How Do Investment Bankers Judge How Well a Company is Performing? - dummies

How Do Investment Bankers Judge How Well a Company is Performing?

By Matt Krantz, Robert R. Johnson

How do investment bankers, investors, and management judge how well a company is performing? For most publicly traded companies, the obvious answer would be how well the stock is doing. The bottom-line test of performance is whether the value of the stock has risen or fallen in recent times and how the stock has performed relative to other publicly traded stocks in the company’s industry or the broad stock market.

But how should you judge the performance of privately held companies? What metrics do investment bankers look for when evaluating private companies and determining the feasibility of bringing such companies public via an initial public offering?

Investment bankers look to the numbers to see how a firm is performing relative to itself over time (in terms of a trend analysis) and against other companies. Generally this analysis is done by examining ratios calculated from financial statements like the balance sheet and income statement. There are a multitude of categories of ratios that investment banking analysts as well as investors can focus on:

  • Activity ratios: These ratios evaluate how efficiently the company is operating the business and focus on such functions as inventory and accounts receivable management, as well as what level of sales the firm achieves from its asset base.

  • Liquidity ratios evaluate the company’s ability to meet short-term obligations such as paying suppliers, bondholders, and landlords.

  • Solvency ratios are the complement to liquidity ratios and measure the firm’s ability to meet long-term obligations to bondholders, lessors, and other long-term creditors.

  • Cash flow ratios evaluate the company’s ability to generate a sufficient level of cash flow to pay creditors and fund future growth.

  • Price multiples evaluate the price of the company relative to fundamentals such as earnings, sales, cash flow, or book value.

  • Profitability ratios evaluate the ability of the company to generate profits relative to revenue, invested assets, and owners’ equity.

Return on equity (ROE) is generally considered to be the most important metric for management, investors, and investment bankers. And not all ROEs are created equal. That, in fact, two companies can have identical ROEs and one company can be in a much better financial position than the other company. With ROE, it isn’t just the bottom-line number that counts; it’s how the firm gets there.