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Pay-back: "Pay-back" is a simple device for calculating the profitability of an investment and for establishing priority among alternative investments. The device is sometimes called "pay-off". The calculation of pay-back is done so that the total invested amount is divided into the annual payment surplus which the investment generates.

The company's Board of Directors will usually have established goals for the maximum time for pay-back of an investment.

Example: A company makes an investment of €10M (ten million Euros) in a new machine. The machine is expected to provide a payment surplus of €3M per year. A straight pay-back will give a payment period of 10/3 = 3.3 years (that is, the investment will have been paid back in 3.3 years). If the requirement is at most a 4-year pay-back, the investment in the example above could be made.

The disadvantage of a simple, straight pay-back is that it does not take into account the company's cost of capital and the fact that the future payments will have a lower present value. The "Pay-back" device can therefore be supplemented with a present value calculation of the future payment surpluses. The discount interest rate which is used must correspond at least to the company's average cost of capital, WACC. If, in the example above, we assume that the company's WACC is 10%, the current value of the annual cash flow will be:

Year 1: €3M x 0.91= €2.73M
Year 2: €3M x 0.83= €2.49M
Year 3: €3M x 0.75= €2.25M
Year 4: €3M x 0.68= €2.04M
Year 5: €3M x 0.62= €1.86M
Etc.

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The diagram above shows the accumulated cash flows as calculated to present value. As appears from the diagram, the investment of €10M will only be repaid after 4.2 years if the cost of capital is included. With a goal for pay-back of at most 4 years, the investment will not be made.

Even if a simple, straight pay-back calculation has its deficiencies, it is a good device for making a quick and simple judgment about whether an investment will meet the company's goal for pay-back time. It is also a good device for prioritizing investments -- the quicker the pay-back the more profitable the investment is. But in order to obtain a more complete picture of the investment it is necessary to use supplemental devices, e.g., DCF and NPV, to determine whether it is profitable or not.

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DCF
NPV

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Pay-off: "Pay-off" is a simple device for calculating the profitability of an investment and prioritizing among investment alternatives. Another name for "pay-back".

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Pay-back

Peer group

A comparison group of similar enterprises in the same industry. In order to be able to compare and evaluate the efficiency of a company it is important to compare its key numbers with those of similar enterprises in the same industry. Competitors' key numbers are especially interesting. Among the important key numbers are profit margin, return on equity capital, R&D costs, and personnel costs in relation to turnover.

Another important measure is the P/E ratio which gives the share's price in relation to the earnings per share.

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PE-ratio

Penny stock

The term originates from the United States and corresponds to shares that have a relatively low price (below $5) and associated with high risk.

Penny stocks offer a relatively low starting investment since the price per share is low and allows higher returns compared to investments in more stable shares, e.g., in blue-chip companies.

Trading volumes are often weak, and when a decline occurs in the stock price, it can be challenging to divest and to get out of the investment. Since the risk is high and the share price volatile, the investor must be aware that the entire invested capital can be lost.

General rules are:

Be careful and do not invest too much
You should know the industry
Chose the right company
Mitigate the risk and invest in more than one company
Be prepared of the worst case

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Blue-chip

P/E ratio: The share priced divided by the earnings per share (price/earnings). The P/E ratio is a very common measure for evaluating the company's market value relative to that of other similar companies.

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Peers

Pirates

Investors who buy significant shares (controlling positions) in a business without certain large owners, the Board of Directors or the management having consented. This is then regarded as a hostile takeover. The investors' intention is often to take advantage of hidden values in the business, for instance by dividing it up and then selling the parts individually. The hypothesis is that 1+1 equals more than 2.

Pirates are regarded by some as being short-sighted, greedy investors while others think that they liberate values in sleepy businesses. See also "Corporate raiders".

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Pitch: When competing suppliers get to introduce themselves to the buyer and to tell about what they can offer and why they rather than others should be chosen. A pitch is a short presentation in which everyone has the same, very limited, time to say why they rather than others should be chosen.

Poison pill: A poison pill is a method to make a hostile takeover of a corporation more difficult and expensive. Poison pills give the board of a company the opportunity to give the existing owners, or management, special rights that will complicate an unwanted buyer's acquisition of the company.

It is a common practice used in the US but is difficult - or impossible - to apply in countries and jurisdictions where all shareholders must be treated equally. The poison pill method can be regulated in the articles of association to allow the Board to make a rights issue to existing shareholders at a very favourable price. The intention is to increase the number of shares in the company and dilute the new owner to a level that an acquisition becomes unprofitable.

Critics argue that poison pills reduce the efficiency of the market when they prevent necessary acquisitions and restructurings. The term is also sometimes used to refer to a clause in a contract. For example, an unexpected situation can turn out to be a big disadvantage to certain parties of the agreement while giving other parties a great advantage.

The term poison pill is a term taken from the spy world. By taking a poison pill, an outed spy - with death as a resort - avoids interrogation and torture.

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Positive cash flow: A company has positive cash flow if it creates sufficient cash (liquid assets) with its own business to cover its costs and investments. If the case flow, i.e. the unrestricted cash, is not needed for the development of the business it can be paid out to the shareholders.

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Portfolio

Is used as a collective concept for the businesses in which an investor has invested. A "portfolio" consists of a number of businesses, and the investor who has the overall responsibility is called the Portfolio manager or something similar.

The businesses in the portfolio usually have no business relationship with each other and are not part of any common group. An individual company is called a portfolio company.

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Post-money

The term "post-money" means the situation in a company after a new issuance of securities. Assume that a company is valued at €10M (ten million Euros) before an addition to capital through a new issuance of securities. The valuation after the new issuance will then be €10 + €5 = €15M, which is the value post-money. The value (€10M) before the new issuance is called pre-money.

Assume that you own 10% of the company before the new issuance, which means that your shares are worth €1M. If you do not subscribe for your share (10% of €5M) you will be diluted by 33%. This means that your share of the company post-money will be 6.67%. Note, however, that your shares are still worth €1M since the company's new value after the contribution will be €15M.

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Pre-emption

A pre-emption clause is a kind of a right of first refusal clause, usually in the certificate or articles of incorporation.

See more under "Pre-emptive rights".

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Pre-emptive rights

Pre-emptive rights

Pre-emptive rights are similar to the rights of first refusal and may be governed either in the certificate or articles of incorporation or in an agreement (shareholders agreement) among the existing shareholders. The intention is to have control over who may come in as a new owner if one of the owners wants to sell her or his shares.

The difference from a right of first refusal is that the person who wants to sell shares must, before the sale occurs, notify the Board of Directors that he or she wants to sell shares. Usually there is already a potential buyer who has stated a price and terms and conditions. The existing owners then have an opportunity to acquire the shares before they are sold to a new owner.

Price and terms and conditions must be the same as in the offer the potential buyer has made. The offer must correspond to a market price and be at arm's length, i.e., where the buyer is not related to or a close friend of the seller. If there is no bid with price information, an effort will be made to find a device for determining the market price. See "Price mechanism".

How a pre-emption rights clause is exercised varies depending on the jurisdiction. But it is common that the communication between the new and the old shareholders will occur through the company's Board of Directors. When the Board of Directors has obtained approval for a new subscription or received information that a sale to a new owner has taken place, the Board of Directors must inform every existing shareholder who is entitled to subscribe or purchase shares as a result of the pre-emptive rights.

If no owner responds to the offer, the transaction can go through with the new owner.

Preferred shares

Preferred shares give the holder special rights ahead of other shareholders. The most common is that such a shareholder has priority with respect to dividends, which means that the holder of preferred shares will get dividends before other shareholders. Preferred shares can also have priority in the event of liquidation of a company (a liquidation preference).

The preference is usually governed by the certificate or articles of incorporation. Shareholders may also agree by means of an agreement (a shareholders' agreement) that certain shares are to have preference with respect to the purchase price which a buyer pays for the company in the event of a future sale. This is called a contractual preference. The preference may also be so designed that certain investors in the company get back the amounts they invested before other owners receive part of the purchase price.

Premium: Compensation or price for an asset, for example for insurance or an option.

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Pre-money

The term "pre-money" means the situation in a company before a new issuance of securities. Assume that a company has a pre-money valuation of €10M (ten million Euros) before a €5M addition to capital through a new issuance of shares. The valuation after the new issuance then will be €10 + €5 = €15M, which is the value post-money.

Assume that you own 10% of the company before the new issuance, which means that your shares "pre-money" are worth €1M. If you do not subscribe for your share (10% of €5M) you will be diluted by 33%, and your share of the company post-money will be 6.67%. Note, however, that your shares are still worth €1M since the company's new value after the contribution will be €15M.

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Price mechanism

At the start of the process for a large share transaction or the sale of a company, it is usual that the price of the company and the shares will be determined by some agreed method. The price mechanism may consist of the value of the company being determined by multiplying its profit by a constant (compare Enterprise Value).

Another method may be that two accountants who are independent of one another provide their respective views as to the value, and the seller and the buyer then agree that the value midway between the accountants' valuations determines the value of the company.

The methods for determine the price of a company are often supplemented by a price adjustment mechanism which will adjust the price if the result, assets or debts on the balance sheet change before the transaction closes. These adjustments may relate to dividends paid to the owners or to changes in cash, inventory or receivables.

Compare also "locked box" which is another example of a price mechanism.

Profitability is measured in percent and is a measure in which the profit is placed in relation to the capital which has been invested. As a private person, for example, the profitability of your savings accounts at a bank is measured by dividing the annual interest by the amount of the accounts. For example, if you have saved €1,000 and receive €50 (your profit) in interest, the profitability of your savings is 5% per year.

In a company, profitability is measured by placing the profit in relation to the capital the company uses.

Profit and profitability are two concepts which are often confused. But as appears from the foregoing, profit is not a measure of profitability. Assume that you have two savings accounts, in which you have saved €1,000 in one and €5,000 in the other. The first account pays interest of €50 and the second €100. The profit (the interest) in the latter account is twice the size and it would be easy to believe that the profitability is higher too. But if the profit is placed in relation to the amount saved, we see that the profitability is 2.5%, that is, only half as large compared with the first account -- which pays 5%.

In a similar fashion, we can look at the profitability in a company. If company A shows a profit of €200M and company B a profit of €400M, this does not necessarily mean that company B, with its higher profit, is more profitable. In order to measure profitability in a company, the profit must be placed in relationship to the capital which the company uses, i.e., the capital which is invested in the company.

We can thus define profitability in a company as:

Profitability=profit/invested capital.

The profit in a company can be seen as the interest" on the capital which has been invested in the company. Sometimes the concept of return on capital is used as a synonym for profitability in a company. The different profitability measures used are:

The term "adjusted equity" capital (AEC) includes that part of the untaxed reserves which belongs to the company and the shareholders after taxes have been paid. In the calculation of the adjusted equity capital regard may also be taken to the average equity capital during the year. Therefore, AEC is usually higher than what is reported on the balance sheet as equity capital.

What, then, is sufficient profitability? The answer, of course, is it depends. In a simplified model of the pricing of capital, it is assumed that the market (lenders, investors, banks and so on) determine what profitability (return) they expect in order to offer capital. The profitability which the market expects determines in turn the price of capital. The interest rate which a bank wants in order to lend you money is thus the market price you have to pay to borrow money from the bank.

The market price of capital varies with the risk, mainly dependent on whether a borrower can re-pay the amount used. For example, in order to get access to capital loan and obtain the market price, you are expected to pay the required interest and amortization. In the same way, it is expected that a company will be able to pay interest and amortization to the bank as well as dividends to its owners.

Of course, the lower the risk that a borrower cannot make its payments to a lender, the lower the price of the loan will be. If there is no uncertainty at all, for instance when the state borrows, it is common to speak of a risk-free investment and a risk-free interest rate. Since the state is usually seen as a very safe payer, the interest rate on government bonds is often used as a measure of a risk-free interest rate. Loans to private persons and businesses therefore include a certain risk premium in addition to the risk-free interest rate.

The price of capital is, however, not only affected by the ability to re-pay capital. It is also affected by the market's willingness to take risk. In good, positive times, lenders and investors are willing to take greater risks and offer capital for lower compensation, and in uncertain times they are asking for a higher price.

How, then, is the market price of equity capital (the owners' capital) to be determined, that is, the capital which is often called risk capital? Basically, the price of equity capital is the return which an investor expects in order to be willing to put capital into a company or to buy shares on a securities exchange.

An investor's requirement as to the return on capital of her or his investments is the sum of risk-free interest plus a risk premium for the unavoidable, systematic business risk, that is, for the risk which cannot be eliminated through the use of a diversified investment portfolio. The size of the risk premium cannot be determined with certainty; it varies with the business, over time and is based to some extent on subjective expectations about the future. The risk is naturally greater with a newly started, unlisted company as compared with a large, listed company, the shares of which can be sold if the investor is not pleased with the developments in the company.

Example:

Assume that the risk-free interest rate, at a particular point in time, is 2%. Assume, further, that the average risk premium, at the same point in time, for large companies on a securities exchange is 5.6%. The total required return (and the price) for securities exchange listed ownership capital here will be 7.6%.

Since the business and financial risk in smaller companies is greater, the risk premium will be affected also. We will assume that a small listed company (e.g., market value less than €50 million) at the same point in time has a risk premium supplement of 3.7%. This gives a total risk premium of 9.3% and a required return of 11.3%.

In an equivalent way, investors will make judgments about risk premiums and return requirements for unlisted companies. It is not uncommon for an investor to require twice the risk premium in order to contribute capital to an unlisted smaller company, which would mean a total return requirement (and price) for equity capital in the company exceeding 20%. A contributing cause of the materially higher risk premium in this case is that the shares can be very difficult to sell (the shares are not liquid) if the investor is not pleased with the developments in the company.

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Lever

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Promissory note

A type of document which shows that there is a debt. It is a written agreement between two or more parties which is prepared in connection with a loan.

The promissory note states who the parties are, the borrower/debtor and the lender/creditor, as well as the terms and conditions of the loan. A promissory note is usually held by the creditor. When the debt has been paid, it will be cancelled and returned to the maker (debtor).

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Proposal: Investment proposals, leads.

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Pro rata: The proportion of an owner's share of the company (the number of shares owned divided by the total number of shares), often measured in percent.

Putting your business card on the table: Introducing yourself to a desirable customer or business partner with hopes of business in the future. You give your business card to the potential customer or leave it on the customer's meeting table.

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