Principles of Finance: Unit 4, What’s That Company Worth?

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.

CoursesFinance Concepts
Principles of Finance
FinanceFinancial Responsibility
Personal Finance
Finance and EconomicsPrinciples of Finance
LanguageEnglish Language
Life SkillsPersonal Finance
SubjectsFinance and Economics

Transcript

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

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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

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

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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

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for only twenty million dollars of net invested capital today

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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

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

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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

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Of their value from the assets they have in the

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door that they manage they take a fee at fi

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

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minimum amount of cash for the nineteen twenty style rainy

02:25

days So book value gets looked at when valuing banks

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But again book value is kind of window dressing in

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just one very small element in valuing things One silly

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

02:39

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

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bad the book value accounting system is in measuring the

02:44

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

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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

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value of all of its asset is one hundred twenty

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million dollars i e net value held on the books

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for that tractor smelting plant the value of remaining leases

03:04

cash debt patents and so on The market tto book

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

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seven hundred twenty million divided by the book value one

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Hundred twenty million and that gets you six x This

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is a relatively high ratio It either means that the

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tractor company is really old and has appreciated a lot

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

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

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instead is a computer software company where book value truly

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has almost no correlation with anything in theory Ah high

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ratio like this anything better than two acts would be

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a reflection that management used its cash well in buying

03:43

things investing in things for the company But since time

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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

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it was a crazy hot area like internet search in

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nineteen ninety nine you know in google being born in

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which case well they would have lagged that search market

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

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taken twenty years to double the book value of the

04:12

company to create a market to book of two ex

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well then they compounded it just seventy two over twenty

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or about three point five percent per year Not very

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good return So you got to take all these book

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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

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p e ratios price to earnings ratio is got it

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

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people to value public or large companies while most small

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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

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

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

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million dollars they earn how much per share Well two

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hundred fifty million five hundred million shares is to fifty

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

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times two fifty twenty times earnings Stock markets historically hovered

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around fifteen twenty times earnings roughly depending on prevailing interest

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rates and the overall global economy and a bunch of

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other factors but twenty times is not a crazy high

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

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about this number in context of real life Your family

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owns a pizza parlor You worked your tails off all

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

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very large restaurant does a million dollars in sales that

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year and after paying for bread electricity booze rent insurance

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labor little league marketing sponsorships and whatever else you net

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after everything a hundred grand in earnings all right someone

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

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

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hundred grand for hundred grand at that number you just

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sell and move on But if your parlor received a

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

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or twenty times that hundred thousand dollars or two million

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

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for a building with bread and light like tomato sauce

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

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building is part of all this you just rented so

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

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Pizza parlors and had a lower body making the pizza

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and kids could custom make their own pizza exactly the

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way they wanted it with x percent cheese and y

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percent spiciness and z percent crusty nous and have it

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all delivered to their home by a drone And they

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could watch it all under glass and a webcam viewing

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

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shut up for fifteen minutes while the owner you know

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did the beer thing And what if the owner of

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robot pizza had patents for all his pizza Robotic stuff

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in his much smaller five restaurants today produced a million

06:44

dollars revenue one hundred grand earnings but he had plans

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next year to open twenty restaurants in the next year

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one hundred restaurants the next year three hundred restaurants with

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each one producing twenty grand in profits Well if he

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had three hundred restaurants coffin out twenty grand a year

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will that be six million a year in profits And

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

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

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given their how into the robot maker the kids seem

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To be so now someone looks at buying robot pizza

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and the price is way higher than twenty times earnings

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What if they offered ten million dollars What does that

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

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earnings is that ten million a multiple of against this

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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

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whole lot of risk that funeral kids fall out of

07:38

love with a robot pieces or that one of them

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escapes the glass and enslaves the kitties and makes them

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so tennis shoes all day long for a dollar The

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basic idea here is that there are lots of variables

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lots of risk lots of unknowns When you hear journalist

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quoting that x y z company just sold for an

07:55

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

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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

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

08:09

what the earnings would go up tio and they go

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up a lot In the next few years they figured

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they were really paying just a few times Earnings of

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the earnings three years from now not one hundred x

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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