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Alan Cring Productions in association with Emergent Light Studio presents the Illinois State Collegiate Compendium, academic lectures in business and economics.

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This is business finance, FIL 341 for autumn semester 2024.

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Today, corporate and stock valuation.

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And I will take something of a back and forth approach to the two subjects.

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They're highly interrelated, but one is a little bit more straightforward than the other.

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But before we go into that fun for the day, I'll look at the numbers.

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And as you can see, it is a very odd day.

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The Dow was started off, it plunged on the opening this morning.

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I mean, it just dropped, it was dropping like a rock.

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And then it just started coming back and everyone said, oh, that was over with.

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But as you can see, it still is a bearish day.

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Just kind of like a kangaroo kind of activity.

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It just is not finding positive territory.

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And one thing though, and I'll point this out in just a minute here, it's something that I had been talking about.

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And I've finally, you're beginning to see some of the financial media picking up on something I've been talking about.

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But right now, as you can see, these indexes actually, the S&P 500 and the NASDAQ started out positive this morning.

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And then they just got spooked down, just straight down.

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Now, these are not massive drops.

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You can see that the Dow is down only a third of a percent.

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And the S&P 500 down a little more, almost a half a percent.

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The NASDAQ is down quite 1%.

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So it's not like a massive black swan or something like that.

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It's just a grouchy day, a bad day on the street.

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But individual stocks are actually kind of doing not bad.

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And I'll show you a few here in just a minute.

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But the good news is over here on the crude.

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There is, I'm afraid that it is short-lived, but the concern that there was going to be a big blow up in the Middle East,

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Israel was going to bomb the hell out of Iran, Iran was going to turn around and bomb the hell out of everybody,

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it looks like, well, it doesn't look like it. I've heard the traders say, well, we're not worried about that now.

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So the price of oil is beginning to ease back down because those expectations of supply interruptions out of the Gulf,

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Persian Gulf, have eased up.

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That's not going to last long if, that's still a powder keg over there.

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But right now there's this kind of this belief that, well, maybe this all will pass, as it has in other times historically.

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In my time in the many years, decades, I've been doing this kind of analysis.

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We've had near wars over there on a number of occasions that just, you saw the same things here.

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Well, they're on the verge of attacking each other, blowing up each other and all that kind of stuff.

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And then they just went away and went back to the usual, we hate you, you hate us tension and all that.

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So this might be one of those little incidents like that.

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Or it could be another kind where there is, I heard someone use a term that I kind of like, a flash war.

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We've had a couple of those in the 50s and 60s and 70s where there was a war, but it lasted only three days or seven days.

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And so those are possibilities too.

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But whatever is going to happen, right now the markets are thinking that it's going to fizzle out.

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And that's why the price of crude is beginning to slip back down.

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It's gone below that old trading range, 72 to 79, and it's heading back for the more recent one that was from 62 to 69 or 61.

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So yay for that. That's going to help us.

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But the gold bugs are a little excited about something.

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I don't know what it is, but there's been some buying in the last five, six hours in the gold market.

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But here's one that is really good news. The bond market, the yields are slipping.

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We've got the bond yield down to four.

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It's dropped a good, healthy five basis points.

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And that means that that upward surge in bond prices, bond yields is at least for the time being over.

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And we may by Friday see the bond yields going below 4% again.

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We were down there almost to 3.5%. And that was really exciting.

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And then we had that spike.

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The bad news is that bond yields going down, that means bond prices are going up.

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That means there's buying in the bond market.

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And if you see over here, there's selling in the equities market.

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In other words, this day is a flight to quality.

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A flight from riskier investment assets, financial assets, to safer financial assets.

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So yeah, great.

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Interest rates, the yields are lower, but we're seeing a flight to quality.

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Now go over here real quick.

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Look at activity on the Standard Port is 500.

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And as you can see, we're still in that, by this time of day, we should see at least 2.2 billion.

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And we're seeing 1.5, 1.6 billion.

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So in other words, these big players are staying on the sidelines.

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There was an article yesterday, and I wish I had saved the website.

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It was these investment types that are, I think it was on Forbes.

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There's been a significant movement of funds into money market accounts over the past weeks.

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Well, that's been going on, and now they're beginning to publish that this is going on.

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And so it's getting noticed now that there is a lot of money on the sidelines.

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This worry about what's happening next.

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And very quickly, looking at the VIX, and I'll look at the core, the index, the volatility index itself.

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As you can see, look at that.

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Son of a biscuit eater.

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Now notice the timeframe on the VIX.

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That's a futures market.

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That's futures activity.

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And as I said, each futures type has its own timeframe on the clock.

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These kinds have maybe, this one starts at about 2.30 in the morning, and it runs until 3 in the afternoon.

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And then there's ones that run much longer, 20 hours.

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Oil has its own time.

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Metals, each one has its own time.

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And so what we're seeing here is that before the opening this morning of the stock markets, of the exchanges,

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you saw the volatility drop.

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It was quiet, like the calm before the storm.

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And then right as the bell was ringing, well, no, just before the bell, the volatility just spiked.

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The market makers were just all over the place.

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Now I use the term market maker, and I think I've said something about it before,

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but a lot of folks have a misunderstanding of how stock prices form and how stock prices change.

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A lot of that is behind the scenes.

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I'm going to have one of my former students from some years, more than a few years back.

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He has been a trader, and he does a good job of explaining the role of the market makers.

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They are the ones who decide what the prices are.

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And they are always acting, of course, in their own interest.

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And they can do things that aren't quite understood by the average trader,

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is when the market makers do their thing, sometimes they will affect,

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they will use options to cover a position as they're pulling in stock.

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They might also be taking covered calls, writing covered calls, or they might be buying puts.

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And then as they do that, that begins to affect the prices that they are going to call out to buy or sell the stock.

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So there's an old saying, derivatives are derivatives because they derive their price from the underlying stock.

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Actually, these days, it's a two-way street.

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The price of the stock drives the price of the options.

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But if the market makers are pulling hard for protecting their positions, covering themselves and all that kind of stuff,

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they can affect the price because that lets the market makers have more room to play

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on what they're doing for calling out prices at which they will buy and sell stocks.

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This is one of the reasons that the brokerage houses are now doing a lot of intra-house dealing.

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In other words, they're not going through market makers.

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They are going to their own, essentially, one side is buying and selling for their customers.

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And then there is another side that has buys and sells and keeps stocks for their own house.

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So instead of going to the market makers to fill an order for a client, they might say,

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well, the market makers are in a pissy mood right now or something like that.

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And they'll just go to their own house, their own investment house in the building and say,

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we want to do this transaction here within the house.

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Now, the house can say, yes, sure, or the house can say, no, we don't want to do any trading in that stock right now

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because our inventory is slim.

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You'll get a better deal from the market makers or something like that.

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Now, I'm oversimplifying this all to hell, but this is the basic outline of what's going on out there in this world.

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So if you're into investments, it is not what we teach you here is just the beginning.

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This is what it looks like on the surface of the ocean.

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And then you go under there and you look and there's a megalodon saying, it's a giant,

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it's a whirlpools and geysers and all that kind of stuff going on under the surface of this.

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And of course, in a course you would take from me here, this is, I can't go into all of it.

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And what's even worse is if I teach a master's level or a PhD level course, I'm taking them down the path of the theory.

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I'm not taking them down the path of here's what happens.

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You want to know what happens?

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Go out there and get a job cupcake.

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You'll see it real quick.

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So I'm trying to give you an insight not into what academia helps you with.

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I'm giving you an insight into the bizarreness of what's going on out there.

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Oh, okay.

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I wanted to go through just a couple of quick stocks here.

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Now, a few I showed you, INTC, Intel.

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Now, the thing about these stocks right now is this is earnings season.

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So you've got the rumors all over the place.

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Are they going to beat their earnings estimate?

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Are they going to miss their earnings estimate and all that?

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Right now, the money is on.

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They gave an estimate of their earnings right here.

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Okay, they gave an estimate that they're going to have slightly negative earnings.

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Now, the rumors now are centering on their earnings aren't going to just be slightly negative.

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They're going to be bad, the earnings on Intel are.

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So that's what's driving the market down right now is these persistent rumors that it's going to be a bad.

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Okay, there's the earnings estimate.

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And then there is the report of the earnings.

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And then there is another, these are calls.

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Actually, they are, they call the Wall Street Boys and they talk to them.

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So they give the estimate to the Wall Street Boys and then shortly after that,

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they publish it for the general media to pick up.

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And then the rumors start and then finally the earnings are issued.

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Now, oftentimes, even though it's technically not right to do it,

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they will give their earnings a few minutes to the Wall Street Boys before the media picks it up and runs with it,

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the general media, general financial media.

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Now, there's another part of it too.

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It's called the guidance call, earnings guidance.

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That's where they explain to the Wall Street Boys, this is what happened.

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This is why it happened.

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And then they are either praised by Wall Street, they're condemned in the call.

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Sometimes those calls can be awful.

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I mean, there's not, well, yes, there is.

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Usually it's a very dignified earnings guidance call.

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Well, this is what we did and this is why this happened, either on the good side or the bad side.

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Guidance calls are more likely to be a thing if they miss their earnings estimate.

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But sometimes it can just be awful.

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I mean, there can be cussing and swearing.

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And of course, the company is just sitting there, I know, I know, because they can't say, you know.

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If they started, if Wall Street Boys started yelling at me because I missed my estimate, I'd say, look, bitch.

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But in that world, they're just going to say, OK, yeah, we're going to do better.

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We're going to fire, lay off a lot of people.

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They'll do all that.

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But it can still be kind of painful to do that.

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So that earnings estimate, they try to hit it on the button.

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But, you know, estimates are what they are, estimates.

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And so Intel is expected to have worse earnings than what they're projecting, what they've estimated.

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And it looks like it's going to be bad enough that there will be a guidance call.

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And that guidance call is going to be, shall we say, contentious.

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Let me look at the one month.

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Right now, there is a slide.

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But if you look on a larger level, it's not as bad a reaction as we've seen to there.

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Let me go back here further.

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Now, notice here that Intel, and I'm focusing, I know I already showed you Intel once,

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but I'm going to just talk about it again here.

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Look at, I'm going to look at the one year.

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So we can see a couple of other quarters.

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Notice in past quarters, they were doing well until this most recent quarter where they reported they missed their earnings

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and they missed them rather badly.

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So going back over here and looking at how Wall Street reacted to that over looking at about a year,

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you notice, oddly enough, that over the past year, there has been a general slide in Intel's stock price.

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And as you can see that there was just a drop off.

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But overall, it has recovered a little bit.

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But I guarantee you, if they have a really bad earnings call this time, it's going to drop hard.

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That's why we're seeing what we're seeing right now.

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The five day, the rumors start and then they corrected, adjusted for what they think the earnings will be.

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That's this part right here.

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And then this recovery is actually a little bit of optimism.

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Well, everyone's saying they're going to drop by, the earnings are going to be this bad.

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And then there's more voices saying not as bad as you thought.

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We think they'll be bad, but not as bad.

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So there's been a little bit of a recovery in here in the past couple of days.

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So that's how you can read these charts.

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Now let's look over here, trying to find something that's a good news kind of stock, or at least in that area.

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I wrote Conoco.

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There we go.

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Now this is oil.

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This is an oil company, Conoco Phillips.

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And as you can see, they're getting potty trained right now by the market.

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If you look over the past six months at them, there has been a general downward decline because oil prices were going down.

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Revenues were going down.

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That has been recovering of late because they benefit from a war premium.

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War is good business, especially for oil companies, for manufacturing companies, some kinds of manufacturing companies.

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So it has been good of late.

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However, there is still a larger trend downward because on the high seas there is a lot of oil in the tankers.

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The intermediates and the very large dirties are full, and they're going into the ports, and they're backing up in the ports right now.

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And so even if we did have a war premium shockwave, it would not mean the end of civilization.

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If we get over the war soon enough, there's plenty of oil out there, and everyone knows who's in the business.

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If you look at the shipping platts charts for the oil tankers, they're just dotting all over the place, heading this way and that way.

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Small ports, medium ports, and the giant ports, there's plenty of oil out there.

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So the long-term outlook for companies like ConocoPhillips, Marathon Oil, those kinds of companies is not that good

219
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because they're going to have to charge lower gas prices and lower prices for the distillates.

220
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So everything looks good right now.

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No apocalypse on the horizon, just in case you want that.

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Now, one more just to look at, Minnesota Mining and Manufacturing.

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I'm at 3M.

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3M, one thing that you can kind of tell is when you've got these basic industries, the basics that are mining,

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and 3M is highly diversified now, but its core is still, it's a metals mining company.

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That's manufacturing and all that good stuff.

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If we look over a period of time, let's look over the last one year.

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That's a recovery. That's recovery.

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This bullshit that we're about to go into a black swan any day now, Jesus is returning and all that, well, I would hope so,

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but unfortunately I have to teach tomorrow because he ain't coming.

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00:21:01,000 --> 00:21:04,000
It's going to keep rising. It's looking good.

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This is what you look at. What are the markets actually saying?

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Regardless of what they're saying and what the podcast talking heads are talking about, look at the trading.

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00:21:17,000 --> 00:21:20,000
Look at what's, greed is driving those prices.

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Greed doesn't do stupid stuff unless it's really something that's attractive that isn't underneath it all.

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But you've seen here, this is growth.

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This is growth of the demand for metals, demand for the consumer goods that 3M makes.

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That's what you should look at.

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And you see this and you look at this, I could show you other examples in other industries.

240
00:21:44,000 --> 00:21:53,000
It does not look bad at all investment prospect wise.

241
00:21:53,000 --> 00:22:00,000
But as long as there's this fear out there, the fear is there, we're not going to grow.

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We're not going to go into a full expansion.

243
00:22:04,000 --> 00:22:06,000
Anyway, enough of that.

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Now, let me take you on a little journey here.

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Now, this you've seen, FIO 240, I guarantee you've seen most of this.

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00:22:16,000 --> 00:22:20,000
But I'm going to take you on a little bit deeper run of it.

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And for the math of it, for a lot of math, I do have Excel templates that will help you do, for example,

248
00:22:28,000 --> 00:22:34,000
pricing a stock by the dividend growth model and all that kind of stuff.

249
00:22:34,000 --> 00:22:36,000
Now, some of these are somewhat incomplete.

250
00:22:36,000 --> 00:22:41,000
You have to do a little more fill in the blank and all that, but it's nothing terrible.

251
00:22:41,000 --> 00:22:50,000
However, there are two kind of different ways that use the same concepts of math,

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00:22:50,000 --> 00:22:57,000
present value of future expected cash flows to determine the value of a company.

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00:22:57,000 --> 00:23:07,000
Ultimately, if we can find a good estimate of the market value, the current market value of a company,

254
00:23:07,000 --> 00:23:10,000
kind of simplistically, we divide by the number of shares outstanding,

255
00:23:10,000 --> 00:23:13,000
and we've got the intrinsic price per share of the company.

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00:23:13,000 --> 00:23:24,000
So, for example, if we find that the present value of future expected cash flows is, let's say, $100 million,

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and this company has a million shares outstanding, well, then $100 million divided by $1,000,

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yeah, shares would mean that each share would be $100,000.

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The bottom line there is that it all comes down to estimating the future expected cash flows,

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estimating them out far enough that we can get a reasonable present value of those future expected cash flows,

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and then divide it by the number of shares, we've got intrinsic value.

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And yes, this is just how it's done by a lot of the analysts in the houses.

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It's just almost a straightforward exercise.

264
00:24:14,000 --> 00:24:21,000
The real trick is estimating future expected cash flows.

265
00:24:21,000 --> 00:24:34,000
And there is a lazy way to do it, and there is the hard way to do it.

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The lazy way to do it is to estimate your current free cash flow, and then apply a growth rate to that estimate,

267
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and then find the present value of that future expected cash flow.

268
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It all boils down to a formula that we have from the past.

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The price, this is the constant growth PV model.

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And it works like this.

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The present value currently would be, if it's constant growth,

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it would be the free cash flow, one period out, divided by the discount rate minus the growth rate.

273
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That's your constant growth model.

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You saw it in FIL 240, and here it is again.

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It's just, it's nothing complicated at all.

276
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This comes from a mathematician, 200, 250 years ago, figured this one out.

277
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He was a child prodigy, and when he got big, he did all kinds of weird math that, a lot of it,

278
00:26:08,000 --> 00:26:13,000
no one understood why are you bothering, you're a brilliant, you're a genius, why are you doing this?

279
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And in some cases, he actually operated under a fictitious name to publish all these different formulas.

280
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And as time went on, over the centuries, we figured out, oh, that's how you do, we can do this.

281
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And in finance, this is one of his formulas, Gauss his name was.

282
00:26:33,000 --> 00:26:49,000
Okay, so, anyway, now, free cash flow one would be free cash flow zero, FCF, times one plus the growth rate.

283
00:26:49,000 --> 00:26:52,000
Okay?

284
00:26:52,000 --> 00:27:01,000
And the discount rate, we would use the weighted average cost of capital.

285
00:27:01,000 --> 00:27:03,000
That's all there is to it.

286
00:27:03,000 --> 00:27:06,000
I mean, it's relatively simple.

287
00:27:06,000 --> 00:27:14,000
And I've got one, an Excel template, you can put in the number for FC zero, and the growth rate,

288
00:27:14,000 --> 00:27:18,000
and the weighted average cost of capital, and boom, there's your Uncle Bob right there.

289
00:27:18,000 --> 00:27:24,000
The present value of the infinite stream of cash that comes from that.

290
00:27:24,000 --> 00:27:34,000
That is the lazy man's way of doing it, and the lazy woman's way of doing it, to be gender neutral there.

291
00:27:34,000 --> 00:27:38,000
We don't do much work for this one.

292
00:27:38,000 --> 00:27:43,000
The trick would be, with this one, would obviously be getting your weighted average cost of capital.

293
00:27:43,000 --> 00:27:46,000
And I've got a template, you can even do that.

294
00:27:46,000 --> 00:27:56,000
Fortunately for us, Excel is quite good at those painfully tedious little calculations.

295
00:27:56,000 --> 00:27:59,000
And I'll show you that on Thursday.

296
00:27:59,000 --> 00:28:05,000
I'll show you how you can actually calculate a weighted average cost of capital.

297
00:28:05,000 --> 00:28:10,000
From the component cost of capital, the cost of debt after taxes, the cost of common equity,

298
00:28:10,000 --> 00:28:13,000
the cost of preferred equity, the cost of new equity.

299
00:28:13,000 --> 00:28:17,000
You can crank it out within a matter of a minute or so.

300
00:28:17,000 --> 00:28:20,000
Just plug in the numbers, and out it comes.

301
00:28:20,000 --> 00:28:25,000
But for now, just whack, I'll just talk about it as whack.

302
00:28:25,000 --> 00:28:28,000
Okay, now, the next one is the growth rate.

303
00:28:28,000 --> 00:28:32,000
What would you say is the constant growth rate?

304
00:28:32,000 --> 00:28:42,000
Well, you could use previous growth rates to figure out what the future growth rate is.

305
00:28:42,000 --> 00:28:45,000
And there are two ways that you could do that.

306
00:28:45,000 --> 00:28:49,000
And I'll show you an example right now.

307
00:28:49,000 --> 00:28:52,000
Matter of fact, let me do something.

308
00:28:52,000 --> 00:28:55,000
I'm going to pull up an Excel sheet.

309
00:28:55,000 --> 00:29:04,000
Since most of you have Excel background, this isn't rocket science, but I'm going to pull up.

310
00:29:04,000 --> 00:29:16,000
Okay, and then I'm going to make this big so my cataract-covered eyes will be able to see what I'm doing here for a little bit.

311
00:29:16,000 --> 00:29:30,000
But let's say year and free cash flow.

312
00:29:30,000 --> 00:29:43,000
Now I'm going to take 2017, 2018, and then I'm going to crank that down.

313
00:29:43,000 --> 00:29:48,000
Let's take it down five years.

314
00:29:48,000 --> 00:29:53,000
Oops, I said five years, not four years.

315
00:29:53,000 --> 00:30:07,000
Okay, now the free cash flow, let's say that it's $520,000.

316
00:30:07,000 --> 00:30:18,000
And then let's go to $545,000.

317
00:30:18,000 --> 00:30:32,000
And then let's take it up to $572,000.

318
00:30:32,000 --> 00:30:44,000
And then $582,000.

319
00:30:44,000 --> 00:30:58,000
And then let's go to $588,000.

320
00:30:58,000 --> 00:31:04,000
Okay, so now two ways to do this.

321
00:31:04,000 --> 00:31:10,000
Now the growth rate, growth rate.

322
00:31:10,000 --> 00:31:14,000
Okay, let's try that again.

323
00:31:14,000 --> 00:31:21,000
Growth rate.

324
00:31:21,000 --> 00:31:35,000
We would take equals the ending value divided by the beginning value minus one.

325
00:31:35,000 --> 00:31:41,000
And then we would give that a percentage to two decimal places.

326
00:31:41,000 --> 00:31:47,000
So now I'm going to repeat that down here.

327
00:31:47,000 --> 00:31:50,000
Oops, that sucked.

328
00:31:50,000 --> 00:31:57,000
Let's try $591,000.

329
00:31:57,000 --> 00:32:00,000
I didn't realize I was dropping off the face of the earth.

330
00:32:00,000 --> 00:32:05,000
$610,000.

331
00:32:05,000 --> 00:32:07,000
Apologies.

332
00:32:07,000 --> 00:32:11,000
My ass.

333
00:32:11,000 --> 00:32:14,000
$610,000.

334
00:32:14,000 --> 00:32:20,000
Take that.

335
00:32:20,000 --> 00:32:23,000
Well, I'm not going to get much out of that.

336
00:32:23,000 --> 00:32:28,000
Okay, so there's your growth rates.

337
00:32:28,000 --> 00:32:41,000
What you would do is you would say equals average, open parentheses,

338
00:32:41,000 --> 00:32:44,000
average growth rate over the past five years.

339
00:32:44,000 --> 00:32:46,000
You're saying, wait a minute, fat boy, that's four years.

340
00:32:46,000 --> 00:32:48,000
It is five years.

341
00:32:48,000 --> 00:32:50,000
Okay.

342
00:32:50,000 --> 00:32:53,000
That's one way that you could do it.

343
00:32:53,000 --> 00:32:57,000
Just take an average of growth rates over five years, 10 years.

344
00:32:57,000 --> 00:33:03,000
Now, if this is done in practice, it's usually over a period of eight to 10 years.

345
00:33:03,000 --> 00:33:06,000
I'm trying to be a little lazy here.

346
00:33:06,000 --> 00:33:08,000
I should have just pulled up something.

347
00:33:08,000 --> 00:33:10,000
But, okay.

348
00:33:10,000 --> 00:33:14,000
Now, that's one way to get a G for practical purposes.

349
00:33:14,000 --> 00:33:19,000
This is called an arithmetic mean, arithmetic mean.

350
00:33:19,000 --> 00:33:24,000
There is another way that is somewhat more sophisticated.

351
00:33:24,000 --> 00:33:34,000
It's called a geometric mean where you would take,

352
00:33:34,000 --> 00:33:37,000
this one actually is kind of interesting.

353
00:33:37,000 --> 00:33:47,000
Let's say that we took these years and we say this one,

354
00:33:47,000 --> 00:33:50,000
this one, the ending value divided by the beginning value,

355
00:33:50,000 --> 00:33:56,000
and we raise it to the one-fourth power,

356
00:33:56,000 --> 00:34:02,000
or this one divided by this one, and we raise it to the one-fifth power.

357
00:34:02,000 --> 00:34:08,000
That would be what's called a geometric mean of them.

358
00:34:08,000 --> 00:34:15,000
It's more sophisticated, and it's not used in practice hardly ever.

359
00:34:15,000 --> 00:34:19,000
It's technically, it would be a more, how should I put it,

360
00:34:19,000 --> 00:34:24,000
kind of more accurate view of it, but it's just not used.

361
00:34:24,000 --> 00:34:28,000
They generally will use just this arithmetic average of growth rates,

362
00:34:28,000 --> 00:34:31,000
and they will pop that in there for the G.

363
00:34:31,000 --> 00:34:34,000
Now, for the weighted average cost of capital,

364
00:34:34,000 --> 00:34:39,000
that is a pain in the ass.

365
00:34:39,000 --> 00:34:44,000
Many of you may remember this from FIL 240.

366
00:34:44,000 --> 00:34:48,000
The weighted average cost of capital, the WAC,

367
00:34:48,000 --> 00:34:55,000
is the weight of debt times the after-tax cost of debt

368
00:34:55,000 --> 00:35:04,000
plus the weight of equity times the cost of equity.

369
00:35:04,000 --> 00:35:06,000
Now you're saying, well, wait a minute, fat boy,

370
00:35:06,000 --> 00:35:09,000
where's the after-tax on the second one?

371
00:35:09,000 --> 00:35:12,000
Dividends are fully taxed.

372
00:35:12,000 --> 00:35:14,000
Debt is cheaper than equity.

373
00:35:14,000 --> 00:35:20,000
One of the big reasons is that your interest payments on debt are tax deductible.

374
00:35:20,000 --> 00:35:27,000
So that means that debt naturally will have an advantage over equity.

375
00:35:27,000 --> 00:35:32,000
There's another reason debt has an advantage over equity, and it's simply this.

376
00:35:32,000 --> 00:35:38,000
The debt holders have the prior claim to the cash flows.

377
00:35:38,000 --> 00:35:42,000
They get paid before the shareholders can see a dime.

378
00:35:42,000 --> 00:35:51,000
If the company makes $500,000 and it owes interest payments of $400,000,

379
00:35:51,000 --> 00:35:54,000
then all the shareholders see is $100,000.

380
00:35:54,000 --> 00:35:56,000
They could get some of that as dividends.

381
00:35:56,000 --> 00:35:58,000
The rest is plowed back into the company,

382
00:35:58,000 --> 00:36:01,000
but they get theirs after the debt has been paid.

383
00:36:01,000 --> 00:36:09,000
That makes debt lower, a lower cost right there

384
00:36:09,000 --> 00:36:13,000
because the debt holders are in a safer position.

385
00:36:13,000 --> 00:36:17,000
If you buy stock in a company, you're all at risk.

386
00:36:17,000 --> 00:36:19,000
If they make money, great.

387
00:36:19,000 --> 00:36:21,000
If they lose money, you're done.

388
00:36:21,000 --> 00:36:25,000
If they go into bankruptcy, you get nothing.

389
00:36:25,000 --> 00:36:29,000
But the debt holders, even in bankruptcy, they get the dibs.

390
00:36:29,000 --> 00:36:31,000
They liquidate the company.

391
00:36:31,000 --> 00:36:37,000
So that's the two reasons that debt is cheaper than equity, generally speaking,

392
00:36:37,000 --> 00:36:40,000
and I'll qualify that a little later in the course,

393
00:36:40,000 --> 00:36:45,000
is that interest is tax deductible, dividends aren't,

394
00:36:45,000 --> 00:36:49,000
and second of all, the debt holders have the prior claim to the free cash flows,

395
00:36:49,000 --> 00:36:54,000
so they're in a safer position, so they don't have as high an expected

396
00:36:54,000 --> 00:37:01,000
or a required rate of return on their investments as lenders to the company.

397
00:37:01,000 --> 00:37:06,000
But that's the simplistic formula for the weighted average cost of capital.

398
00:37:06,000 --> 00:37:11,000
Now, one thing about that return after tax cost of debt,

399
00:37:11,000 --> 00:37:15,000
the first way you would do it is just look at the coupon rate

400
00:37:15,000 --> 00:37:20,000
on their most recent issue of debt.

401
00:37:20,000 --> 00:37:24,000
Okay, they've got some senior debt with 4% coupons.

402
00:37:24,000 --> 00:37:27,000
They've got some senior support native with 5%.

403
00:37:27,000 --> 00:37:34,000
They've got some junior debt that has 7.2% coupons on it.

404
00:37:34,000 --> 00:37:38,000
More risk because they're lower down on the feeding food chain.

405
00:37:38,000 --> 00:37:42,000
So you would just take that highest coupon, the marginal coupon.

406
00:37:42,000 --> 00:37:47,000
So the cost of debt is, let's say, let me put it here.

407
00:37:47,000 --> 00:37:55,000
Coupon on the highest cost debt would be 7.2%.

408
00:37:55,000 --> 00:37:59,000
The tax rate is 21%.

409
00:37:59,000 --> 00:38:13,000
So the after tax cost of debt would be 7.2% times 1 minus 0.21.

410
00:38:13,000 --> 00:38:16,000
So if I run that on a calculator, I'm just going to cheat here

411
00:38:16,000 --> 00:38:33,000
and grab this Excel sheet equals 7.2% times open parentheses 1 minus 0.21.

412
00:38:33,000 --> 00:38:35,000
Close the parentheses.

413
00:38:35,000 --> 00:38:41,000
And there's your Uncle Bob right there again showing up for the Sunday dinner.

414
00:38:41,000 --> 00:38:46,000
Whoops, I didn't mean to do that percent and then do that.

415
00:38:46,000 --> 00:38:55,000
5.69%.

416
00:38:55,000 --> 00:39:00,000
That would be your after tax cost of debt.

417
00:39:00,000 --> 00:39:02,000
But that's wrong.

418
00:39:02,000 --> 00:39:04,000
That's not how you should do it.

419
00:39:04,000 --> 00:39:08,000
The problem is that that coupon is a historical number.

420
00:39:08,000 --> 00:39:12,000
The coupon was negotiated at the time the indenture agreement was signed

421
00:39:12,000 --> 00:39:15,000
between the investment banker representing the lenders

422
00:39:15,000 --> 00:39:18,000
and the company as the borrower.

423
00:39:18,000 --> 00:39:21,000
It happened in the past.

424
00:39:21,000 --> 00:39:25,000
The one that you really should be using is the yield to maturity

425
00:39:25,000 --> 00:39:28,000
on the most expensive debt, the YTM,

426
00:39:28,000 --> 00:39:34,000
because that is the market's required rate of return right now.

427
00:39:34,000 --> 00:39:42,000
Let's say that the yield to maturity on this junior debt is right now 7.4%.

428
00:39:42,000 --> 00:39:45,000
That's the number that you want to use.

429
00:39:45,000 --> 00:39:50,000
Because if the company went out today and borrowed that same money,

430
00:39:50,000 --> 00:39:58,000
it would be at least 7.4% is what the lenders would want now.

431
00:39:58,000 --> 00:40:01,000
That's what they're saying by the yield to maturity.

432
00:40:01,000 --> 00:40:05,000
They've dropped the price of the bond so the bond is selling at a discount to par,

433
00:40:05,000 --> 00:40:08,000
so the yield is above the coupon.

434
00:40:08,000 --> 00:40:10,000
Notice how I'm talking a little faster now.

435
00:40:10,000 --> 00:40:13,000
We went through bonds in the first part of the course,

436
00:40:13,000 --> 00:40:19,000
and now I'm throwing it at you as if you know it like you know the back of your hand,

437
00:40:19,000 --> 00:40:21,000
which I know you probably don't.

438
00:40:21,000 --> 00:40:23,000
You'd have to be a little slower in doing this.

439
00:40:23,000 --> 00:40:28,000
But I'm just talking to you at this level now because this is what you'll need to be at

440
00:40:28,000 --> 00:40:32,000
to come up to the classes after this.

441
00:40:32,000 --> 00:40:34,000
Okay, good news.

442
00:40:34,000 --> 00:40:40,000
However, that actually is probably a little underestimated

443
00:40:40,000 --> 00:40:44,000
because if the junior debt is what they've got there,

444
00:40:44,000 --> 00:40:51,000
their lowest quality debt is this junior debt that is yielding right now 7.4%.

445
00:40:51,000 --> 00:40:54,000
If they went out there and borrowed more money,

446
00:40:54,000 --> 00:40:59,000
it would be junior subordinated unless they pay off that junior debt.

447
00:40:59,000 --> 00:41:02,000
The next level of debt would be junior subordinated,

448
00:41:02,000 --> 00:41:09,000
so its coupon would be higher and so its yield to maturity would be higher

449
00:41:09,000 --> 00:41:14,000
because it has more risk than the existing junior debt.

450
00:41:14,000 --> 00:41:21,000
So this one is even something of an underestimate of what would happen next,

451
00:41:21,000 --> 00:41:23,000
but this is the one that you should use

452
00:41:23,000 --> 00:41:30,000
because we would be only guessing at what the next level of debt would have for a coupon

453
00:41:30,000 --> 00:41:32,000
and all that good stuff.

454
00:41:32,000 --> 00:41:35,000
Now, if...

455
00:41:35,000 --> 00:41:41,000
Oh, well, let me not do that.

456
00:41:41,000 --> 00:41:47,000
So that number is a pain in the butt,

457
00:41:47,000 --> 00:41:57,000
but remember that the weight of debt plus the weight of equity equals 1.0.

458
00:41:57,000 --> 00:42:04,000
In other words, the two weights together are the capital structure,

459
00:42:04,000 --> 00:42:07,000
the total assets of the company, okay?

460
00:42:07,000 --> 00:42:10,000
So we're at that level now.

461
00:42:10,000 --> 00:42:13,000
Now, the next level, and then I'm going to quit.

462
00:42:13,000 --> 00:42:19,000
I'm going to drop this one and get back into the center of today's lecture.

463
00:42:19,000 --> 00:42:28,000
The problem here is that this son of a dog combines a bunch of things.

464
00:42:28,000 --> 00:42:36,000
There is the weight of preferred stock times the cost of preferred

465
00:42:36,000 --> 00:42:46,000
plus the weight of common stock times the cost of retained earnings.

466
00:42:46,000 --> 00:42:51,000
I hate saying that because it's cost of common stock

467
00:42:51,000 --> 00:43:02,000
plus the weight of new stock times the cost of new issue stock.

468
00:43:02,000 --> 00:43:05,000
Now, the problem here is this.

469
00:43:05,000 --> 00:43:09,000
The weight of your retained earnings...

470
00:43:09,000 --> 00:43:12,000
I'm sorry, the cost of your retained earnings,

471
00:43:12,000 --> 00:43:17,000
the cost of your existing shareholders is going to be pretty...

472
00:43:17,000 --> 00:43:18,000
It can be steep.

473
00:43:18,000 --> 00:43:21,000
You can see 16%, 22%.

474
00:43:21,000 --> 00:43:24,000
It is inversely related to the price of the stock,

475
00:43:24,000 --> 00:43:28,000
and I'll show that in a little bit here if I have the time tonight, today.

476
00:43:28,000 --> 00:43:31,000
But we keep going here.

477
00:43:31,000 --> 00:43:37,000
The weight of new stock will be more than the weight of existing stock.

478
00:43:37,000 --> 00:43:40,000
I'm sorry, I'm saying weight, cost, cost.

479
00:43:40,000 --> 00:43:45,000
The cost of new issue common stock is going to be higher

480
00:43:45,000 --> 00:43:48,000
than the cost of existing common stock.

481
00:43:48,000 --> 00:43:52,000
Your stockholders are a cost to you.

482
00:43:52,000 --> 00:43:55,000
They're a cost to you.

483
00:43:55,000 --> 00:44:01,000
If you have new stock issued, it's going to be worse.

484
00:44:01,000 --> 00:44:04,000
And here's why.

485
00:44:04,000 --> 00:44:10,000
If my stock runs at $50 a share, I go out there,

486
00:44:10,000 --> 00:44:15,000
okay, my existing shareholders, $50 a share.

487
00:44:15,000 --> 00:44:16,000
So I go to an investment banker.

488
00:44:16,000 --> 00:44:19,000
Hey, I'd like to raise some capital through equity,

489
00:44:19,000 --> 00:44:23,000
a new seasoned offering of common stock.

490
00:44:23,000 --> 00:44:26,000
Well, you think, well, it's going to sell at $50 a share.

491
00:44:26,000 --> 00:44:28,000
Sure enough, it will.

492
00:44:28,000 --> 00:44:30,000
You ain't going to get $50 a share.

493
00:44:30,000 --> 00:44:34,000
The investment bankers are going to get a cut.

494
00:44:34,000 --> 00:44:41,000
You will not get the full power of $50 for every new share you issue

495
00:44:41,000 --> 00:44:47,000
because the investment bankers are going to take their fees out of it,

496
00:44:47,000 --> 00:44:52,000
their brokerage fees, their consulting fees, their accounting, their lawyers,

497
00:44:52,000 --> 00:44:54,000
probably their mothers.

498
00:44:54,000 --> 00:44:56,000
Everyone is going to get in there.

499
00:44:56,000 --> 00:45:02,000
You will probably see $46, maybe $45 a share for new common stock,

500
00:45:02,000 --> 00:45:07,000
which means that the cost of those new shareholders is greater

501
00:45:07,000 --> 00:45:11,000
than the cost of your existing shareholders.

502
00:45:11,000 --> 00:45:13,000
You don't get as much impact out of them.

503
00:45:13,000 --> 00:45:15,000
Think about it this way.

504
00:45:15,000 --> 00:45:18,000
You're a married man, sir.

505
00:45:18,000 --> 00:45:21,000
Your family costs you a lot of money.

506
00:45:21,000 --> 00:45:23,000
But it's a great family.

507
00:45:23,000 --> 00:45:27,000
But now you decide that you're getting to that age, about 40,

508
00:45:27,000 --> 00:45:35,000
and you're feeling that need to find someone on the side, a mistress.

509
00:45:35,000 --> 00:45:38,000
Well, she's not going to put up with macaroni and cheese every night.

510
00:45:38,000 --> 00:45:43,000
You're going to have to buy more for her to keep her happy.

511
00:45:43,000 --> 00:45:47,000
You know the story. You and me know.

512
00:45:47,000 --> 00:45:50,000
The new is going to cost more than the old does.

513
00:45:50,000 --> 00:45:53,000
Your old car is an opportunity cost to you.

514
00:45:53,000 --> 00:45:59,000
But that is nothing compared to the cost right in your face of buying a new car.

515
00:45:59,000 --> 00:46:01,000
It just isn't.

516
00:46:01,000 --> 00:46:05,000
It's going to be more expensive to bring something new into the family.

517
00:46:05,000 --> 00:46:09,000
And the investment bankers are going to make sure you know that.

518
00:46:09,000 --> 00:46:11,000
Now, I'll tell you a story.

519
00:46:11,000 --> 00:46:16,000
If you were in my class, I may have told you before, my class, my 240,

520
00:46:16,000 --> 00:46:18,000
you may have heard this story before.

521
00:46:18,000 --> 00:46:24,000
In my consulting days, I went from being a little piss-ass consultant

522
00:46:24,000 --> 00:46:29,000
for idiotic companies around central Ohio

523
00:46:29,000 --> 00:46:36,000
to a place where I stepped into a world of ridiculously large money deals.

524
00:46:36,000 --> 00:46:40,000
A couple of young men were out of Coral Gables.

525
00:46:40,000 --> 00:46:44,000
Their parents had found my name, heard about me somehow,

526
00:46:44,000 --> 00:46:49,000
and they called me and they said, our boys are out there doing deals.

527
00:46:49,000 --> 00:46:55,000
Would you watch them, go everywhere with them, and make sure they don't do something stupid?

528
00:46:55,000 --> 00:46:58,000
And I said, look, I don't want to do this.

529
00:46:58,000 --> 00:47:03,000
You sound like what they're doing is some, like rain making.

530
00:47:03,000 --> 00:47:05,000
Oh yeah, they're doing rain making.

531
00:47:05,000 --> 00:47:10,000
They're bringing money to small companies that need money to get their operations started.

532
00:47:10,000 --> 00:47:14,000
Now, the one thing that I didn't ask at the time was where is this money coming from?

533
00:47:14,000 --> 00:47:17,000
I assumed that it was all respectable and all that.

534
00:47:17,000 --> 00:47:21,000
As the years would pass, I would find out that wasn't the case.

535
00:47:21,000 --> 00:47:26,000
But there was one deal after another, 100,000, 500,000,

536
00:47:26,000 --> 00:47:32,000
and then there came this odd, bizarre deal out in Atlanta, at the Atlanta airport,

537
00:47:32,000 --> 00:47:38,000
and the back lot, back in the old days, the back lot was just all these different little buildings

538
00:47:38,000 --> 00:47:44,000
and house trailers that were housing little operations, little puddle jumping operations,

539
00:47:44,000 --> 00:47:47,000
a little delivery services, and all this.

540
00:47:47,000 --> 00:47:51,000
We had an appointment with the two Momo boys, these two young men,

541
00:47:51,000 --> 00:47:56,000
to talk to this guy out there in a trailer in the back lot.

542
00:47:56,000 --> 00:48:00,000
As it turned out, he was involved.

543
00:48:00,000 --> 00:48:12,000
He had developed a plan to get a hold of some old 707s and 727s from a bankrupt airline in Europe.

544
00:48:12,000 --> 00:48:17,000
They were going to put these, he was going to put them, bring them back into service,

545
00:48:17,000 --> 00:48:24,000
as delivery for UPS, United States Postal Service, and FedEx, and DHI.

546
00:48:24,000 --> 00:48:32,000
He would take their packages from one city to another in these old jets, and it was actually kind of a good idea.

547
00:48:32,000 --> 00:48:41,000
He had made the arrangement to acquire seven of these derelict jets, and he was going to do this.

548
00:48:41,000 --> 00:48:48,000
He had all the FAA paperwork just stacked everywhere in this place, and we went in there,

549
00:48:48,000 --> 00:48:52,000
he was a very strange guy, he looked almost elderly.

550
00:48:52,000 --> 00:48:54,000
This was in the later 1990s.

551
00:48:54,000 --> 00:49:00,000
He had a white beard, and these steely blue eyes, and a big cigar, and he had this vision.

552
00:49:00,000 --> 00:49:05,000
He kept looking at me, because I was a pilot at the time, and he said,

553
00:49:05,000 --> 00:49:07,000
you understand, don't you?

554
00:49:07,000 --> 00:49:09,000
I said, yeah, I get it, I get it, it can work.

555
00:49:09,000 --> 00:49:15,000
We've got to do a lot of numbers work here, but what are you saying, what's the bottom line, what do you need?

556
00:49:15,000 --> 00:49:18,000
He said, $5 million.

557
00:49:18,000 --> 00:49:21,000
I thought, well, this is not going to work.

558
00:49:21,000 --> 00:49:27,000
And one of the young men said, we can do this, this will work.

559
00:49:27,000 --> 00:49:30,000
Okay, $5 million.

560
00:49:30,000 --> 00:49:37,000
And we talked for a while longer, and then we had parked our nice black Crown Vic

561
00:49:37,000 --> 00:49:46,000
maybe about 50 yards away from where his operation was, and there was a reason for that.

562
00:49:46,000 --> 00:49:51,000
Because we knew what was going to happen next, eventually, and it happened.

563
00:49:51,000 --> 00:49:58,000
He said, okay, we're going to get together at $7 million, and we can probably do that within a week.

564
00:49:58,000 --> 00:50:00,000
And he said, oh no, no, $5 million.

565
00:50:00,000 --> 00:50:02,000
Oh no, $7 million.

566
00:50:02,000 --> 00:50:03,000
We get $2 million.

567
00:50:03,000 --> 00:50:05,000
We get $2 million.

568
00:50:05,000 --> 00:50:08,000
Oh, he just shit his pants, he just went crazy.

569
00:50:08,000 --> 00:50:11,000
What the hell are you trying to do to us?

570
00:50:11,000 --> 00:50:16,000
So as a stage thing, we just got up and said, thank you for your time, and we walked out.

571
00:50:16,000 --> 00:50:22,000
Now the one young man deliberately walked behind us slowly while we just walked to the Crown Vic

572
00:50:22,000 --> 00:50:26,000
and looked really irritated waiting for Dan to show back up instead of talk.

573
00:50:26,000 --> 00:50:28,000
This guy came out, wait, wait, wait.

574
00:50:28,000 --> 00:50:34,000
So Dan and him talked under the voice, and they came back to us, and he said, we got him at $6.5 million.

575
00:50:34,000 --> 00:50:37,000
Okay, you see, it was all set up.

576
00:50:37,000 --> 00:50:39,000
And so that was how it worked out.

577
00:50:39,000 --> 00:50:42,000
So here's what the lesson is.

578
00:50:42,000 --> 00:50:44,000
Do you see the float?

579
00:50:44,000 --> 00:50:47,000
$1.5 million on $5 million.

580
00:50:47,000 --> 00:50:48,000
That's the float.

581
00:50:48,000 --> 00:50:57,000
He was on the hook for $6.5 million, except that he wasn't going to get $6.5 million.

582
00:50:57,000 --> 00:51:06,000
He was going to have to live with $5 million, but have $6.5 million in equity hanging over his head.

583
00:51:06,000 --> 00:51:08,000
We controlled the company.

584
00:51:08,000 --> 00:51:13,000
So that gives you the idea of, that gives you a real world idea of what float can do.

585
00:51:13,000 --> 00:51:15,000
Now that was excessive float.

586
00:51:15,000 --> 00:51:18,000
$1.5 on $6.5, that's awful.

587
00:51:18,000 --> 00:51:19,000
That's evil.

588
00:51:19,000 --> 00:51:23,000
I should burn in hell for that one, but I didn't.

589
00:51:23,000 --> 00:51:31,000
It actually all fell apart because at the end of the day, it turned out that he was one of the FAA,

590
00:51:31,000 --> 00:51:33,000
finally tracked back, paid attention.

591
00:51:33,000 --> 00:51:39,000
It turned out he was part of the crew that had been involved in the Iran-Contra affair.

592
00:51:39,000 --> 00:51:43,000
If you watched the movie Air America, those were the pilots.

593
00:51:43,000 --> 00:51:47,000
He was one of the pilots from that movie, Air America.

594
00:51:47,000 --> 00:51:50,000
And if you don't know about it, I'm not going to explain it to you.

595
00:51:50,000 --> 00:51:52,000
Trust me, it happened.

596
00:51:52,000 --> 00:51:59,000
He had been in prison because he was transporting marijuana and other drugs up from Central America,

597
00:51:59,000 --> 00:52:09,000
and they were being traded with major drug dealers in the United States for weapons from Iran.

598
00:52:09,000 --> 00:52:17,000
Iran was sending those weapons down to our favored rebels in Central America to fight the Nicaraguan

599
00:52:17,000 --> 00:52:23,000
communist government, and so he landed his plane and the DEA was waiting for him.

600
00:52:23,000 --> 00:52:27,000
And of course, he said, I'm working for the CIA, and they said, CIA?

601
00:52:27,000 --> 00:52:29,000
I said, no, who?

602
00:52:29,000 --> 00:52:34,000
And so he went to prison for two years, and so the FAA wasn't going to let him run an airline.

603
00:52:34,000 --> 00:52:36,000
So the deal fell apart in the end anyway.

604
00:52:36,000 --> 00:52:37,000
But watch Air America.

605
00:52:37,000 --> 00:52:38,000
You can see it.

606
00:52:38,000 --> 00:52:41,000
True story, bizarre as hell.

607
00:52:41,000 --> 00:52:47,000
Anyway, that's a long way around to explain that the float is going to kill you on this.

608
00:52:47,000 --> 00:52:55,000
16% on return here, try 18%, 19%, 20% on new issue common stock.

609
00:52:55,000 --> 00:52:58,000
So we put all this together here.

610
00:52:58,000 --> 00:53:02,000
We get our weighted average cost of capital, and we'll do one in class.

611
00:53:02,000 --> 00:53:04,000
I've got a template, so you don't have to.

612
00:53:04,000 --> 00:53:09,000
That can kill you if you do this by hand, because you see these weights here?

613
00:53:09,000 --> 00:53:12,000
Each of those is a market weight.

614
00:53:12,000 --> 00:53:19,000
So you have to take the total market value and break it up into what part of that market value of the company

615
00:53:19,000 --> 00:53:24,000
is coming from your debt, what part is coming from your preferred stock,

616
00:53:24,000 --> 00:53:26,000
what part is coming from your common stock.

617
00:53:26,000 --> 00:53:29,000
And we ignore the new issue.

618
00:53:29,000 --> 00:53:34,000
We'll just ignore that unless you really want to walk on the wild side.

619
00:53:34,000 --> 00:53:36,000
So anyway, we get back over here.

620
00:53:36,000 --> 00:53:39,000
We get this, and we've got a value for the company.

621
00:53:39,000 --> 00:53:51,000
So let's say that the company, the free cash flow for last year was $320 million.

622
00:53:51,000 --> 00:53:56,000
We have a growth rate used, we'll use an average for the last five years.

623
00:53:56,000 --> 00:54:06,000
We have a growth rate of, let's say, 2.3%, and our weighted average cost of capital is coming out to be,

624
00:54:06,000 --> 00:54:12,000
let's say, 8.4%.

625
00:54:12,000 --> 00:54:15,000
So now we can take a present value.

626
00:54:15,000 --> 00:54:28,000
Right now, the intrinsic value of the entire company, survey says, would be $320 million

627
00:54:28,000 --> 00:54:51,000
over times 1 plus.023 divided by the weighted average cost of capital,.084 less.023.

628
00:54:51,000 --> 00:54:58,000
And so we crank that out, and I'll just do it here just to save myself.

629
00:54:58,000 --> 00:55:22,000
So we got $320 million times 1 plus.023, close the parentheses, divided by, open parentheses,.08.

630
00:55:22,000 --> 00:55:23,000
I should pull up the template.

631
00:55:23,000 --> 00:55:36,000
I've got a template for this that I'm doing barehanded,.023, close the parentheses.

632
00:55:36,000 --> 00:55:38,000
Did I do this all right?

633
00:55:38,000 --> 00:55:40,000
Yes, I did, for once in my life.

634
00:55:40,000 --> 00:55:44,000
Oh, I should put an equal sign, for God's sake.

635
00:55:44,000 --> 00:56:01,000
Equals, make that a comma, make that a number, $100,000,000, $5.367 billion.

636
00:56:01,000 --> 00:56:03,000
That's intrinsic value.

637
00:56:03,000 --> 00:56:07,000
Then you get the number of shares outstanding of the company.

638
00:56:07,000 --> 00:56:20,000
Let's say that this company has shares outstanding, is let's say,

639
00:56:20,000 --> 00:56:28,000
100 million shares outstanding.

640
00:56:28,000 --> 00:56:42,000
And so you would take that number right there, equals that number, divided by 100,

641
00:56:42,000 --> 00:56:47,000
you got $53.67 intrinsic value.

642
00:56:47,000 --> 00:56:54,000
So the bottom line of this is, yes, we can find intrinsic values.

643
00:56:54,000 --> 00:57:00,000
It's an estimate, obviously, but then again, everything in our lives is an estimate.

644
00:57:00,000 --> 00:57:06,000
But when I say overvalued, undervalued, well, it's overvalued, it's a little above its intrinsic price,

645
00:57:06,000 --> 00:57:12,000
a little below, this is the analysis that you do for that kind of stuff.

646
00:57:12,000 --> 00:57:14,000
And it is done.

647
00:57:14,000 --> 00:57:18,000
This is old school stuff, but it's still pretty popular.

648
00:57:18,000 --> 00:57:28,000
Now, I will mention, mention a new way of doing this, and I'm not going to go into it here.

649
00:57:28,000 --> 00:57:39,000
If you take a derivatives course from me, there's a, we've got a new professor, and he's darn good, great guy.

650
00:57:39,000 --> 00:57:45,000
And he's really, he does his thing, but he doesn't step into this, and I would step into this,

651
00:57:45,000 --> 00:57:55,000
where we can actually use options pricing theory to value, find the value, intrinsic value of stock.

652
00:57:55,000 --> 00:58:08,000
That's done now by a couple of houses, both in New York and in Europe,

653
00:58:08,000 --> 00:58:11,000
where they're using the options pricing model, the Black-Scholes model,

654
00:58:11,000 --> 00:58:17,000
that thing I kind of waved my hand at, chapter, whatever the hell that was, chapter six or something.

655
00:58:17,000 --> 00:58:25,000
But you can find the price of the stock by treating the common stock itself as an option,

656
00:58:25,000 --> 00:58:37,000
and then using the Black-Scholes options pricing model on the parameters to get a price of that option.

657
00:58:37,000 --> 00:58:45,000
Essentially, the stock in that model is a put option, because at any given time,

658
00:58:45,000 --> 00:58:54,000
the company has the right, but not the obligation, to put the company to the debt holders.

659
00:58:54,000 --> 00:59:02,000
If the value of the company falls below a certain amount, that would mean that it couldn't make its interest payments.

660
00:59:02,000 --> 00:59:13,000
It has the right to put the stock, put the company, the actual company, represented by a stock, to the bond holders.

661
00:59:13,000 --> 00:59:21,000
It is actually a classic put option, complicated as hell, but it is a put option.

662
00:59:21,000 --> 00:59:28,000
But that is not being used, and for your purposes, both in manual calculations on Excel,

663
00:59:28,000 --> 00:59:38,000
or if you're using chat GPTs to do your legwork, you would use a model like this, what I'm showing you here, not the OPM model.

664
00:59:38,000 --> 00:59:46,000
There are AIs, and they are being done by AIs, who are using the new method, using Black-Scholes options pricing model,

665
00:59:46,000 --> 00:59:52,000
but it's not what you will see out there if you have to do this kind of stuff.

666
00:59:52,000 --> 01:00:01,000
Now, what I've talked to you about here is a free cash flow approach that just assumes that your free cash flows

667
01:00:01,000 --> 01:00:09,000
are going to grow at a constant rate, or approximately at a constant rate for the foreseeable future.

668
01:00:09,000 --> 01:00:18,000
That's probably not a good idea, unless the company is very stable, an old stable company.

669
01:00:18,000 --> 01:00:28,000
It's more likely, in other words, the free cash flows are not going to grow like this.

670
01:00:28,000 --> 01:00:32,000
They're going to be blowing, blowing, blowing, blowing, blowing all over the place.

671
01:00:32,000 --> 01:00:44,000
They're just going to be hopping up and down, which means that you can't assume that FCF sub 4 is going to be 1 plus G to the fourth power.

672
01:00:44,000 --> 01:00:52,000
The reality is it probably won't. That means you have to dig in and go five yards, three yards in a cloud of dust,

673
01:00:52,000 --> 01:00:57,000
year by year, estimating the free cash flows, year by year by year.

674
01:00:57,000 --> 01:01:06,000
And that's where you get into, essentially, pro forma financial statements, pro forma income statement, pro forma balance sheet.

675
01:01:06,000 --> 01:01:15,000
The way that method goes is that you're going to have your income statement in your balance sheet.

676
01:01:15,000 --> 01:01:39,000
And you're going to have your revenues minus your costs. That gets you to op-inc minus your interest expense.

677
01:01:39,000 --> 01:01:51,000
That's going to get you to your pre-tax minus the tax gets you to the net income.

678
01:01:51,000 --> 01:01:55,000
Okay, wonderful. Just great.

679
01:01:55,000 --> 01:02:01,000
And then you have to estimate all of those for, let's say, 10 years out.

680
01:02:01,000 --> 01:02:05,000
It all pivots on the revenue projections.

681
01:02:05,000 --> 01:02:10,000
In other words, you make an assumption about revenues year by year by year,

682
01:02:10,000 --> 01:02:15,000
and then these you are finding as you're setting those as percentages off the revenue,

683
01:02:15,000 --> 01:02:19,000
like we did with common size financial statements.

684
01:02:19,000 --> 01:02:26,000
So, essentially, well, costs are going to be 40% of the revenue.

685
01:02:26,000 --> 01:02:33,000
Interest expense, we are going to hold a leverage position that will make interest expense 5%.

686
01:02:33,000 --> 01:02:38,000
Pre-tax tax is going to stay at a happy 21%.

687
01:02:38,000 --> 01:02:43,000
You drill it down from the revenues, getting the numbers for the other ones from percentages.

688
01:02:43,000 --> 01:02:48,000
And then you get down there, and then you work your way down to the free cash flow.

689
01:02:48,000 --> 01:02:52,000
And you just keep doing this over and over, year by year by year.

690
01:02:52,000 --> 01:02:59,000
Now, obviously, your numbers are going to get fuzzier and fuzzier, projecting revenues farther and farther out.

691
01:02:59,000 --> 01:03:05,000
The assumption here is that once you've gotten out to about year 10,

692
01:03:05,000 --> 01:03:15,000
the contribution of free cash flows after that as a present value is going to be not enough for you to worry about.

693
01:03:15,000 --> 01:03:22,000
I mean, if you want to do 15, 20 years, sure, but at some point, I mean, your present values,

694
01:03:22,000 --> 01:03:26,000
discounting back one year, two years, three years, they're significant values.

695
01:03:26,000 --> 01:03:31,000
But once you get out there and you're taking to the negative 15th power,

696
01:03:31,000 --> 01:03:38,000
some one plus weighted average cost of capital to the negative 15th power,

697
01:03:38,000 --> 01:03:45,000
those factors are going to be small enough that you can pretty much ignore them after a certain point.

698
01:03:45,000 --> 01:03:51,000
Ten years really is enough to get a good estimate.

699
01:03:51,000 --> 01:03:59,000
So, in other words, your whole point here, the whole point of this exercise is to get you to the point

700
01:03:59,000 --> 01:04:11,000
where the value of the company right now, intrinsic value,

701
01:04:11,000 --> 01:04:29,000
is going to be free cash flow at year one, free cash flow at year two, and chop chop, free cash flow at year nine,

702
01:04:29,000 --> 01:04:35,000
maybe going out, free cash flow at year 10.

703
01:04:35,000 --> 01:04:42,000
And then you just telescope those back, discounting it at the weighted average cost of capital.

704
01:04:42,000 --> 01:04:49,000
Just to straight up find the present value of each of these numbers, discounting at the weighted average cost of capital.

705
01:04:49,000 --> 01:05:00,000
And in this model, it's better than that one because that's just over, that's the late, like I said, the lazy guy's way of doing it.

706
01:05:00,000 --> 01:05:04,000
Just a growth rate for the whole period.

707
01:05:04,000 --> 01:05:11,000
Doing it this way is more realistic, especially because you have control of what you're estimating the revenue is.

708
01:05:11,000 --> 01:05:15,000
This is where you begin to think, okay?

709
01:05:15,000 --> 01:05:24,000
We see the economy growing and our market share growing over the next three, four years, and then we see a recession,

710
01:05:24,000 --> 01:05:33,000
so you adjust the revenue down for the period of a recession as predicted by your economic jockeys in the company and all that.

711
01:05:33,000 --> 01:05:41,000
And then, so you are granularizing your revenues and then driving everything off those.

712
01:05:41,000 --> 01:05:54,000
The other part of this, the one criticism is that really, I mean, how can you say that the percentage of your cost is always going to be this

713
01:05:54,000 --> 01:05:56,000
throughout your period of analysis?

714
01:05:56,000 --> 01:06:00,000
For the next 10 years, your costs are going to be 40%, 30%.

715
01:06:00,000 --> 01:06:03,000
Okay, fine, adjust them.

716
01:06:03,000 --> 01:06:10,000
But another way you do it is to say, we're going to set targets, and this is where managerial finance comes into play.

717
01:06:10,000 --> 01:06:12,000
We're going to set a target.

718
01:06:12,000 --> 01:06:21,000
We will have our costs be this percentage, and if they drift off that, then we're going to find out why, and heads are going to roll.

719
01:06:21,000 --> 01:06:26,000
We're going to, that requires that this is a feedback into the company.

720
01:06:26,000 --> 01:06:35,000
You're saying, oh, I shouldn't be using this number, the 40% or 20% or whatever.

721
01:06:35,000 --> 01:06:37,000
Well, why can't I use that?

722
01:06:37,000 --> 01:06:40,000
Are you saying that you can't control costs?

723
01:06:40,000 --> 01:06:42,000
You come right back at them.

724
01:06:42,000 --> 01:06:52,000
You give me a percentage, and then, or what you want it to be, and then you are not going to criticize me if you fall off that percentage,

725
01:06:52,000 --> 01:06:59,000
because that was your problem to keep it on that number, what your target amount was.

726
01:06:59,000 --> 01:07:01,000
Now, you break this down.

727
01:07:01,000 --> 01:07:03,000
Obviously, the cost thing, you break it down.

728
01:07:03,000 --> 01:07:09,000
Selling general administrative expenses, you can granularize it as much as you want.

729
01:07:09,000 --> 01:07:16,000
Your interest expense, you're going to have to feed back into when we retire a bond issue.

730
01:07:16,000 --> 01:07:18,000
Is it going to be in the next 10 years?

731
01:07:18,000 --> 01:07:20,000
Well, then our interest expense will go down.

732
01:07:20,000 --> 01:07:23,000
Are we going to have to borrow more money in year five?

733
01:07:23,000 --> 01:07:24,000
Okay, it will go up.

734
01:07:24,000 --> 01:07:31,000
Just get the numbers in there, starting with percentages, and then adjusting them as necessary.

735
01:07:31,000 --> 01:07:35,000
This is how we really do it.

736
01:07:35,000 --> 01:07:41,000
These are called these five, these 10 years of income statement and balance sheets.

737
01:07:41,000 --> 01:07:43,000
If you haven't heard the term, I've used it a couple of times in here.

738
01:07:43,000 --> 01:07:47,000
Those are called pro forma income statements and balance sheets, pro formas.

739
01:07:47,000 --> 01:07:53,000
Now, if you're ever doing a business plan, they are going to ask you for your pro formas.

740
01:07:53,000 --> 01:07:57,000
I heard even one angel investor call them the PFs.

741
01:07:57,000 --> 01:08:00,000
I didn't even know what he was talking about for a whole pro forma.

742
01:08:00,000 --> 01:08:07,000
In your business plan, you better have five years of pro formas, at least, and you do it this way.

743
01:08:07,000 --> 01:08:13,000
As a matter of fact, that's one of the great powers of AI right now.

744
01:08:13,000 --> 01:08:18,000
I can have a chat GPT go through pro formas.

745
01:08:18,000 --> 01:08:20,000
I've done it in the past month.

746
01:08:20,000 --> 01:08:21,000
I had it do it.

747
01:08:21,000 --> 01:08:24,000
It was amazing how fast it did it.

748
01:08:24,000 --> 01:08:26,000
Then I told everyone I did it.

749
01:08:26,000 --> 01:08:29,000
It took me a long time, but that's the benefit of being a professor.

750
01:08:29,000 --> 01:08:32,000
You can say you do more work than you do.

751
01:08:32,000 --> 01:08:34,000
With that, that's all I have for you today.

752
01:08:34,000 --> 01:08:44,000
I thank you.