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Principles of Finance Videos 166 videos

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Principles of Finance: Unit 6, Mathy Evaluation of an Investment 8 Views


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Description:

Time for a mathy evaluation of an investment. And yes, mathy is the technical term.

Language:
English Language

Transcript

00:00

Principles of finance a la shmoop a mathy evaluation of an investment all

00:08

right you're a young financial analyst at a mutual fund company you wear a red [People standing in a cue]

00:12

tie in a white shirt and are learning the various expressions you're supposed

00:16

to make when whining about taxes you know from the old people there you dream

00:21

of becoming the man well for your coverage you inherit dumbest waste of

00:26

time ever or DWOTE yeah that's actually a company that is your research director

00:31

or boss assigns you to cover this internet media company if you don't own

00:36

it and it then goes up a lot you look like an idiot and vice versa so punting [Person places football on the ground]

00:42

on even having an opinion on DWOTE is not an option meaning that you have to

00:47

come up with a buy sell or hold recommendation on the stock at a given

00:50

price so how do you do the math to come up with a recommendation beyond

00:54

blindfolds dart boards and Ouija boards and a donkey and a tail there well the [Donkey appears in a field]

00:59

key elements you note about the DWOTE story here we go they have a dollar a

01:03

share in cash on the balance sheet no debt no big off-balance sheet assets or

01:08

patent things that matter and they also have a dollar a share in trailing one

01:12

year fully taxed earnings or net income the stock is currently trading at $65 a

01:18

share or 65 times trailing earnings and yes if you subtract $1 from that you get

01:24

an equity capitalization of 64 times but kind of a rounding error here and the

01:29

scheme of things you think about it so we're gonna move on you heroically note

01:32

that in order to just get your money back in cash at this rate it would take [Man discussing DWOTE in a presentation]

01:37

your company DWOTE about 65 years to do this

01:41

yeah 64 maybe a little less than that with interest and all that but that

01:44

we're not gonna go there so lots of optimism lives around DWOTE trading at 65

01:49

last year's real profit well compounding your angst on all of this you work for a

01:53

conservative mutual fund firm who normally prefer a stocks which pay a

01:57

dividend but this is a tech company a tech media company run by 20-somethings [Young tech workers discussing work]

02:02

so yeah there's no dividend for you the overall markets trading at about 18

02:06

times earnings a bit higher than its historic levels of about 14 times but

02:10

with the Fed giving money away and we say that in quotes in the form of

02:14

very low interest rates well the higher multiple seems fair assuming that

02:18

everything else like growth rates margins etc are all about normal

02:23

whatever normal is that is growth prospects fears of war risks of Europe [Soldiers prone firing guns]

02:28

defaulting again North Korean nukes Taylor Swift accused of lip-syncing and

02:33

so on all that's normal right so you mumble and you note that if you

02:37

had a pizza parlor that made a million dollars a year it would be like the

02:40

seller of that pizza parlor asking you for sixty five million dollars for that

02:45

pizza parlor and yeah that feels like a lot of money for a pizza parlor you

02:49

wonder how a pizza parlor could ever sell for sixty five million dollars [Man discussing pizza parlor]

02:53

maybe if it sold the real estate along with it and that real estate that we're

02:57

sitting directly on a gummy bear mine but yeah sixty five times earnings cool [Man holding gummy bears]

03:01

company but wow I wouldn't be the only one in the world in love with it you

03:06

could replicate your own pizza parlor for a hundred grand in stoves and food

03:10

and cheese and dough and stuff and maybe a hundred grand or so for fronted costs

03:14

of rent and labor roundup for insurance and a little local marketing and you're

03:18

at 250 grand all-in if you wanted to start your own pizza parlor albeit from [Person taking pizza from stove]

03:22

scratch so wait how do you get to paying 65 million dollars for 1 million dollars

03:28

of earnings from this notional pizza parlor but first you think why would any

03:33

idiot pay 65 million dollars for a pizza parlor well they wouldn't nobody really

03:38

pays 65 times earnings for anything just because you see that multiple quoted by

03:44

poorly schooled financial journalists does not mean that you should believe it [Financial journalist sitting at desk]

03:48

if an investor is paying 65 times earnings on this year's numbers they

03:52

must be expecting massively fast earnings growth so they're thinking

03:56

about what multiple of earnings they're paying on next year's earnings or the

04:00

next year's and by the way pizza parlor sell for like four times earnings maybe

04:05

five with seller financing why because pizza parlors don't grow very fast they [Pizza growing in size]

04:10

have limited upside like how many people can you have put through a pizza parlor

04:14

in a year not that many you compare that to a website well it's a whole different

04:18

deal right and who really wants to own a place where little kids scream pick [Kids screaming and running around a pizza parlor]

04:22

their noses and the restrooms have you know poor aim but

04:26

DWOTE yeah it ain't no pizza parlor it's a video sharing platform for your pets

04:31

think dog Vanity Fair, squirrel selfies, platypus profiles, zebras being zazzy...

04:39

everyone loves the site the company doesn't spend a dime on marketing

04:43

because customers just walk in or you know click in the front door and that [Images of people clicking computer mouse]]

04:47

clicking thing is important unlike a pizza parlor which has a limited

04:51

capacity of maybe a thousand meals a day on a ridiculously record busy day well

04:56

there's essentially no limit to how many clicks DWOTE conserve it could literally

05:00

serve a billion clicks an hour if it wanted to

05:03

anyway the customers love the product and they get addicted fast DWOTE sells [Girl looking at computer screen]

05:08

ads and for the power users who want to market their own pet wares largely

05:12

insurance and organic foods and training devices there's a subscription fee of a

05:18

hundred bucks a month well the company has shockingly high margins as well the

05:22

only have 40 employees most of whom are in Latvia and none of whom were in

05:26

California..DWOTE hosts its site on Amazon Web Services which is super cheap [View of an office appears]

05:31

and the company's revenues could go up a hundred X and their expenses would

05:35

only double, wow you think that is scale way better business than the pizza

05:40

parlor right well what are the odds you wonder that people will still be using

05:43

DWOTE in five years hmm that's harder what are the odds people will still be

05:48

eating pizza in five years yeah much easier different risks different rewards

05:53

so the company has 100 million dollars in revenues this year operating expense [DWOTE financial standings appear]

05:56

of 15 million in pre-tax profits of 85 its biggest expenses taxes which 20 mill

06:02

oh and to make the math easier less hard they have 65 million shares outstanding

06:07

so yeah that's 65 million dollars in earnings buck a share there and a bunch

06:12

of thoughts come into your brain how can a little company of such ridiculously

06:16

high margins that are sustainable these margins are higher than the profit

06:20

margins Microsoft had in their heyday as a monopoly are these margins really

06:26

sustainable the company grew a hundred percent from last year can it keep [Important questions appear]

06:29

growing at that rate and it's such high margins like won't they have to spend a

06:33

bunch of dough marketing themselves is this a real business or a fad like

06:37

remember guitar hero pokemons go one direction yeah [One Direction band together]

06:41

well, your boss mumbles your boss at the mutual fund there I think I have things [Boss mumbling to man]

06:45

in my golf bag older than the CEO of this company does she know what she's

06:50

doing and then you ask what's for dinner well you get hungry doing financial

06:54

analysis very few six-packs in the mutual fund world all right so the [Man with six pack and cheese burger appears]

06:58

company has 100 million dollars in trailing revenues ten million dollars

07:01

comes from selling ads on the site and 90 million comes from subscriptions to

07:04

power users who pay a thousand bucks a year eighty to a hundred bucks a month

07:08

roughly but if you buy a year at a time you get the discount mainly to make the

07:12

math easier for this problem so the company has 90,000 power users

07:16

subscribers paying at a grand a year let's think about that is that a lot or

07:21

a little 90,000 well eBay has like a million power sellers but you wonder how [Man with eBay briefcase for a head working out]

07:26

big this pet market is maybe it's tapping out so you do some research and

07:30

you find that 114 percent of the world owns a pet and many own two so that's

07:35

how we got that math there and in most places people treat their pets better [Woman with a cat and a toddler appears]

07:38

than they treat their human children how crazy would it be for the subscriber

07:42

number to double like could it get to 180,000 well there's like 300 million

07:47

people in America and change and like seven billion in the world is that

07:50

really hard to think about could it get to a million well it almost has to have

07:54

a clear line to a million paying subscribers because if it doesn't well

07:57

it's not worth the risk here of 65 times earnings if the company ever missed a

08:01

quarter that is they produced growth numbers below published or [Man discussing whisper numbers]

08:04

whispered street expectations well the stock would fall out of love and plummet

08:09

that is people who owned it with high growth expectations would sell and sell

08:13

and sell and continue to sell the stock until value buyers stepped in to buy it

08:18

and put a floor on the stock but wow that's a long way down from here in this

08:22

market you know that a normal multiple is like yeah 20x for a software company

08:26

something like that maybe 25 but for a value buyer to step in the stock could [Man assessing value]

08:30

have to fall like 15 or so a share maybe less crushing and that's down $50 from

08:36

here ugh and you picture the HR lady at your mutual fund company calling you [Man thinking of HR lady]

08:40

down to her office telling you to bring your jacket and your little desk plant

08:44

with you tons of risk on the downside you pull your hair

08:48

prepping for a bigger Caesar salad that's already starting to go on up [Mans hair transforms into caesar salad]

08:52

there and you do some research and after poking around and using Google properly

08:56

you discover that the company is reserving massive storage space

09:00

everywhere hmm well yeah video takes up a lot of space it wouldn't do that if

09:06

the advance indications of demand weren't good then you meet with the CEO and [Man sits down with the CEO]

09:11

in the meeting you notice tons of pictures of animals all over her desk

09:15

and walls and around her neck she's kind of weird she stands to shake your hand [CEO stands up and shakes mans hand]

09:20

but tada you see that she is pregnant you want to talk about her stock she

09:26

wants to talk about being a parent and you have seven kids who were adopted

09:30

when she learns of your massive fatherhood well suddenly you feel her

09:34

liking on you a lot she's relentless and asking you all about your daily life the

09:40

events you share how it is to be a father of seven kids you know that

09:43

normally these interviews go the other way around with you interrogating the

09:47

CEO but this time she's interrogating you about babies odd and then a light

09:53

shines through the window on your Caesar salad you feel the warmth and you [Light shines on mans head]

09:56

realize because you're smart and they hired you and they pay you a lot of

10:00

money to work at this mutual fund company that she's about to launch a

10:03

video product for parents to share videos of their children with their pets [Woman with child on a swing]

10:09

a whole new market financially probably 40 times the size of the pet market you

10:15

reckon and since this company already has a loving cute brand while who

10:18

doesn't love baby zebras and platypuses or platypi is it more whatever you're

10:23

willing to bet that it will be trusted and embraced by a million parents in not [Images of parents with their kids]

10:28

too long so yeah babies wow that's a big idea the revenues from that would dwarf

10:33

her pet revenues you take a deep breath knowing that the laws of regulation FD

10:38

financial disclosure she cannot disclose anything to you that isn't already

10:43

publicly broadly known and she didn't tell you she's doing a site about babies

10:48

you're just making a big guess here and you could be wrong so you could ask flat

10:53

out if she's launching that product on the baby's thing and watch her face lie [Man discussing baby video launch to CEO]

10:57

or you could just let it go and buy the stock well the financial estimate

11:01

projection math is easy ish if they got to a

11:04

million users paying a grand a year with maybe half from the US and half from

11:09

everywhere else because many other countries around the world do have

11:12

babies that would be a billion dollars a year in revenues a million times a

11:16

thousand one BFG a big fat gig even if expenses ballooned massively the company [Expenses balloon inflates]

11:22

would still show something like 800 million dollars in pre-tax profits

11:27

it would have generated a ton of cash for itself in the interim and the cash

11:31

matters example in 2009 Apple is trading for about 50 bucks a share and had 40

11:35

bucks a share in cash and no debt meaning the street valued the equity of

11:39

Apple for just $10 a share you could have bought some how do you feel and

11:43

after tax in this setting DWOTE would have something like 650 million dollars

11:48

in profits on 65 million shares outstanding in that'd be earnings of

11:52

like $100 a share now multiply that by 50 bucks and you get a company worth

11:57

some five billion dollars in change and there's probably upside even from there [Apple and DWOTE growth numbers appear]

12:02

so if you actually believed those growth numbers you'd be paying less than one

12:06

times earnings if you bought the stock today even at the high multiple of

12:10

trailing earnings $65 and albeit earnings of the stock a few years from

12:14

now could be a whole lot different well you run not walk to the lobby and you [Man running towards lobby]

12:19

call in a big fat buy order to your traitor at your mutual fund company and

12:23

then you pray a lot [Man praying in church]

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