Alan Cring Productions in association with Emergent Light Studio presents the Illinois State Collegiate Compendium, academic lectures in business and economics.
This is business finance, FIL 341 for autumn semester 2024.
Today, corporate and stock valuation.
And I will take something of a back and forth approach to the two subjects.
They're highly interrelated, but one is a little bit more straightforward than the other.
But before we go into that fun for the day, I'll look at the numbers.
And as you can see, it is a very odd day.
The Dow was started off, it plunged on the opening this morning.
I mean, it just dropped, it was dropping like a rock.
And then it just started coming back and everyone said, oh, that was over with.
But as you can see, it still is a bearish day.
Just kind of like a kangaroo kind of activity.
It just is not finding positive territory.
And one thing though, and I'll point this out in just a minute here, it's something that I had been talking about.
And I've finally, you're beginning to see some of the financial media picking up on something I've been talking about.
But right now, as you can see, these indexes actually, the S&P 500 and the NASDAQ started out positive this morning.
And then they just got spooked down, just straight down.
Now, these are not massive drops.
You can see that the Dow is down only a third of a percent.
And the S&P 500 down a little more, almost a half a percent.
The NASDAQ is down quite 1%.
So it's not like a massive black swan or something like that.
It's just a grouchy day, a bad day on the street.
But individual stocks are actually kind of doing not bad.
And I'll show you a few here in just a minute.
But the good news is over here on the crude.
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,
Israel was going to bomb the hell out of Iran, Iran was going to turn around and bomb the hell out of everybody,
it looks like, well, it doesn't look like it. I've heard the traders say, well, we're not worried about that now.
So the price of oil is beginning to ease back down because those expectations of supply interruptions out of the Gulf,
Persian Gulf, have eased up.
That's not going to last long if, that's still a powder keg over there.
But right now there's this kind of this belief that, well, maybe this all will pass, as it has in other times historically.
In my time in the many years, decades, I've been doing this kind of analysis.
We've had near wars over there on a number of occasions that just, you saw the same things here.
Well, they're on the verge of attacking each other, blowing up each other and all that kind of stuff.
And then they just went away and went back to the usual, we hate you, you hate us tension and all that.
So this might be one of those little incidents like that.
Or it could be another kind where there is, I heard someone use a term that I kind of like, a flash war.
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.
And so those are possibilities too.
But whatever is going to happen, right now the markets are thinking that it's going to fizzle out.
And that's why the price of crude is beginning to slip back down.
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.
So yay for that. That's going to help us.
But the gold bugs are a little excited about something.
I don't know what it is, but there's been some buying in the last five, six hours in the gold market.
But here's one that is really good news. The bond market, the yields are slipping.
We've got the bond yield down to four.
It's dropped a good, healthy five basis points.
And that means that that upward surge in bond prices, bond yields is at least for the time being over.
And we may by Friday see the bond yields going below 4% again.
We were down there almost to 3.5%. And that was really exciting.
And then we had that spike.
The bad news is that bond yields going down, that means bond prices are going up.
That means there's buying in the bond market.
And if you see over here, there's selling in the equities market.
In other words, this day is a flight to quality.
A flight from riskier investment assets, financial assets, to safer financial assets.
So yeah, great.
Interest rates, the yields are lower, but we're seeing a flight to quality.
Now go over here real quick.
Look at activity on the Standard Port is 500.
And as you can see, we're still in that, by this time of day, we should see at least 2.2 billion.
And we're seeing 1.5, 1.6 billion.
So in other words, these big players are staying on the sidelines.
There was an article yesterday, and I wish I had saved the website.
It was these investment types that are, I think it was on Forbes.
There's been a significant movement of funds into money market accounts over the past weeks.
Well, that's been going on, and now they're beginning to publish that this is going on.
And so it's getting noticed now that there is a lot of money on the sidelines.
This worry about what's happening next.
And very quickly, looking at the VIX, and I'll look at the core, the index, the volatility index itself.
As you can see, look at that.
Son of a biscuit eater.
Now notice the timeframe on the VIX.
That's a futures market.
That's futures activity.
And as I said, each futures type has its own timeframe on the clock.
These kinds have maybe, this one starts at about 2.30 in the morning, and it runs until 3 in the afternoon.
And then there's ones that run much longer, 20 hours.
Oil has its own time.
Metals, each one has its own time.
And so what we're seeing here is that before the opening this morning of the stock markets, of the exchanges,
you saw the volatility drop.
It was quiet, like the calm before the storm.
And then right as the bell was ringing, well, no, just before the bell, the volatility just spiked.
The market makers were just all over the place.
Now I use the term market maker, and I think I've said something about it before,
but a lot of folks have a misunderstanding of how stock prices form and how stock prices change.
A lot of that is behind the scenes.
I'm going to have one of my former students from some years, more than a few years back.
He has been a trader, and he does a good job of explaining the role of the market makers.
They are the ones who decide what the prices are.
And they are always acting, of course, in their own interest.
And they can do things that aren't quite understood by the average trader,
is when the market makers do their thing, sometimes they will affect,
they will use options to cover a position as they're pulling in stock.
They might also be taking covered calls, writing covered calls, or they might be buying puts.
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.
So there's an old saying, derivatives are derivatives because they derive their price from the underlying stock.
Actually, these days, it's a two-way street.
The price of the stock drives the price of the options.
But if the market makers are pulling hard for protecting their positions, covering themselves and all that kind of stuff,
they can affect the price because that lets the market makers have more room to play
on what they're doing for calling out prices at which they will buy and sell stocks.
This is one of the reasons that the brokerage houses are now doing a lot of intra-house dealing.
In other words, they're not going through market makers.
They are going to their own, essentially, one side is buying and selling for their customers.
And then there is another side that has buys and sells and keeps stocks for their own house.
So instead of going to the market makers to fill an order for a client, they might say,
well, the market makers are in a pissy mood right now or something like that.
And they'll just go to their own house, their own investment house in the building and say,
we want to do this transaction here within the house.
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
because our inventory is slim.
You'll get a better deal from the market makers or something like that.
Now, I'm oversimplifying this all to hell, but this is the basic outline of what's going on out there in this world.
So if you're into investments, it is not what we teach you here is just the beginning.
This is what it looks like on the surface of the ocean.
And then you go under there and you look and there's a megalodon saying, it's a giant,
it's a whirlpools and geysers and all that kind of stuff going on under the surface of this.
And of course, in a course you would take from me here, this is, I can't go into all of it.
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.
I'm not taking them down the path of here's what happens.
You want to know what happens?
Go out there and get a job cupcake.
You'll see it real quick.
So I'm trying to give you an insight not into what academia helps you with.
I'm giving you an insight into the bizarreness of what's going on out there.
Oh, okay.
I wanted to go through just a couple of quick stocks here.
Now, a few I showed you, INTC, Intel.
Now, the thing about these stocks right now is this is earnings season.
So you've got the rumors all over the place.
Are they going to beat their earnings estimate?
Are they going to miss their earnings estimate and all that?
Right now, the money is on.
They gave an estimate of their earnings right here.
Okay, they gave an estimate that they're going to have slightly negative earnings.
Now, the rumors now are centering on their earnings aren't going to just be slightly negative.
They're going to be bad, the earnings on Intel are.
So that's what's driving the market down right now is these persistent rumors that it's going to be a bad.
Okay, there's the earnings estimate.
And then there is the report of the earnings.
And then there is another, these are calls.
Actually, they are, they call the Wall Street Boys and they talk to them.
So they give the estimate to the Wall Street Boys and then shortly after that,
they publish it for the general media to pick up.
And then the rumors start and then finally the earnings are issued.
Now, oftentimes, even though it's technically not right to do it,
they will give their earnings a few minutes to the Wall Street Boys before the media picks it up and runs with it,
the general media, general financial media.
Now, there's another part of it too.
It's called the guidance call, earnings guidance.
That's where they explain to the Wall Street Boys, this is what happened.
This is why it happened.
And then they are either praised by Wall Street, they're condemned in the call.
Sometimes those calls can be awful.
I mean, there's not, well, yes, there is.
Usually it's a very dignified earnings guidance call.
Well, this is what we did and this is why this happened, either on the good side or the bad side.
Guidance calls are more likely to be a thing if they miss their earnings estimate.
But sometimes it can just be awful.
I mean, there can be cussing and swearing.
And of course, the company is just sitting there, I know, I know, because they can't say, you know.
If they started, if Wall Street Boys started yelling at me because I missed my estimate, I'd say, look, bitch.
But in that world, they're just going to say, OK, yeah, we're going to do better.
We're going to fire, lay off a lot of people.
They'll do all that.
But it can still be kind of painful to do that.
So that earnings estimate, they try to hit it on the button.
But, you know, estimates are what they are, estimates.
And so Intel is expected to have worse earnings than what they're projecting, what they've estimated.
And it looks like it's going to be bad enough that there will be a guidance call.
And that guidance call is going to be, shall we say, contentious.
Let me look at the one month.
Right now, there is a slide.
But if you look on a larger level, it's not as bad a reaction as we've seen to there.
Let me go back here further.
Now, notice here that Intel, and I'm focusing, I know I already showed you Intel once,
but I'm going to just talk about it again here.
Look at, I'm going to look at the one year.
So we can see a couple of other quarters.
Notice in past quarters, they were doing well until this most recent quarter where they reported they missed their earnings
and they missed them rather badly.
So going back over here and looking at how Wall Street reacted to that over looking at about a year,
you notice, oddly enough, that over the past year, there has been a general slide in Intel's stock price.
And as you can see that there was just a drop off.
But overall, it has recovered a little bit.
But I guarantee you, if they have a really bad earnings call this time, it's going to drop hard.
That's why we're seeing what we're seeing right now.
The five day, the rumors start and then they corrected, adjusted for what they think the earnings will be.
That's this part right here.
And then this recovery is actually a little bit of optimism.
Well, everyone's saying they're going to drop by, the earnings are going to be this bad.
And then there's more voices saying not as bad as you thought.
We think they'll be bad, but not as bad.
So there's been a little bit of a recovery in here in the past couple of days.
So that's how you can read these charts.
Now let's look over here, trying to find something that's a good news kind of stock, or at least in that area.
I wrote Conoco.
There we go.
Now this is oil.
This is an oil company, Conoco Phillips.
And as you can see, they're getting potty trained right now by the market.
If you look over the past six months at them, there has been a general downward decline because oil prices were going down.
Revenues were going down.
That has been recovering of late because they benefit from a war premium.
War is good business, especially for oil companies, for manufacturing companies, some kinds of manufacturing companies.
So it has been good of late.
However, there is still a larger trend downward because on the high seas there is a lot of oil in the tankers.
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.
And so even if we did have a war premium shockwave, it would not mean the end of civilization.
If we get over the war soon enough, there's plenty of oil out there, and everyone knows who's in the business.
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.
Small ports, medium ports, and the giant ports, there's plenty of oil out there.
So the long-term outlook for companies like ConocoPhillips, Marathon Oil, those kinds of companies is not that good
because they're going to have to charge lower gas prices and lower prices for the distillates.
So everything looks good right now.
No apocalypse on the horizon, just in case you want that.
Now, one more just to look at, Minnesota Mining and Manufacturing.
I'm at 3M.
3M, one thing that you can kind of tell is when you've got these basic industries, the basics that are mining,
and 3M is highly diversified now, but its core is still, it's a metals mining company.
That's manufacturing and all that good stuff.
If we look over a period of time, let's look over the last one year.
That's a recovery. That's recovery.
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,
but unfortunately I have to teach tomorrow because he ain't coming.
It's going to keep rising. It's looking good.
This is what you look at. What are the markets actually saying?
Regardless of what they're saying and what the podcast talking heads are talking about, look at the trading.
Look at what's, greed is driving those prices.
Greed doesn't do stupid stuff unless it's really something that's attractive that isn't underneath it all.
But you've seen here, this is growth.
This is growth of the demand for metals, demand for the consumer goods that 3M makes.
That's what you should look at.
And you see this and you look at this, I could show you other examples in other industries.
It does not look bad at all investment prospect wise.
But as long as there's this fear out there, the fear is there, we're not going to grow.
We're not going to go into a full expansion.
Anyway, enough of that.
Now, let me take you on a little journey here.
Now, this you've seen, FIO 240, I guarantee you've seen most of this.
But I'm going to take you on a little bit deeper run of it.
And for the math of it, for a lot of math, I do have Excel templates that will help you do, for example,
pricing a stock by the dividend growth model and all that kind of stuff.
Now, some of these are somewhat incomplete.
You have to do a little more fill in the blank and all that, but it's nothing terrible.
However, there are two kind of different ways that use the same concepts of math,
present value of future expected cash flows to determine the value of a company.
Ultimately, if we can find a good estimate of the market value, the current market value of a company,
kind of simplistically, we divide by the number of shares outstanding,
and we've got the intrinsic price per share of the company.
So, for example, if we find that the present value of future expected cash flows is, let's say, $100 million,
and this company has a million shares outstanding, well, then $100 million divided by $1,000,
yeah, shares would mean that each share would be $100,000.
The bottom line there is that it all comes down to estimating the future expected cash flows,
estimating them out far enough that we can get a reasonable present value of those future expected cash flows,
and then divide it by the number of shares, we've got intrinsic value.
And yes, this is just how it's done by a lot of the analysts in the houses.
It's just almost a straightforward exercise.
The real trick is estimating future expected cash flows.
And there is a lazy way to do it, and there is the hard way to do it.
The lazy way to do it is to estimate your current free cash flow, and then apply a growth rate to that estimate,
and then find the present value of that future expected cash flow.
It all boils down to a formula that we have from the past.
The price, this is the constant growth PV model.
And it works like this.
The present value currently would be, if it's constant growth,
it would be the free cash flow, one period out, divided by the discount rate minus the growth rate.
That's your constant growth model.
You saw it in FIL 240, and here it is again.
It's just, it's nothing complicated at all.
This comes from a mathematician, 200, 250 years ago, figured this one out.
He was a child prodigy, and when he got big, he did all kinds of weird math that, a lot of it,
no one understood why are you bothering, you're a brilliant, you're a genius, why are you doing this?
And in some cases, he actually operated under a fictitious name to publish all these different formulas.
And as time went on, over the centuries, we figured out, oh, that's how you do, we can do this.
And in finance, this is one of his formulas, Gauss his name was.
Okay, so, anyway, now, free cash flow one would be free cash flow zero, FCF, times one plus the growth rate.
Okay?
And the discount rate, we would use the weighted average cost of capital.
That's all there is to it.
I mean, it's relatively simple.
And I've got one, an Excel template, you can put in the number for FC zero, and the growth rate,
and the weighted average cost of capital, and boom, there's your Uncle Bob right there.
The present value of the infinite stream of cash that comes from that.
That is the lazy man's way of doing it, and the lazy woman's way of doing it, to be gender neutral there.
We don't do much work for this one.
The trick would be, with this one, would obviously be getting your weighted average cost of capital.
And I've got a template, you can even do that.
Fortunately for us, Excel is quite good at those painfully tedious little calculations.
And I'll show you that on Thursday.
I'll show you how you can actually calculate a weighted average cost of capital.
From the component cost of capital, the cost of debt after taxes, the cost of common equity,
the cost of preferred equity, the cost of new equity.
You can crank it out within a matter of a minute or so.
Just plug in the numbers, and out it comes.
But for now, just whack, I'll just talk about it as whack.
Okay, now, the next one is the growth rate.
What would you say is the constant growth rate?
Well, you could use previous growth rates to figure out what the future growth rate is.
And there are two ways that you could do that.
And I'll show you an example right now.
Matter of fact, let me do something.
I'm going to pull up an Excel sheet.
Since most of you have Excel background, this isn't rocket science, but I'm going to pull up.
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.
But let's say year and free cash flow.
Now I'm going to take 2017, 2018, and then I'm going to crank that down.
Let's take it down five years.
Oops, I said five years, not four years.
Okay, now the free cash flow, let's say that it's $520,000.
And then let's go to $545,000.
And then let's take it up to $572,000.
And then $582,000.
And then let's go to $588,000.
Okay, so now two ways to do this.
Now the growth rate, growth rate.
Okay, let's try that again.
Growth rate.
We would take equals the ending value divided by the beginning value minus one.
And then we would give that a percentage to two decimal places.
So now I'm going to repeat that down here.
Oops, that sucked.
Let's try $591,000.
I didn't realize I was dropping off the face of the earth.
$610,000.
Apologies.
My ass.
$610,000.
Take that.
Well, I'm not going to get much out of that.
Okay, so there's your growth rates.
What you would do is you would say equals average, open parentheses,
average growth rate over the past five years.
You're saying, wait a minute, fat boy, that's four years.
It is five years.
Okay.
That's one way that you could do it.
Just take an average of growth rates over five years, 10 years.
Now, if this is done in practice, it's usually over a period of eight to 10 years.
I'm trying to be a little lazy here.
I should have just pulled up something.
But, okay.
Now, that's one way to get a G for practical purposes.
This is called an arithmetic mean, arithmetic mean.
There is another way that is somewhat more sophisticated.
It's called a geometric mean where you would take,
this one actually is kind of interesting.
Let's say that we took these years and we say this one,
this one, the ending value divided by the beginning value,
and we raise it to the one-fourth power,
or this one divided by this one, and we raise it to the one-fifth power.
That would be what's called a geometric mean of them.
It's more sophisticated, and it's not used in practice hardly ever.
It's technically, it would be a more, how should I put it,
kind of more accurate view of it, but it's just not used.
They generally will use just this arithmetic average of growth rates,
and they will pop that in there for the G.
Now, for the weighted average cost of capital,
that is a pain in the ass.
Many of you may remember this from FIL 240.
The weighted average cost of capital, the WAC,
is the weight of debt times the after-tax cost of debt
plus the weight of equity times the cost of equity.
Now you're saying, well, wait a minute, fat boy,
where's the after-tax on the second one?
Dividends are fully taxed.
Debt is cheaper than equity.
One of the big reasons is that your interest payments on debt are tax deductible.
So that means that debt naturally will have an advantage over equity.
There's another reason debt has an advantage over equity, and it's simply this.
The debt holders have the prior claim to the cash flows.
They get paid before the shareholders can see a dime.
If the company makes $500,000 and it owes interest payments of $400,000,
then all the shareholders see is $100,000.
They could get some of that as dividends.
The rest is plowed back into the company,
but they get theirs after the debt has been paid.
That makes debt lower, a lower cost right there
because the debt holders are in a safer position.
If you buy stock in a company, you're all at risk.
If they make money, great.
If they lose money, you're done.
If they go into bankruptcy, you get nothing.
But the debt holders, even in bankruptcy, they get the dibs.
They liquidate the company.
So that's the two reasons that debt is cheaper than equity, generally speaking,
and I'll qualify that a little later in the course,
is that interest is tax deductible, dividends aren't,
and second of all, the debt holders have the prior claim to the free cash flows,
so they're in a safer position, so they don't have as high an expected
or a required rate of return on their investments as lenders to the company.
But that's the simplistic formula for the weighted average cost of capital.
Now, one thing about that return after tax cost of debt,
the first way you would do it is just look at the coupon rate
on their most recent issue of debt.
Okay, they've got some senior debt with 4% coupons.
They've got some senior support native with 5%.
They've got some junior debt that has 7.2% coupons on it.
More risk because they're lower down on the feeding food chain.
So you would just take that highest coupon, the marginal coupon.
So the cost of debt is, let's say, let me put it here.
Coupon on the highest cost debt would be 7.2%.
The tax rate is 21%.
So the after tax cost of debt would be 7.2% times 1 minus 0.21.
So if I run that on a calculator, I'm just going to cheat here
and grab this Excel sheet equals 7.2% times open parentheses 1 minus 0.21.
Close the parentheses.
And there's your Uncle Bob right there again showing up for the Sunday dinner.
Whoops, I didn't mean to do that percent and then do that.
5.69%.
That would be your after tax cost of debt.
But that's wrong.
That's not how you should do it.
The problem is that that coupon is a historical number.
The coupon was negotiated at the time the indenture agreement was signed
between the investment banker representing the lenders
and the company as the borrower.
It happened in the past.
The one that you really should be using is the yield to maturity
on the most expensive debt, the YTM,
because that is the market's required rate of return right now.
Let's say that the yield to maturity on this junior debt is right now 7.4%.
That's the number that you want to use.
Because if the company went out today and borrowed that same money,
it would be at least 7.4% is what the lenders would want now.
That's what they're saying by the yield to maturity.
They've dropped the price of the bond so the bond is selling at a discount to par,
so the yield is above the coupon.
Notice how I'm talking a little faster now.
We went through bonds in the first part of the course,
and now I'm throwing it at you as if you know it like you know the back of your hand,
which I know you probably don't.
You'd have to be a little slower in doing this.
But I'm just talking to you at this level now because this is what you'll need to be at
to come up to the classes after this.
Okay, good news.
However, that actually is probably a little underestimated
because if the junior debt is what they've got there,
their lowest quality debt is this junior debt that is yielding right now 7.4%.
If they went out there and borrowed more money,
it would be junior subordinated unless they pay off that junior debt.
The next level of debt would be junior subordinated,
so its coupon would be higher and so its yield to maturity would be higher
because it has more risk than the existing junior debt.
So this one is even something of an underestimate of what would happen next,
but this is the one that you should use
because we would be only guessing at what the next level of debt would have for a coupon
and all that good stuff.
Now, if...
Oh, well, let me not do that.
So that number is a pain in the butt,
but remember that the weight of debt plus the weight of equity equals 1.0.
In other words, the two weights together are the capital structure,
the total assets of the company, okay?
So we're at that level now.
Now, the next level, and then I'm going to quit.
I'm going to drop this one and get back into the center of today's lecture.
The problem here is that this son of a dog combines a bunch of things.
There is the weight of preferred stock times the cost of preferred
plus the weight of common stock times the cost of retained earnings.
I hate saying that because it's cost of common stock
plus the weight of new stock times the cost of new issue stock.
Now, the problem here is this.
The weight of your retained earnings...
I'm sorry, the cost of your retained earnings,
the cost of your existing shareholders is going to be pretty...
It can be steep.
You can see 16%, 22%.
It is inversely related to the price of the stock,
and I'll show that in a little bit here if I have the time tonight, today.
But we keep going here.
The weight of new stock will be more than the weight of existing stock.
I'm sorry, I'm saying weight, cost, cost.
The cost of new issue common stock is going to be higher
than the cost of existing common stock.
Your stockholders are a cost to you.
They're a cost to you.
If you have new stock issued, it's going to be worse.
And here's why.
If my stock runs at $50 a share, I go out there,
okay, my existing shareholders, $50 a share.
So I go to an investment banker.
Hey, I'd like to raise some capital through equity,
a new seasoned offering of common stock.
Well, you think, well, it's going to sell at $50 a share.
Sure enough, it will.
You ain't going to get $50 a share.
The investment bankers are going to get a cut.
You will not get the full power of $50 for every new share you issue
because the investment bankers are going to take their fees out of it,
their brokerage fees, their consulting fees, their accounting, their lawyers,
probably their mothers.
Everyone is going to get in there.
You will probably see $46, maybe $45 a share for new common stock,
which means that the cost of those new shareholders is greater
than the cost of your existing shareholders.
You don't get as much impact out of them.
Think about it this way.
You're a married man, sir.
Your family costs you a lot of money.
But it's a great family.
But now you decide that you're getting to that age, about 40,
and you're feeling that need to find someone on the side, a mistress.
Well, she's not going to put up with macaroni and cheese every night.
You're going to have to buy more for her to keep her happy.
You know the story. You and me know.
The new is going to cost more than the old does.
Your old car is an opportunity cost to you.
But that is nothing compared to the cost right in your face of buying a new car.
It just isn't.
It's going to be more expensive to bring something new into the family.
And the investment bankers are going to make sure you know that.
Now, I'll tell you a story.
If you were in my class, I may have told you before, my class, my 240,
you may have heard this story before.
In my consulting days, I went from being a little piss-ass consultant
for idiotic companies around central Ohio
to a place where I stepped into a world of ridiculously large money deals.
A couple of young men were out of Coral Gables.
Their parents had found my name, heard about me somehow,
and they called me and they said, our boys are out there doing deals.
Would you watch them, go everywhere with them, and make sure they don't do something stupid?
And I said, look, I don't want to do this.
You sound like what they're doing is some, like rain making.
Oh yeah, they're doing rain making.
They're bringing money to small companies that need money to get their operations started.
Now, the one thing that I didn't ask at the time was where is this money coming from?
I assumed that it was all respectable and all that.
As the years would pass, I would find out that wasn't the case.
But there was one deal after another, 100,000, 500,000,
and then there came this odd, bizarre deal out in Atlanta, at the Atlanta airport,
and the back lot, back in the old days, the back lot was just all these different little buildings
and house trailers that were housing little operations, little puddle jumping operations,
a little delivery services, and all this.
We had an appointment with the two Momo boys, these two young men,
to talk to this guy out there in a trailer in the back lot.
As it turned out, he was involved.
He had developed a plan to get a hold of some old 707s and 727s from a bankrupt airline in Europe.
They were going to put these, he was going to put them, bring them back into service,
as delivery for UPS, United States Postal Service, and FedEx, and DHI.
He would take their packages from one city to another in these old jets, and it was actually kind of a good idea.
He had made the arrangement to acquire seven of these derelict jets, and he was going to do this.
He had all the FAA paperwork just stacked everywhere in this place, and we went in there,
he was a very strange guy, he looked almost elderly.
This was in the later 1990s.
He had a white beard, and these steely blue eyes, and a big cigar, and he had this vision.
He kept looking at me, because I was a pilot at the time, and he said,
you understand, don't you?
I said, yeah, I get it, I get it, it can work.
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?
He said, $5 million.
I thought, well, this is not going to work.
And one of the young men said, we can do this, this will work.
Okay, $5 million.
And we talked for a while longer, and then we had parked our nice black Crown Vic
maybe about 50 yards away from where his operation was, and there was a reason for that.
Because we knew what was going to happen next, eventually, and it happened.
He said, okay, we're going to get together at $7 million, and we can probably do that within a week.
And he said, oh no, no, $5 million.
Oh no, $7 million.
We get $2 million.
Oh, he just shit his pants, he just went crazy.
What the hell are you trying to do to us?
So as a stage thing, we just got up and said, thank you for your time, and we walked out.
Now the one young man deliberately walked behind us slowly while we just walked to the Crown Vic
and looked really irritated waiting for Dan to show back up instead of talk.
This guy came out, wait, wait, wait.
So Dan and him talked under the voice, and they came back to us, and he said, we got him at $6.5 million.
Okay, you see, it was all set up.
And so that was how it worked out.
So here's what the lesson is.
Do you see the float?
$1.5 million on $5 million.
That's the float.
He was on the hook for $6.5 million, except that he wasn't going to get $6.5 million.
He was going to have to live with $5 million, but have $6.5 million in equity hanging over his head.
We controlled the company.
So that gives you the idea of, that gives you a real world idea of what float can do.
Now that was excessive float.
$1.5 on $6.5, that's awful.
That's evil.
I should burn in hell for that one, but I didn't.
It actually all fell apart because at the end of the day, it turned out that he was one of the FAA,
finally tracked back, paid attention.
It turned out he was part of the crew that had been involved in the Iran-Contra affair.
If you watched the movie Air America, those were the pilots.
He was one of the pilots from that movie, Air America.
And if you don't know about it, I'm not going to explain it to you.
Trust me, it happened.
He had been in prison because he was transporting marijuana and other drugs up from Central America,
and they were being traded with major drug dealers in the United States for weapons from Iran.
Iran was sending those weapons down to our favored rebels in Central America to fight the Nicaraguan
communist government, and so he landed his plane and the DEA was waiting for him.
And of course, he said, I'm working for the CIA, and they said, CIA?
I said, no, who?
And so he went to prison for two years, and so the FAA wasn't going to let him run an airline.
So the deal fell apart in the end anyway.
But watch Air America.
You can see it.
True story, bizarre as hell.
Anyway, that's a long way around to explain that the float is going to kill you on this.
16% on return here, try 18%, 19%, 20% on new issue common stock.
So we put all this together here.
We get our weighted average cost of capital, and we'll do one in class.
I've got a template, so you don't have to.
That can kill you if you do this by hand, because you see these weights here?
Each of those is a market weight.
So you have to take the total market value and break it up into what part of that market value of the company
is coming from your debt, what part is coming from your preferred stock,
what part is coming from your common stock.
And we ignore the new issue.
We'll just ignore that unless you really want to walk on the wild side.
So anyway, we get back over here.
We get this, and we've got a value for the company.
So let's say that the company, the free cash flow for last year was $320 million.
We have a growth rate used, we'll use an average for the last five years.
We have a growth rate of, let's say, 2.3%, and our weighted average cost of capital is coming out to be,
let's say, 8.4%.
So now we can take a present value.
Right now, the intrinsic value of the entire company, survey says, would be $320 million
over times 1 plus.023 divided by the weighted average cost of capital,.084 less.023.
And so we crank that out, and I'll just do it here just to save myself.
So we got $320 million times 1 plus.023, close the parentheses, divided by, open parentheses,.08.
I should pull up the template.
I've got a template for this that I'm doing barehanded,.023, close the parentheses.
Did I do this all right?
Yes, I did, for once in my life.
Oh, I should put an equal sign, for God's sake.
Equals, make that a comma, make that a number, $100,000,000, $5.367 billion.
That's intrinsic value.
Then you get the number of shares outstanding of the company.
Let's say that this company has shares outstanding, is let's say,
100 million shares outstanding.
And so you would take that number right there, equals that number, divided by 100,
you got $53.67 intrinsic value.
So the bottom line of this is, yes, we can find intrinsic values.
It's an estimate, obviously, but then again, everything in our lives is an estimate.
But when I say overvalued, undervalued, well, it's overvalued, it's a little above its intrinsic price,
a little below, this is the analysis that you do for that kind of stuff.
And it is done.
This is old school stuff, but it's still pretty popular.
Now, I will mention, mention a new way of doing this, and I'm not going to go into it here.
If you take a derivatives course from me, there's a, we've got a new professor, and he's darn good, great guy.
And he's really, he does his thing, but he doesn't step into this, and I would step into this,
where we can actually use options pricing theory to value, find the value, intrinsic value of stock.
That's done now by a couple of houses, both in New York and in Europe,
where they're using the options pricing model, the Black-Scholes model,
that thing I kind of waved my hand at, chapter, whatever the hell that was, chapter six or something.
But you can find the price of the stock by treating the common stock itself as an option,
and then using the Black-Scholes options pricing model on the parameters to get a price of that option.
Essentially, the stock in that model is a put option, because at any given time,
the company has the right, but not the obligation, to put the company to the debt holders.
If the value of the company falls below a certain amount, that would mean that it couldn't make its interest payments.
It has the right to put the stock, put the company, the actual company, represented by a stock, to the bond holders.
It is actually a classic put option, complicated as hell, but it is a put option.
But that is not being used, and for your purposes, both in manual calculations on Excel,
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.
There are AIs, and they are being done by AIs, who are using the new method, using Black-Scholes options pricing model,
but it's not what you will see out there if you have to do this kind of stuff.
Now, what I've talked to you about here is a free cash flow approach that just assumes that your free cash flows
are going to grow at a constant rate, or approximately at a constant rate for the foreseeable future.
That's probably not a good idea, unless the company is very stable, an old stable company.
It's more likely, in other words, the free cash flows are not going to grow like this.
They're going to be blowing, blowing, blowing, blowing, blowing all over the place.
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.
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,
year by year, estimating the free cash flows, year by year by year.
And that's where you get into, essentially, pro forma financial statements, pro forma income statement, pro forma balance sheet.
The way that method goes is that you're going to have your income statement in your balance sheet.
And you're going to have your revenues minus your costs. That gets you to op-inc minus your interest expense.
That's going to get you to your pre-tax minus the tax gets you to the net income.
Okay, wonderful. Just great.
And then you have to estimate all of those for, let's say, 10 years out.
It all pivots on the revenue projections.
In other words, you make an assumption about revenues year by year by year,
and then these you are finding as you're setting those as percentages off the revenue,
like we did with common size financial statements.
So, essentially, well, costs are going to be 40% of the revenue.
Interest expense, we are going to hold a leverage position that will make interest expense 5%.
Pre-tax tax is going to stay at a happy 21%.
You drill it down from the revenues, getting the numbers for the other ones from percentages.
And then you get down there, and then you work your way down to the free cash flow.
And you just keep doing this over and over, year by year by year.
Now, obviously, your numbers are going to get fuzzier and fuzzier, projecting revenues farther and farther out.
The assumption here is that once you've gotten out to about year 10,
the contribution of free cash flows after that as a present value is going to be not enough for you to worry about.
I mean, if you want to do 15, 20 years, sure, but at some point, I mean, your present values,
discounting back one year, two years, three years, they're significant values.
But once you get out there and you're taking to the negative 15th power,
some one plus weighted average cost of capital to the negative 15th power,
those factors are going to be small enough that you can pretty much ignore them after a certain point.
Ten years really is enough to get a good estimate.
So, in other words, your whole point here, the whole point of this exercise is to get you to the point
where the value of the company right now, intrinsic value,
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,
maybe going out, free cash flow at year 10.
And then you just telescope those back, discounting it at the weighted average cost of capital.
Just to straight up find the present value of each of these numbers, discounting at the weighted average cost of capital.
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.
Just a growth rate for the whole period.
Doing it this way is more realistic, especially because you have control of what you're estimating the revenue is.
This is where you begin to think, okay?
We see the economy growing and our market share growing over the next three, four years, and then we see a recession,
so you adjust the revenue down for the period of a recession as predicted by your economic jockeys in the company and all that.
And then, so you are granularizing your revenues and then driving everything off those.
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
throughout your period of analysis?
For the next 10 years, your costs are going to be 40%, 30%.
Okay, fine, adjust them.
But another way you do it is to say, we're going to set targets, and this is where managerial finance comes into play.
We're going to set a target.
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.
We're going to, that requires that this is a feedback into the company.
You're saying, oh, I shouldn't be using this number, the 40% or 20% or whatever.
Well, why can't I use that?
Are you saying that you can't control costs?
You come right back at them.
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,
because that was your problem to keep it on that number, what your target amount was.
Now, you break this down.
Obviously, the cost thing, you break it down.
Selling general administrative expenses, you can granularize it as much as you want.
Your interest expense, you're going to have to feed back into when we retire a bond issue.
Is it going to be in the next 10 years?
Well, then our interest expense will go down.
Are we going to have to borrow more money in year five?
Okay, it will go up.
Just get the numbers in there, starting with percentages, and then adjusting them as necessary.
This is how we really do it.
These are called these five, these 10 years of income statement and balance sheets.
If you haven't heard the term, I've used it a couple of times in here.
Those are called pro forma income statements and balance sheets, pro formas.
Now, if you're ever doing a business plan, they are going to ask you for your pro formas.
I heard even one angel investor call them the PFs.
I didn't even know what he was talking about for a whole pro forma.
In your business plan, you better have five years of pro formas, at least, and you do it this way.
As a matter of fact, that's one of the great powers of AI right now.
I can have a chat GPT go through pro formas.
I've done it in the past month.
I had it do it.
It was amazing how fast it did it.
Then I told everyone I did it.
It took me a long time, but that's the benefit of being a professor.
You can say you do more work than you do.
With that, that's all I have for you today.
I thank you.