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Principles of Finance: Unit 1, The Five Principles of Finance 106 Views


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What are the five principles of finance? We're talking the time value of money, the relationship between risk and reward, and... you'll have to watch the vid for the others.

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00:00

Principles of Finance, a la Shmoop. The five principles of Finance. Why is

00:07

there always a number like this, like the Four Horsemen of the Apocalypse, the six

00:12

wives, of Henry the eighth's, the three musketeers, the seven Habits of Highly

00:17

Effective People. Finance more, or less has five wheels under its chassis and [car with five wheels]

00:22

that fifth wheel sort of explains why the markets and the economy so often you

00:26

know go off the rails. Anyway just know these five bad boys. Here we go.

00:30

Principal one, the time value of money. Mantra, a dollar today is worth more than

00:36

a dollar tomorrow. Why? Well because you can in theory, always invest that dollar

00:41

and get a positive financial return from that investment. If you picked quote, the

00:45

safest bet in the world, unquote. Well by investing in American Treasury bills,

00:50

which are guaranteed more, or less by the American government's ability to tax its

00:54

hardworking people. Well then you'd get a small return on your [man talking in dark room]

00:59

investment. For a more practical example think about you investing a thousand

01:03

bucks to buy a t-bill yielding three percent.

01:05

Well bonds like this usually pay twice a year, so six months later you'd get what?

01:09

Well if your total interest per year was three percent, on a grand invested then

01:13

you'd get thirty bucks, a year, for doing a whole lot of nothing. Other than let[money in bank vault with American flag]

01:17

your grand sit with the Gov. So twice a year you'd get a check for fifteen bucks.

01:21

But it's about two lattes, but it's a positive investment return that's pretty

01:25

much guaranteed. Silly example, but there were about a hundred eighty two point

01:29

five days, that made up the six months, that yielded to you, your $15. So how much

01:35

did you earn per day, based on that figure? Well about fifteen dollars,

01:38

divided by one hundred eighty point five, or about eight cents a day. Well the gist

01:42

here is that, the thousand dollars today, was worth more than the thousand dollars [January calendar]

01:47

tomorrow. That is invested in the form of a very safe 3% T bill. The dollar today was

01:53

worth about eight cents more than the dollar tomorrow.

01:56

Well time values a pretty dull concept when it's three percent a year, on a

02:00

relatively small amount of money. But let's calculate something more fun. Okay,

02:04

our idea of fun, sorry. We netted a hundred million dollars after tax, after

02:08

an IPO of a company we founded. We want some toys and bling. First off we want

02:13

to shrink the world, so let's buy a jet. A

02:15

shiny new cj3, cost about twelve million dollars and another fortune to operate,

02:21

to ensure, to store, to gas up, to pilot and so on, but don't let's ignore all that. So

02:27

we plan to keep it 20 years. After 20 years, the plane will be worth, [jet flying]

02:30

not much. Figure four million dollars, at auction, so we'll lose eight million

02:34

dollars over twenty years, or four hundred grand a year, so yeah that jet

02:38

was expensive. But it gets way, way, worse. With a 20 year time frame, we could have

02:43

felt pretty good about putting our money in the stock market in equities, in the

02:47

form of an index fund. Over the hundred and fifty or so years that the modern

02:51

stock market has been tracked over most 20-year periods the markets gone up,

02:56

about eight, or nine percent. And with dividends reinvested, maybe a little [stock graph incline]

03:00

bit more. And yes there were bad periods where performance was flattish, but there

03:03

were also really good periods, where performance was way better than that

03:07

eight or nine percent figure. So let's just pick the middle of the curve for

03:10

now. If all we did with our twelve million dollars, was put it in the market

03:13

and get it back 20 years later in a bad stock market era. Well we'd have done

03:18

way better financially, than if we had bought that new jet outright. Right? We

03:22

lost eight million dollars for the pleasure, plus maintenance, gas and risk

03:26

and the comparable cost to fly commercial would have been massively [man in commercial airline]

03:29

less, that we won't even bother with that now. Let's bet that the market does what

03:34

it usually does on average over this 20 year period. It goes up 8.2% a year, well

03:39

had we invested in our index fund, which charged us point two percent a year for

03:43

maintaining that index. We would have had a ton more dough.

03:47

How much more? Well the magic formula, take the dollar amount you invested and

03:50

multiply it by one, plus the rate of return and take that quantity to the power of years.

03:55

Looks like this, in this case the formula would be, twelve million dollars, times [man presenting in dark room]

03:59

one, plus point zero eight, to the 20th power and note that the market went up

04:05

8.2% a year, but we only kept eight point zero percent of it because we had point

04:10

two percent a year in fees. This is a big deal when you look at mutual funds which

04:14

carry are R rated fees and then hedge funds which carry triple X's, but we'll

04:19

get into that later. Anyway, 1.08 to the twentieth powers about five, so gulp if

04:23

you would put your twelve million dollars into an index [man presenting in conference room]

04:26

fund twenty years later, it would be worth sixty million dollars. Instead of the

04:31

four million dollars, you got. And yes that's the right math we checked it twice.

04:35

Jets are nearly the worst investment you can make and life's short and the super wealthy,

04:39

well they want, what they want. As Marie Antoinette said, let them eat jet fuel.

04:44

Well one other note, worth noting here, is a cute little formula called the rule of

04:48

72. Read it, know it, know how to use it, it saves lives.

04:51

Well it doesn't really save lives, but it'll make yours a lot better,

04:54

our lawyers made us say this. All right moving on, principle two, risk and reward

04:58

are related. Popcorn question, why do you get eight percent returns from the stock [movie theater]

05:03

market in equities and you only get three percent from safe bonds. Well a

05:07

bunch of things affect rates, of investment returns. But the biggest issue

05:11

revolves, around whether you'll get your money back, or not. And/or a positive

05:15

multiple of your money back over time. Okay here's a chart of bond performance,

05:21

it's flat. Basically it's a dead man's pulse. Very few bonds don't pay back what [money on table]

05:26

they promised and yes a few go bust but compared with equities, bonds are a

05:30

massively safer investment. But you pay a big price for that safety over time. That

05:35

twelve million dollar jet money, invested in a bond over 20 years at 3%, well

05:40

ignoring taxes, which are also generally worse for bonds, than stocks. Well it gives

05:44

you just about twenty one point six million. Way better than owning that jet

05:48

and think about how many first-class commercial tickets that dough would have

05:51

bought. He had a lot of pretzels. Anyway with stocks, you turned your dough into

05:55

sixty million dollars in twenty years, so for that bond safety you just paid [finance chart]

05:59

almost forty million dollars, in net difference over those twenty years for

06:04

that safety. How's that feel? You feel safe for now, or just less wealthy? Well

06:09

things could have gone the other way, had you bought at the worst time. Say

06:13

late 1973, held them to the worst period in 1993, with dividends reinvested. Well

06:19

you would have compounded at only about six percent, about ten percent with

06:23

dividends reinvested, albeit well with a lot of headache.

06:26

Look at how stocks declined from 73, to 83, brutal. But also look how dividend [stock graph chart]

06:32

rates went up. That is when companies stocks declined,

06:36

they don't usually just cut their dividends, they keep paying them. And

06:39

investors who need and/or want the cash returned to them from their initial

06:42

investments are happy to get checks four times a year, because while equity

06:46

dividends are paid quarterly, unlike bonds, which are paid twice a year. But

06:50

look at the chart, could you have stomached being down almost 50 percent

06:54

from 73 to 79? Would you have panicked at just the [bond action site]

06:58

wrong time and sold all of your stocks and moved into bonds at just the wrong

07:02

time? Well taking on risk is a lot about personality and liquidity, ie

07:06

you don't need that investment to be cashed out tomorrow and well it's about

07:11

courage too. But over time as you take bigger risk you would expect to be

07:14

rewarded incrementally, for taking on that risk. And there are times to not

07:18

take a lot of risk, of course as well. Like if you're planning on buying a home [pink house]

07:22

in six months, well you likely don't want to be invested in the market. In a bad

07:26

six month period, things can go down a lot. The big fat hairy idea here, well

07:31

it's that time bails you out of risk when you're investing in stocks. If you

07:35

can hold an investment a very long time, historically it's made no sense to own

07:40

bonds instead of stocks. All right moving on principle three, the market as a

07:44

popularity contest, versus being a weighing machine. Warren Buffett, the [man walking out of pool]

07:48

Michael Phelps of public investing said, in the short term the market is a

07:52

popularity contest. In the long term it's a weighing machine. Well what on earth

07:57

does that mean? Well he's referring to short-term and long-term thinking in

08:01

investing and Buffett is a famously long-term greedy investor. That is

08:05

Buffett likes to buy things and stick them in a drawer for decades, not weeks.

08:09

Over time market prices are truth, they are accurate, they are honest. But in

08:15

short periods of time the market can go crazy. Later in this course we'll get

08:19

into the internet bubble of the late 1990s, where companies would go public on

08:22

very little revenue, with valuations of billions of dollars, many of them died, or [graveyard with tombstones]

08:27

simply had aweful investing returns, due to the schmuck, or speculative buyers who

08:31

bought them. A few did really well, a little company called Google's one of

08:35

them, Amazon's another, eBay, PayPal another. But most ended up doing poorly if

08:40

you held them 20 years. Conversely toward the end of the

08:42

2008 nine mortgage crisis, a ton of companies were trading the other way, Ie

08:47

crazy cheap. And these were stable always gonna be there companies, like

08:52

coca-cola and Pepsi. Which traded down to below, ten times earnings at one point. [soda market graph chart]

08:56

Like the market in the short term, was telling you that the odds of people

09:00

drinking drinks, not just soft drinks was kind of an iffy proposition.

09:04

Well things normalized, with Coke and Pepsi trading at right around there

09:07

adjusted historical price, to earnings ratios in the low 20s, eventually. Key

09:12

takeaway, be sensitive to the sentiment the market is feeding you, but when you

09:16

buy stocks for the long haul just buy good companies and good industries, right.

09:20

Even if you overpay in the short run, good companies bail you out in the long

09:25

run. All right, principle four, cash is king. Ever hear of Hollywood accounting, [Hollywood sign]

09:30

profits, well they don't exist when the talent in the movie participates, or gets

09:35

a percentage of them. Let's go through a simple example with something a bit more

09:38

tangible. The company, We're Nuts about lug Nuts, has four hundred million

09:42

dollars in revenues, in a given year, and 300 million dollars in expenses. Leaving

09:45

a hundred million dollars, to be taxed. Tack on a 30 percent tax rate and after

09:49

30 million dollars in taxes, the company is left with seventy million bucks in

09:53

earnings. Well the shady mystical figure, in all of [man silhouette]

09:56

these calculations is the notional definition of expenses. Let's say the

10:00

company spent three hundred million dollars on a factory, to stamp out its

10:03

lug nuts more efficiently. Well the accounting rules might require that all

10:07

that money be expensed, in three years or it might be in 30, or it might be viewed

10:12

as an investment and it just stays static forever, held that Book value. If a

10:17

company had to expense everything in three years, well then the company would

10:20

be required to expense a third of that hundred million dollars of that 300

10:25

million each year. If they had to expense the capital expenditure of the lugnut [robot working in factory]

10:29

roboto stamper in three years then a hundred million dollars of profits in

10:33

that year in the two subsequent years would be fully wiped out. The company

10:37

would essentially pay no taxes and well end of story.

10:41

Alternately the company might have had to amortize that cost over 30 years,

10:46

taking off 10 million dollars a year, in expenses. From an accounting perspective

10:49

then the company would show 90 million of profits and pay 27 million bucks in [white board with expenses and profits]

10:54

taxes. For now don't worry about the numbers too much the key idea, is that in

10:57

order to fairly evaluate the value of a company, you have to follow the cash, or

11:02

cash earnings and look through accounting tricks, which can change the

11:06

bottom line in earnings, dramatically. All right well the magic word in all of this

11:10

is GAAP. that's GAAP and you're supposed to say it like that. It stands for

11:14

generally accepted accounting principles, and it basically just tolds that when you

11:18

practice accounting, you always present your numbers in the most reasonably

11:22

conservative manner possible. In doing so, you take away the risk of you know

11:27

puffing out your feathers, saying that your company is in fact more profitable

11:32

than it really is. For example think about the case where

11:34

your lugnut Roboto stamper really does wear out in ten years and it has to be [robot breaking down]

11:38

replaced. Well in that case the 300 million dollars spent to build it should

11:43

in fact be taken away in some form, amortize, depreciated in a sinking fund,

11:47

whatever, so that it surprises nobody when in 10 years, you owe another 300

11:52

million dollars to go buy, or build a new one. All right moving on, principle five,

11:56

last one, here stick with us. Agency problems, all right well what is an agent? [man in office room]

12:01

For most people when they hear that term they think about a guy in a slick suit

12:04

in the Hollywood office selling clients time into a studio system with a lot of

12:08

let's do lunch you know that regular catchphrase and that really is what

12:11

financial agency is about. When a client hires an agent, a relationship structure

12:16

is formed. That is there are legal requirements around the behavior of that

12:21

agent, specifically the agent has to look out for the best interests of his client

12:26

and he has to put his own best interests on the backburner. This structure is a [bacon cooking on stove]

12:29

really big deal in the financial world, because so many poor unsuspecting,

12:33

uneducated, people have been screwed over in the process by big city slickers

12:38

taking their dough, with no comeuppance. Myriad laws, regarding disclosure and

12:43

appropriateness of advice and other elements all have blood on their hands.

12:48

That is each law, that you'll learn about exists because somebody, was screwed over,

12:52

or sued and a new law was edited to cover that corner case situation. Where a

12:57

fast-talking thief, took the money of our beloved mom and pa

13:01

kettle. [man in conference room presenting]

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