuation.

32
Just like with DCFs, you can also create sensitivities for NAV models. The variables
you would use are dependent on the industry. For Seven Gen, I used the price of the
commodities as well as the discount rate, but you could also perform sensitivities on the
production growth rate or the 2015 estimated production.
Conclusion
NAV models are fundamentally more detailed versions of DCF models. Rather than
estimating terminal growth rates, you would instead analyze each revenue driver and
estimate things like production growth rates or interest rate spreads. This of course takes
a bit more time, but the end result is almost always more accurate. If it is difficult to
conceptualize the NAV model, think of it like ABC costing (from managerial accounting).
It is a meticulous process where you find each cost driver (or revenue driver in this case),
project future cash flows and discount them to arrive at your net present value of the
company.
Here’s a question to think about… I’ve been thinking about this problem since I started
writing this.
• DCF models subtract capital expenditure from cash flows because it is an indirect
cost for the company and it reduces cash. I am unsure about NAV models though.
Theoretically, they should also be subtracting capital expenditure (especially
for growing companies). Think about Seven Gen; they are growing production by
creating wells and rigs to effectively ‘develop’ their undeveloped land. By definition,
this is capital expenditure; however, it doesn’t seem to be reflected anywhere in the
model. Revenues are going up, but costs remain the same.
If you already know the answer to this or figured it out, could you message me (Stephen
Peng). Thanks

TECHNICAL ANALYSIS
Technical analysis is a method of evaluating securities by analyzing the statistics generated
by market activity. It is based on three assumptions: 1) the market discounts everything,
2) price moves in trends and 3) history tends to repeat itself. Technicians believe that all
the information they need about a stock can be found in its charts. Technical traders take
a short-term approach to analyzing the market. Criticism of technical analysis stems from
the efficient market hypothesis, which states that the market price is always the correct
one, making any historical analysis useless.
Technical analysis is used amongst sales and trading professionals especially within the
forex and commodity trading world (as it has proven to be more useful).
Technical analysis shouldn’t be used to fundamentally analyze a company as it does
not take in to account many aspects of a business that make it an actually good or bad
investment. But technical analysis has proven to be useful in the short-term to decide
when the proper time (based on price pressures and volume fluctuations) to enter the
market is. We do not want to make you focus too much on this section as it is a heavily
debated area in the realm of investing, but we will introduce you to 3 common techniques
and hopefully it will spark your interest to delve deeper in to the many other technical
strategies out in the world.
Most chart patterns show a lot of variation in price movement. This can make it difficult
for traders to get an idea of a security’s overall trend. One simple method traders use to
combat this is to apply moving averages. A moving average is the average price of a security
over a set amount of time. By plotting a security’s average price, the price movement is
smoothed out. Once the day-to-day fluctuations are removed, traders are better able to
identify the true trend and increase the probability that it will work in their favor.
Simple Moving Average (SMA)
This is the most common method used to calculate the moving average of prices. It simply
takes the sum of all of the past closing prices over the time period and divides the result
by the number of prices used in the calculation. For example, in a 10-day moving average,
the last 10 closing prices are added together and then divided by 10. As you can see in
the chart belows, a trader is able to make the average less responsive to changing prices
by increasing the number of periods used in the calculation. Increasing the number of
time periods in the calculation is one of the best ways to gauge the strength of the long-
term trend and the likelihood that it will reverse. Figure 1 Many individuals argue that the
usefulness of this type of average is limited because each point in the data series has the
same impact on the result regardless of where it occurs in the sequence. The critics argue
7

34Technical Analysis
that the most recent data is more important and, therefore, it should also have a higher
weighting. This type of criticism has been one of the main factors leading to the invention
of other forms of moving averages.
Indicators are calculations based on the price and the volume of a security that measure
such things as money flow, trends, volatility and momentum. Indicators that are used in
technical analysis provide an extremely useful source of additional information. These
indicators help identify momentum, trends, volatility and various other aspects in a
security to aid in the technical analysis of trends.
MACD
The moving average convergence divergence (MACD) is one of the most well known
and used indicators in technical analysis. This indicator is comprised of two exponential
moving averages, which help to measure momentum in the security. The MACD is simply
the difference between these two moving averages plotted against a centerline. The
centerline is the point at which the two moving averages are equal. Along with the MACD
and the centerline, an exponential moving average of the MACD itself is plotted on the
chart. The idea behind this momentum indicator is to measure short-term momentum
compared to longer term momentum to help signal the current direction of momentum.
MACD= shorter term moving average - longer term moving average
When the MACD is positive, it signals that the shorter term moving average is above
the longer term moving average and suggests upward momentum. The opposite holds
Simple Moving Average Chart

35
true when the MACD is negative - this signals that the shorter term is below the longer
and suggest downward momentum. When the MACD line crosses over the centerline, it
signals a crossing in the moving averages.
Technical Analysis
MACD Histogram
The histogram is plotted on the centerline and
represented by bars. Each bar is the difference
between the MACD and the signal line or, in
most cases, the nine-day exponential moving
average. The higher the bars are in either direc-
tion, the more momentum behind the direction
in which the bars point.
The blue histogram above is a representation of the MACD histogram .

36
RSI Index
The relative strength index (RSI) is another one of the most used and well-known
momentum indicators in technical analysis. RSI helps to signal overbought and oversold
conditions in a security. The indicator is plotted in a range between zero and 100. A reading
above 70 is used to suggest that a security is overbought, while a reading below 30 is used
to suggest that it is oversold. This indicator helps traders to identify whether a security’s
price has been unreasonably pushed to current levels and whether a reversal may be on
the way.
Technical Analysis
RSI Chart

OIL & GAS
Why care about Oil and Gas?
The oil and gas sector is important for iBanking in Canada, because we are primarily a
commodity and natural resource exporting economy. A lot of M&A deal flows within
Canada, as well as cross border deals witht the U.S., and the country’s biggest IPOs
are almost always oil and gas companies. Furthermore, there currently exists a huge
opportunity to purchase undervalued O&G companies that have been mispriced due to
the recent downtown. Private equity funds such as KKR have already committed billion
dollar funds to do so.
READ LIMESTONE’S Oil and Gas Primer
• The primer is comprehensive and its best features are: (1) it goes in depth on the
scientific properties of oil and gas. (2) It explains the process of actually extracting
the oil and gas. (3) It has great diagrams and visuals
• Note that the text below summarizes a lot of the Limestone Content into a word
document. We also added a few different topics – namely, the factors that influence
oil and gas prices
Units of measurement
• Barrel of oil (bbl) = 42 gallons of oil 
• Thousand cubic feet (Mcf) = natural gas 
• Conversion: 1 Barrel of oil equivalent = 5.8 MMBtu
• 1000 cubic feet (Mcf) = 1 MM BTU 
• 1BBL= 5.8 Mcf = ~6Mcf natural gas
Standardized Indexes
WTI: West Texas Intermediate = the U.S. benchmark for crude oil prices
Henry Hub (or NYMEX Natural Gas) = the North American standard for natural gas prices
Western Canada Select = the benchmark Canadian Oil Sands crude oil index
Brent Crude: the international crude benchmark; historically trades higher than WTI
Crude Oil: Heavy or Light, Sweet or Sour
• Crude oil with a heavy sulfur content is said to be sour. Crude oil with a low sulfur
content is said to be sweet. Sweet crude is more desirable than sour crude because
it can be synthesized to form more products; as such, upstream producers often
spend millions of dollars on sweetening plants. Similarly, lighter crude is more
desirable than heavier crude because this type of crude yields greater proportions
8
INDUSTRY SPECIFICS

38Industry Specifics: Oil and Gas
of lighter petroleum products like gasoline.
Miscellaneous
• Hydraulic Fracturing: The process of injecting high-pressure liquids into the ground,
creating fractures in the rocks and rock formations. This eases the extraction process
by allowing oil and gas to flow more easily through the bedrock.
• Horizontal Hydraulic Fracturing: Since the 2000s, advances in drilling and
completion technology have made this type of drilling more economical.
• Montney:AlargeareaoflandextendingfromtherightmostborderofBritishColumbia
to just west of the Canadian Oil Sands. This piece of land has slowly become the
country’s most economical piece of land to drill on because of the abundance of
LNGs (Liquefied Natural Gas)
• Liquefied Natural Gas: compression of natural gas into a liquid to ease in the
storage and transportation of conventional natural gas. Condensate, a natural
gas liquid found in the Montney, is used to dilute oil sands bitumen to allow it
to flow in a pipeline
• There are four types of oil and gas companies: upstream, midstream, downstream,
and integrated. Upstream producers engage in the exploration and extraction of
oil and gas reserves. Midstream companies deal with the transportation of oil and
gas by pipelines, rail, barge, trucks, etc. Downstream companies engage in refining
petroleum crude oil into refined hydrocarbons, such as gasoline and heating oil
Industry Specific Multiples
EV/EBITDAX
EBITDAX, not EBITDA: The “X” stands for Exploration Expense, and we add back
this expense to EBITDA when working with E&P companies because of the issue with
successful efforts vs. full cost accounting above: we’re normalizing the metric.
Enterprise Value/Daily Production: EV/BOE/D
Also referred to as price per flowing barrel, this is a key metric used by many oil and gas
analysts. This takes the enterprise value (market cap + debt + preferred stock + minority
interest - cash) and divides it by barrels of oil equivalent per day (BOE/D). All oil and gas
companies report production in BOE. If the multiple is high compared to the firm’s peers,
it is trading at a premium; and if the multiple is low amongst its peers, it is trading at a
discount.
Enterprise Value/Proven + Probable Reserves: EV/2P
This metric helps analysts understand how well resources will support the company’s
operations. After an oil and gas exploration team conducts a seismic survey on a piece
of land, it comes up with the proven and probable reserves. Proven reserves have a 90%
chance of being present. Probably reserves have a 50% chance of being present. There is
a third P – albeit rarely used – called possible reserves, which have a 10% chance of being
present. Generally, the EV/2P ratio should not be used in isolation, as not all reserves are
the same. However, this multiple can still be an important metric to use to evaluate the
valuation of acquiring properties when little is known about the cash flow. Reserves can be
proven, probable or possible reserves.

Price-to-Cash Flow: P/CF
Oil and gas analysts will often use the price-to-cash flow per share multiple. A few
advantages of this multiple is that in contrast to earnings, book value and P/E ratio, cash
flow is harder to manipulate. Earnings can always be tweaked by aggressive accounting,
and book value is calculated using subjective depreciation methods. One disadvantage is
that while easily calculated, it can be a little misleading if there is a case of above-average
or below-average financial leverage.
Enterprise Value/Debt-Adjusted Cash Flow: EV/DACF
The capital structure of oil and gas firms can be dramatically different. Firms with higher
levels of debt, or more leverage, will show a better P/CF ratio, which is why the EV/DACF
multiple is preferred.
Reserve Life Index (RLI)
Year End Reserves/Expected Annual Production: calculates the total number of years of
drilling it takes to deplete all current reserves.
DCPU: Distributed Cash Per Unit
• Useful in measuring stakeholder value created
• Assume that the company adds nothing to its reserves and that it produces 100% of
its reserves until it runs out of natural resources completely
NAV Model
1. Set Up Columns to Track Each Commodity, Revenue, Expenses, and Cash Flows.
You want to track the beginning and ending reserves each year, the annual production
volume and the average price for each commodity; typically, you use the same low/mid/
high price cases that you used in the company’s operating model.
2. Assume Production Decline Rates and Calculate Revenue Until the Reserves Run Out
Depending on the company’s previous history, you might assume a decline rate of 5-10%
per year - potentially more or less, depending on how mature it is.
In each year, you assume that you produce either the production volume of that year or the
remaining reserves - whichever number is lower.
Then, you’d multiply the production volume by the average price each year for all
commodities to get the revenue by year.
3. Project (SOME) Expenses
You focus on Production and Development expenses here, both of which may be linked
to the company’s production in the first place. Find these figures in the company’s annual
report and corporate presentations.
You don’t assume anything for Exploration, since you’re pretending that the company finds

nothing and dwindles to $0 in the future, and you leave out items like corporate overhead
and SG&A, because we’re valuing the company on an asset-level.
4. Calculate and Discount After-Tax Cash Flows
Subtract the expenses from the revenue each year, and then multiply by (1 - Tax Rate) to
calculate the after-tax cash flows.
Then, you add up and discount everything based on the standard 10% discount rate used
in the Oil & Gas industry (no WACC or Cost of Equity here).
5. Add in Other Assets and Business Segments
For example, if the company has undeveloped land or if it has midstream or downstream
operations, you might estimate the value of those based on an EBITDA multiple (or $ per
acre for land) and add them in. You add all those up to arrive at the Enterprise Value, and
then you convert the EV back into Equity by adding cash, subtracting debt, subtracting
minority interest, and subtracting preferred stock, and calculate the company’s Implied
Share Price by dividing that figure by the diluted shares outstanding.
Sum of the Parts
For cases where the company is highly diversified - think Exxon Mobil - you need to value
its upstream, midstream, downstream and other segments separately and add up the
values at the end.
So you might, for example, use traditional multiples like EBITDA for the midstream and
downstream segments, and then use Proved Reserves or Production multiples for the
upstream segment and add them together to arrive at the final value. Or you might use a
NAV model for upstream and a DCF model for other segments and add those up.

What causes changes in oil prices?
Oil is a commodity, and similar to most commodities, it is intrinsically more volatile than
traditional investments such as stocks and bonds. The price of oil is primarily supply driven,
and in a seller’s market, producers oftentimes collude together to maximize profits. OPEC
is a consortium comprising of 13 oil-producing nations – with Saudi Arabia being the largest
producer, controlling 40% of the world’s oil supply. Because these countries are largely
“Swing”producers,meaningthattheycontrolsubstantialstocksofoilandareabletoadjust
their production for minimal costs (due to possessing large spare production capacity),
they are effectively able to control global crude oil prices through underproduction and
overproduction. The organization’s goal over the past decade and a half has been to keep
the price of oil around $30/barrel in order to push Western competitors to the breaking
point (where variable cost exceeds revenue). This way, the organization would enjoy
a monopoly where after foreign competitors are forced to liquidate assets and declare
bankruptcy, they could hike up the price of oil. However, major global events have made
the task increasingly difficult. A few of these major global events include:
Natural Disasters
Natural disasters, such as Hurricane Katrina in 2005, inadvertently cut supply. Because
natural disasters are difficult to predict and oftentimes too costly to prevent, they almost
always drive up the prices of commodities. This is because supply precipitously decreases
while demand remains the same. Using the Hurricane Katrina example, U.S. production
was halted and oil prices jumped from $70/barrel to $80/barrel within a few days and
would have continued soaring had it not been for president Bush releasing 30 million
barrels from the Strategic Petroleum Reserve, bringing down oil prices.
War and Politics
Political instability has caused a great deal of pressure on oil prices. This pressure can
either drive oil prices up or down. For example, in July of 2008, crude oil prices hit an all
time high of $136/barrel due to global concerns surrounding the wars in both Iraq and
Afghanistan. Because the Middle East is one of the most oil rich regions in the world,
there existed a very real possibility of the U.S. neutralizing the area and taking control over
production. This would have greatly cut the supply of oil, which leads to a price hike. An
example of political instability leading to the downward pressure of oil would be embargos
and oil rich producers. The United Nations as well as almost every Western country
imposed embargos against Russia after its annexation of Crimea. Russia, being one of the
world’s biggest oil producers, suffered heavily because of its inability to find demand. The
unmet supply, coupled with oil prices severely declining due to OPEC’s supply glut led to
Russia almost defaulting again on its Ruble.
Recessions
A recession is one of the rare cases where demand is dictating the price of oil. Austerity
focused fiscal policy (the opposite of Keynesian policy) suggests that the government
– and similarly consumers – cut back on spending in order to combat the effects of a

recession. Trivially, a cut in consumer and government spending implies a reduced need
for oil and its synthesized products (i.e. gasoline). With machines operating at rates far
lower than full capacity and jobs and businesses shutting down, demand for oil and natural
would naturally decline. This decline in demand along with a stagnant supply decreases
the price of oil
Speculation & Futures Contracts
While demand and supply affect oil prices, it is actually oil futures that set the price of oil.
A futures contract for oil is a binding agreement that gives a buyer the right to buy a barrel
of oil at a set price in the future. Speculation over these future prices, oftentimes through
the factors mentioned above, influences the current price of oil and natural gas.
The recent oil downturn can be attributed to three factors: lower demand for oil in Europe
and China, OPEC imposing a supply glut in order to gain market dominance (i.e. force
competitors below breakeven prices), as well as the introduction of horizontal hydraulic
fracturing in U.S. Shale plays (which made the U.S. self sufficient, decreasing global
demand as well as increasing supply).

REAL ESTATE INVESTMENT TRUST
Real estate investment trusts (REITs) are companies that own and most often actively
manage income-producing commercial real estate. Some REITs make or invest in loans
and other obligations that are secured by real estate collateral. The shares of most large
REITs are publicly traded.
REITs are required to distribute at least 90 percent of their taxable income to shareholders
annually in the form of dividends.
Financial progress can be gauged is by comparing levels of Funds From Operations (FFO).
FFO, the industry’s supplemental performance measure, differs mainly from net income
by excluding depreciation and amortization of real estate assets and gains and losses from
most property sales.
FFO is reported in the footnotes, and companies are required to reconcile FFO and net
income. The general calculation involves adding depreciation back to net income (since
depreciation is not a real use of cash, as discussed in the above paragraph) and subtracting
the gains on the sales of depreciable property. These gains are subtracted because we
assume that they are not recurring and therefore do not contribute to the sustainable
dividend-paying capacity of the REIT.
In estimating the value of an REIT, professional analysts therefore use a measure called
“adjusted funds from operations” (AFFO). AFFO does not have a uniform definition.
However, the most important adjustment made to calculate it is the subtraction of capital
expenditures.
Once we have the FFO and the AFFO, we can try to estimate the value of the REIT. The
key assumption here is the expected growth in FFO or AFFO. This involves taking a careful
look at the underlying prospects of the REIT and its sector.
9
INDUSTRY SPECIFICS
Calculating Funds of REITs

44
Important REIT characteristics to look at is the growth in the following areas:
• Prospects for rent increases
• Prospects to improve/maintain occupancy rates
• A specific plan to upgrade/upscale properties
• A popular and successful tactic is to acquire “low-end” properties and upgrade
them to attract a higher quality tenant. Often a virtuous cycle ensues. Better tenants
lead to higher occupancy rates (fewer evictions) and higher rents. External growth
prospects
The total return on an REIT investment comes from two sources: (1) dividends paid and
(2) price appreciation. We can break down the expected price appreciation into two
components:
1) Growth in FFO/AFFO
2) Expansion in the price-to-FFO or price-to-AFFO multiple
Utilizing these as trading multiples, you can use them within comparable tables to create
a valuation. Analyzing dividend yield is also key as REITS are usually used as lower risk
vehicles in a financial portfolio.
Many REIT analysts look at net asset value (NAV) as a reference point for the valuation
of a company. NAV equals the estimated market value of a REIT’s total assets (mostly
real property) minus the value of all liabilities. When divided by the number of common
shares outstanding, the net asset value per share is viewed by some as a useful guideline
for determining the appropriate level of share price. You can refer to the NAV valuation
section of this guide to perform the valuation.
Industry Specifics: Real Estate Investment Trust

FINANCIAL INSTITUTIONS GROUP
The Financial Institutions Group, or “FIG”, includes: Banks, Insurance Companies,
Asset Managers, Diversified Financial Companies (Credit card companies and the
like), Intermediaries / Securities Firms / Other Financial Companies (Custodial Banks,
Exchanges, Brokers, Financial Technology, etc.) Like Energy and Real Estate, FIGs are a
slightly different beast from your typical EBITDA / cash flow driven companies (“Widget”
companies) because the balance sheet drives the income statement, and not the other
way around. The assets of FIG companies (loans, investments, cash and securities, etc.)
generate revenue in the form of interest and investment income.
Basically, FIG companies “borrow money” (i.e., source capital) cheaply and then “lend
money” (invest that capital) expensively. Much (though not all) of their income is
generated by the spread between those two rates of return. Additionally, because of the
sources of some of their capital (largely individual consumers), there is strict regulation
surrounding what kind of assets FIG companies can and cannot hold on their balance
sheet, and in what quantities.
Banks
How Do Banks Make Money?
Net Interest Income (50-75% of revenues).
The interest they receive on their interest-earning assets (loans), less the cost of: The
interest they pay on their interest-bearing liabilities (deposits) and the cost of bad loans
(mortgages they foreclose on)
Banks hold deposits, for which they pay little interest, and use them to make loans, for
which they earn as much interest as they can. They also have to eat the cost of loans that
default, how much of which is dependent on the quality of said loans and what collateral
(if any) is associated with them. Recall from macroeconomics that a bank is able to
constantly loan out money and make profits on spreads as long as the bank is capitally
adequate.
Besides just deposits, banks can also fund their lending activities using wholesale funding
from other financial institutions, the government (i.e., the Fed), and the capital markets.
Together, these comprise a bank’s interest-bearing liabilities. Equity contributions are also
a source of capital, though it is usually fairly limited because of how banks deliver value
to shareholders and the capital requirements associated with how they maintain their
balance sheets.
10
INDUSTRY SPECIFICS

46Industry Specifics: Financial Institutions Group
The investments banks “interest-earning assets” are primarily composed of loans
(mortgages, commercial financings, construction loans, etc.), but can also include
investments in other sources (securities, proprietary PE-type investments, stocks and
bonds, etc.) depending on a bank’s capital position. The reason that interest expense is
included “above” the top line (in net revenues) is because interest expense for a bank is
analogous to COGS for a widget company. The uses of the liabilities drive bank interest
expensesarefungiblebetweenbeingoperationalandbeingatraditionalsourceoffinancing
since again, their assets are their capital.
Non-interest income (25-50% of revenues)
Sources of non-interest income mostly compose of fees, but can include other fun stuff
as well.
Banks charge fees for pretty much anything they can get away with – likely the best know
examples are investment banks charging advisory fees and commercial banks charging
lending and deposit fees (think ATM fees and the like).
Besides fees, other common sources of non-interest income include:
• Principal Transactions– for certain sources of their capital, banks are not limited
solely to fixed income able to make principal investments which are slightly more
risky – merchant banking, for example.
• Asset Management – Detailed further below, but also a fee – on the assets being
managed
• Credit cards – Besides the loans associated with the card, banks also use them to
generate interchange fees (essentially a transaction fee – the reason so many delis
in the city don’t take AmEx is because their interchange fees are much higher than
other issuers)
• Some investment income not included in interest income (typically from principal
transactions)
• Anything else that doesn’t involve interest income.

Income Statement and Profitability Ratios
Income Statement: Now, taking the above and walking through the rest of the Income
Statement, we have the following (explanations below):
Interest Income
Less: Interest Expense
= Net Interest Income
Add: Non-interest income
= Total Revenue
Less: Non-interest Expense
= Pre-Tax, Pre-Provision Earnings
Less: Credit Loss Provisions
= EBT
Less: Taxes
= Net Income
Definitions:
Non-interest Expense – Essentially SG&A. Includes compensation expense, technology
and equipment, marketing and sales, etc.
Credit Loss Provisions – Banks have to assume that some portion of their loans are going
to default. In anticipation of that, they set aside a certain amount of capital each period to
match what they estimate the losses will be for the loans they originated. This is charged
against the I/S in the period during which the loan is originated – i.e., not when the loans
actually default (if they default). The capital they set aside and charge against their
revenues goes to a reserve fund (a contra asset) on the B/S called Loan Loss Reserves –
discussed below.
Key Profitability Ratios:
Net Interest Margin (NIM) – Net Interest Income / Average Earning Assets
• Higher is better
• How effectively bank is using assets to generate income
Efficiency Ratio = Non-Interest Expense / Net Revenues
• Lower is better
• Measure of operational efficiency
Return on Average Assets (ROAA) = Net Income / Avg. Assets
• How effectively bank is using assets to generate income

Return on Average Common Equity (ROAE) = Net Income / Avg. Common Equity
• Ability to generate returns to investors in its common stock
Loan Loss Reserves and Asset Quality
Loan Loss Reserves
As mentioned above, banks set aside a provision each period based on the loans they
originated in that period. This goes to a contra asset called Loan Loss Reserves, which is
basically an “emergency fund” for when loans go bad and the bank has to cover the cost
of default.
Where it gets tricky is that a loan can be behind on payments and not be considered a
default. The process of disposing of bad loans therefore involves the following steps:
1. Loan is made
2. Borrower stops repaying loan
3. Up until 90 days past due, the bank accrues the interest on the loan as if it will
eventually be paid back.
4. After 90 days past due, the loan goes to nonaccrual (they stop assuming they will
get paid back any interest) and is considered a Non-performing Loan (NPL)
5. TheNPLisappraised(basedonthevalueofthecollateralandanymoneytheborrower
can repay) and the expected loss from the loan is charged against the reserves (the
Net Charge-offs, or NCO)
6. After the loan is foreclosed, any collateral is sold, and any recaptured principal is
added back to the reserve as Recoveries. In the case of mortgages or real-estate
loans, the collateral is called Other Real Estate Owned (OREO) – basically all the
houses the bank has repossessed that they haven’t been able to sell yet.
Each period, the reserve calculation is as follows:
Loan Loss reserve, BOP
Less: NCO
Add: Recovers
Add: Credit Loss Provision Expense (from I/S)
= Loan loss Reserves, EOP

Asset Quality Ratios
A banks asset quality is determined by what portion of their earning assets are not
performing – i.e., not paying up. A bank with a lower portion of NPLs and Non-performing
Assets (NPAs) (any earning asset that isn’t earning, whether due to default or non-
payment) is going to perform better, so banks want to minimize these kinds of loans while
also making sure they have enough reserves to cover the loss potentially associate with
them.
NPLs / Loans and NPAs / (Loans + OREO)
• Lower is better
• Reflect the portion of assets not earning money
NCOs / Avg. Loans
• Lower is Better
• Amount of loan losses caused by customers default and lack of collateral
Loan Loss Reserves / Total Loans
• Higher is better, but too high means a bank could have money used for reserves
that could be put to better use (i.e. increasing the Return on Equity with riskier
investments)
• Indicates adequacy of size of reserves
Capital Adequacy and Regulation
To reiterate, a bank wants as many interest earning assets as possible… and it wants to
earn as much interest on those assets as possible. The problem is that, generally, loans
with higher interest rates are also loans with higher risk profiles. Since the deposit base
utilized by banks is one of the foundations of the financial system, there are all sorts of
capital requirements regarding what a bank can and cannot use different types of capital
for. Taken to an extreme, if a bank took everyone’s deposits and lost them all betting on
red, then a lot of people would be SOL (the FDIC only covers up to $250k). Regulators
don’t want that to happen, so they put in rules saying “You can’t bet people’s money on
red, because that’s too risky, but you can invest this money in treasuries or something we
think is safe”.
To determine if a bank has enough capital to handle a “worst-case scenario” (think stress
tests), banks use a variety of capital ratios to determine how solvent they really are and
how big the risk that they lose everybody’s money is. The numerator of these ratios is
some definition of what a bank’s “safe” capital (sources of funding) is, which is divided
into tiers of decreasing safety thusly:
Tier I
• Tangible Common Equity (TCE) – Equity less preferred equity, goodwill, and other
intangible assets
• Preferred Stock
• Trust Preferred Securities (TRUPS) – A hybrid security primarily used by banks

Tier II
• Loan Loss Reserves
• Subordinated Debt
While the denominator is some representation of a bank’s total assets (i.e., loans and
other investments):
Tangible Assets (TA) – Total assets less goodwill and intangibles (i.e., assets that could be
reasonably recovered in bankruptcy)
Average Tangible Assets (ATA) – Average TA over a given period
Risk-Weighted Assets (RWA) – Total assets, where each asset class is weighted based
on its level of risk. The risk-weightings for cash, for example, is 0%, since cash is “risk
free”. Thus, for RWA calculations, Cash would be deducted since it bears no risk. Most
governmentsecuritiesareweightedat20%,sincetheyare“kindofsafe”,whilecommercial
loans and ABS / MBS are weighted 100% of their value, and can be rated higher than
100% if they are below investment grade (BB).
Capital Adequacy Ratios
Tangible Capital – Simple, conservative approach to evaluating bank solvency
Tangible Common Equity Ratio (TCE) = (Total equity – intangible assets, goodwill, and
preferred stock) / TA, essentially tells you the amount of losses a bank can take before
shareholders equity goes to zero
Capital Adequacy Ratio = (Tier 1 Capital + Tier 2 Capital)/Risk Weighted Assets
The current capital adequacy ratio that the international Basel II accord mandates is 8.5%
for Canadian banks. Many banks often set aside more capital than the 8.5% as a safety
precaution to extremely poor economic stress scenarios. In order to achieve at least an
AA credit rating, banks need to ensure that they will not default on their tier 1 and tier 2
capital on a 99.95% confidence level.
Regulatory Ratios – Used by bank regulators to capture the difference in risk between
asset classes
Tier 1 Common Capital = (Tier 1 Assets less preferred shares and non-controlling interest)
/ RWA

Valuation
As opposed to industrial companies and due to the nature of their business, banks are
valued based on cash flows to shareholders only (in contrast to cash flows to shareholders
and debt holders), as debt funding is directly correlated to the bank’s assets and its
profitability.
Banks tend to trade primarily based on Tangible Book Value (book value that would be
available to shareholders in bankruptcy) and Earnings (P/TBV and P/E).
• P/E – Because of the capital adequacy concerns mentioned above, banks are only
able to dividend a limited amount of their earnings each period to equity holders,
since they may have to retain some portion of their earnings in order to improve and/
or maintain their capital position. Higher multiples are driven by higher quality (i.e.,
consistent) earnings
• P/TBV – A representation of how many income-producing assets a bank has. Higher
multiples are driven by higher ROTCE ratios.
• DCFs–WhileDCFsarerarelyusedtovaluebanks,theycanbeappliedtoanestimation
of future dividends (assuming a constant capital ratio) though this method is heavily
dependent on cash flow and growth assumptions.
Insurance Companies
How Insurers Make Money?
This can be broken down into two ways again:
1) Underwriting Income
The premium payments they receive, less:
The claims payouts they make
The operational costs associated with generating the policies that pay those claims
2) Investment Income
Money they make by investing the cash they receive from premiums before they have to
pay out claims
Most of their income typically comes from investments. Insurers can and do make money
from their insurance operations, but they usually price their products competitively so
that they receive as many premiums as possible. Sometimes this means that they break
even (or even come out negative) on a given insurance product because if they price it any
more expensively then a competitor will capture that premium.
Premiums are analogous to a bank’s deposit base – they represent cash with almost no
cost-of-capital (or even negative cost of capital if an insurer is able to turn an operating
profit) that insurers can invest for themselves (hence why Warren Buffet loves insurance
so much). They want the investment income they can make on the cash they have lying
around while it’s waiting to be paid out for policies.

Life vs. P&C
The insurance industry is broadly divided into two categories: Life Insurance, and Property
& Casualty (P&C) Insurance (i.e. car / house / medical insurance – anything that isn’t life
insurance).
The reason for the distinction is because of the nature of the payout periods for life
insurance vs. other kinds – life policies, by definition, last longer than any other type of
insurance a consumer may purchase. Therefore, once they sell a policy, they know with
reasonable certainty that they have the capital they get from those premiums for a fairly
long amount of time, allowing them to make conservative, long-term investments that will
generate more investment income than ones with lower time horizons.
P&C insurers, on the other hand, have much shorter policies and payout periods. As such,
in addition to investment income, they tend to rely slightly more on the income they can
generate from their actual underwriting operations because they’re churning through
policies.
Accounting Quirks
Thetotalvalueofagiveninsurancepolicyisnotstatic.Therevenueandexpensesassociated
with a policy (both historical and projected) can change over multiple periods. As such,
there are a lot of accounting quirks associated with how insurers report their financials,
mostly to do with how to reconcile the timing mismatch and estimates informing their
underwriting profit. There are a boatload of variables that can affect how a policy is valued.
Example to demonstrate:
Let’s say you have a 3 year renters insurance policy, which you paid entirely up front. The
insurer now has your cash in its hand, which it can use to invest, but it doesn’t actually
“earn” the money for years 2 and 3 until years 2 and 3 happen, so what’s the fairest way to
recognize it? And what about the associated investment income?
Then, let’s say halfway through year 2, you get robbed and they have to pay out the full
value of your claim. The recognized claim expenses associated with the policy to that
point had actually been nil, but the reported expenses had been estimated (based on
actuarial statistics). Now the insurer has to take this actual expense amount (the claim
payout) and spread it out over the 3 years, including retroactively updating the recognized
year 1 expense amount.
Then on top of that it turns out the salesman who sold the claim had a clause in his
contract that he would lose his unvested bonus if a certain amount of his policy sales
resulted in claims, so now the commission expense associated with the policy also has to
retroactively change for year 1 and the estimate for commission expense may have to be
lowered for year 3.

You also have the investment income / losses, which include both realized and unrealized
interest income, dividends, capital gains and losses, etc, and all the fun accounting rules
that get associated with them.
Add to all this the fact that most insurers also take out their own insurance policies (called
re-insurance) in order to hedge / manage their overall risk, so if your policy was reinsured
it was likely ceded, or “given” to another insurer, who is actually the one now responsible
for paying you (though indirectly).
Oh, and don’t forget the taxes associated with all of the above.
Ratios
Weighted Investment Returns = Interest and Investment Income / Total Value of All Cash
and Investments
• Tells if an insurer is putting its money to good use
Expense Ratio = Total Expenses (Commissions + Underwriting Expense) / Average value
of assets under management
• Lower is better
Valuation
Valuing insurers is slightly different for Life vs. P&C insurers. Both generate investing
income, so valuation based on balance sheet (including ROE and ROA) is important in
the same way it is for banks. Because P&C insurers generate more of their income from
underwriting, their valuation is also informed more by their operational performance.
Ratios Both:
• P/BV or P/ TBV – Higher for higher ROE
For P&C:
• P/E – Higher for higher quality earnings
For Life:
• P/Embedded Value – Higher for higher ROEV
DCFs are also possible for insurers in a similar way to banks – they can be valued based on
their expected future dividends assuming constant capital requirements.

Other FIG Sub Sectors
Diversified or Specialty Finance
These include FinCos (payday lenders, etc.), “Non-Bank” Credit Card Companies (Visa /
AmEx / MC), Mortgage REITS, Business Development Companies (BDCs), and agency
(GSEs)
The main source of revenue for both banks and specialty finance companies is net interest
spread earned on loans and leases, with the funding model as the primary differentiator
Whereas banks primarily extend loans by expanding credit through fractional reserve
banking, i.e. “deposit funding”, specialty finance companies must secure its loanable
funds in the capital markets
Deposit funding is a unique legal privilege granted to banks, but comes with significant
regulatory strings attached limiting the potential scope of banks’ lending activities Hence,
there is a need for specialty finance companies to deliver credit products that do not fit
well within a bank regulatory construct Specialty finance companies also compete directly
with banks in certain areas.
Diversified financials are valued in the same way that banks are.

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