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Principles of Finance Videos 156 videos

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Description:

Robot pizza is the way of the future. The way of the present? Checking out this video on the different ways to view and value a company.

Language:
English Language

Transcript

00:00

Principles of finance ah la shmoop what's that company worth

00:07

Well sometimes the world values companies based on what they

00:09

call wall street metrics things like price to earnings ratios

00:14

and comparable stock prices or values of competitors maybe even

00:18

multiples of revenue But that's just one set of ways

00:21

to view or value a company and since there are

00:24

so many different types of company's having a few perspectives

00:28

on valuing them is probably a good idea So from

00:31

an investor's perspective the company can be evaluated through green

00:36

lenses You've already seen it a few times in the

00:38

course When you put a dollar in today as an

00:40

investor well you have to get more than a dollar

00:43

back tomorrow or it was likely a bad deal and

00:46

hint from warren buffett Don't do the bad deals only

00:49

do the good ones but when you go shopping for

00:51

stocks or companies or projects to invest in there's a

00:54

discipline that most financial managers follow so that when the

00:57

ceo or bored or angry shareholders yell at them they

01:01

have a foundation to their actions And it's usually something

01:04

a little more sophisticated than because my friend told me

01:07

To the easiest and probably least useful evaluation metric is

01:11

book value Recall that this metric is just the net

01:15

balance sheet value you are holding for a given thing

01:19

with your nerdiest bean counter hat on like you know

01:22

you bought a tractor smelting factory ten years ago for

01:25

one hundred million dollars Today you hold it on the

01:27

books for being worth twenty million in value and well

01:30

it works perfectly fine It'll work for another twenty years

01:33

and while it might sell ala carte for twenty million

01:36

dollars on ebay today well it produces tractors really cheaply

01:40

and just fine Thank you very much or said differently

01:43

for only twenty million dollars of net invested capital today

01:46

from a book value perspective while that smelter is able

01:50

to produce five thousand tractors a year yeah really efficient

01:53

production protractor So in this case the book value is

01:56

highly understated and it's way more common for book value

02:00

to be understated than overstated If the company you're looking

02:03

at uses honest non fraudulent gap accounting most accounting laws

02:07

tend to over depreciate things rather than under it Appreciate

02:11

them Banks insurance companies often arrive a very large part

02:14

Of their value from the assets they have in the

02:16

door that they manage they take a fee at fi

02:19

turns into cash By law they're required to hold a

02:22

minimum amount of cash for the nineteen twenty style rainy

02:25

days So book value gets looked at when valuing banks

02:29

But again book value is kind of window dressing in

02:32

just one very small element in valuing things One silly

02:35

ratio you'll hear quoted every now and then is market

02:39

to book ratio and it's really a measure of how

02:42

bad the book value accounting system is in measuring the

02:44

rial market value of something so let's say we have

02:48

an easy to value public company has forty million shares

02:51

outstanding and trades at eighteen bucks a share That gives

02:53

it a market capitalization of seventeen Twenty million The book

02:57

value of all of its asset is one hundred twenty

02:59

million dollars i e net value held on the books

03:01

for that tractor smelting plant the value of remaining leases

03:04

cash debt patents and so on The market tto book

03:08

ratio here is six it's just the market value of

03:11

seven hundred twenty million divided by the book value one

03:13

Hundred twenty million and that gets you six x This

03:15

is a relatively high ratio It either means that the

03:18

tractor company is really old and has appreciated a lot

03:22

of it's today Well functioning assets to being worth almost

03:25

zero or this isn't a tractor company at all and

03:28

instead is a computer software company where book value truly

03:31

has almost no correlation with anything in theory Ah high

03:35

ratio like this anything better than two acts would be

03:38

a reflection that management used its cash well in buying

03:43

things investing in things for the company But since time

03:46

isn't an element in book value calculations while it's really

03:50

hard to tell whether or not they were good like

03:52

if the company's financial managers double the value of the

03:54

company in two years well that's probably really good unless

03:57

it was a crazy hot area like internet search in

04:01

nineteen ninety nine you know in google being born in

04:04

which case well they would have lagged that search market

04:07

by six hundred percent Well conversely if the manager's had

04:10

taken twenty years to double the book value of the

04:12

company to create a market to book of two ex

04:15

well then they compounded it just seventy two over twenty

04:17

or about three point five percent per year Not very

04:21

good return So you got to take all these book

04:23

value numbers with a grain of salt but they're important

04:25

paying attention to all right moving on that was book

04:28

value Now we're looking at the wall street metric of

04:30

p e ratios price to earnings ratio is got it

04:34

well they're probably the most common metric used by normal

04:37

people to value public or large companies while most small

04:41

companies don't have really fern ings or a long history

04:44

of earnings that can derive fair multiple based on revenue

04:47

growth margins and cash flow production with calculation on this

04:50

one's easy company acts has a hundred million chairs and

04:53

we'll learn after taxes appreciation and everything two hundred fifty

04:56

million dollars they earn how much per share Well two

04:59

hundred fifty million five hundred million shares is to fifty

05:01

a share Their stock trades of fifty bucks it's twenty

05:03

times two fifty twenty times earnings Stock markets historically hovered

05:07

around fifteen twenty times earnings roughly depending on prevailing interest

05:11

rates and the overall global economy and a bunch of

05:13

other factors but twenty times is not a crazy high

05:16

multiple it's high but not crazy high so let's think

05:19

about this number in context of real life Your family

05:21

owns a pizza parlor You worked your tails off all

05:24

year long serving pepperoni beer and salad things you're one

05:28

very large restaurant does a million dollars in sales that

05:31

year and after paying for bread electricity booze rent insurance

05:34

labor little league marketing sponsorships and whatever else you net

05:37

after everything a hundred grand in earnings all right someone

05:40

comes along and wants to buy your pizza parlor what's

05:43

likely you'd be thinking you'd sell it for what three

05:45

hundred grand for hundred grand at that number you just

05:48

sell and move on But if your parlor received a

05:51

quote stock market multiple you'd be getting twenty times earnings

05:55

or twenty times that hundred thousand dollars or two million

05:58

dollars for your pizza parlor Doesn't that sound ridiculously high

06:01

for a building with bread and light like tomato sauce

06:04

in it Some cheese and you don't even own the

06:07

building is part of all this you just rented so

06:09

yeah that's crazy high but what if someone owned five

06:13

Pizza parlors and had a lower body making the pizza

06:15

and kids could custom make their own pizza exactly the

06:19

way they wanted it with x percent cheese and y

06:21

percent spiciness and z percent crusty nous and have it

06:25

all delivered to their home by a drone And they

06:27

could watch it all under glass and a webcam viewing

06:30

in robot making that pizza's entertainment so that they'd finally

06:34

shut up for fifteen minutes while the owner you know

06:36

did the beer thing And what if the owner of

06:37

robot pizza had patents for all his pizza Robotic stuff

06:41

in his much smaller five restaurants today produced a million

06:44

dollars revenue one hundred grand earnings but he had plans

06:47

next year to open twenty restaurants in the next year

06:49

one hundred restaurants the next year three hundred restaurants with

06:52

each one producing twenty grand in profits Well if he

06:55

had three hundred restaurants coffin out twenty grand a year

06:58

will that be six million a year in profits And

07:00

now there's no guarantee he grows from five parlors two

07:03

three hundred in just three years But it isn't crazy

07:06

given their how into the robot maker the kids seem

07:09

To be so now someone looks at buying robot pizza

07:11

and the price is way higher than twenty times earnings

07:14

What if they offered ten million dollars What does that

07:16

number mean Well what they're getting at is which year's

07:19

earnings is that ten million a multiple of against this

07:23

year's hundred grand in earnings it's one hundred times earnings

07:26

crazy high but against the three years from now projected

07:29

earnings of six million dollars it's only like one point

07:32

seven times earnings crazy low But that number carries a

07:35

whole lot of risk that funeral kids fall out of

07:38

love with a robot pieces or that one of them

07:40

escapes the glass and enslaves the kitties and makes them

07:43

so tennis shoes all day long for a dollar The

07:46

basic idea here is that there are lots of variables

07:49

lots of risk lots of unknowns When you hear journalist

07:52

quoting that x y z company just sold for an

07:55

insane hundred times earnings multiple it's likely that is more

07:58

of the same story as robot pizza here Probably there

08:01

was a balance of risk and reward in predicting future

08:04

earnings and whoever the buyer was paid one hundred times

08:06

Last year's earnings Well that buyer haddock Clear vision for

08:09

what the earnings would go up tio and they go

08:11

up a lot In the next few years they figured

08:14

they were really paying just a few times Earnings of

08:17

the earnings three years from now not one hundred x

08:20

last year's numbers let's Just say good financial managers don't

08:23

drive their cars just by looking in the rear view

08:26

mirror Unless there's a robot cracks re driving the car

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