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, evaluation of corporations.
Now I'm going to do this in two parts, and as I've been asked to do, making sure that everything is visually on the board.
So the first pass, I will do the example that is in your PowerPoint.
Now there's a mistake in it, and that actually is a good thing, because then we can, I'll take you through this dry run, it'll just be a simple example.
And then from there, on Thursday's class, I'll take you through another one that's a little more realistic.
The one that is in the PowerPoint is very simplified, but it is excellent for getting you started.
This is where we get to the point where we are building pro forma income statements and balance sheets.
Standard practice. Anyone who doesn't do it this way is just getting too darn fancy for normal analysis.
We are just projecting. The main part of this is to project our need for capital in the years ahead.
Now this is a hugely important thing because a company that's growing, it can fund operations to a certain extent from its sales.
What we call internally generated equity. That's the fancy word for it.
You're actually earning money that you spend. However, that is not nearly enough for a growing corporation's needs.
So there is that, where do we get money, how much do we need, and what is the type of capital that we are looking for?
Debt, equity, accommodation. And that's a difficult thing because, look, if you go to an IB, you've projected,
we're going to need $93 million in external capital. Okay. You're going to need to know that at least two years before it happens.
You can't call an investment banker and say, hey, you know, we got, it's like November and come January, we're going to need $93 million.
Can you chop something off the money block you've got? You're going to say, are you on crack? No. It goes through an offering.
And then we will have to set up this offering, negotiate everything with you, and talk to our power investors.
And then we craft the terms of the offering, debt, equity, both. And that is a long procedure.
There are accountants, lawyers involved, there's the SEC involved, there's the state securities regulators.
This is not something that happens overnight. It doesn't happen in six months.
It is going, so in other words, if I, I need to project what I need out there at least five years,
and it gets fuzzier as time goes along, but you've got to be pretty darn accurate at year two, year three, about your needs.
And what you need next year, you should already have known that two years ago so that you have that set up,
so that that comes in, it makes its landing on time for when you need it.
The alternative is the companies that are foolish. They get into a desperate situation.
They don't do proper projections, pro-forma income statements and balance sheets,
so they don't know what their additional funds needed, their AFN is.
And so what do they have to do? Well, they scramble.
They end up going to short-term markets where the rates are very high.
And some companies, eventually it just ends the company because they're always in this catch-ass, catch-can kind of situation
where they're trying to get funds together a month before they need lots of money.
So what do they end up doing? They pour out commercial paper.
They pour out other kinds of short-term debt, and that's expensive scratch.
I mean, the short-term players are going to ask for a pretty serious amount of money.
Think about it this way. I'm going to need $10 million, and what can you do for me?
Okay, $10 million. Okay, I'll tell you what we'll do.
We'll lend you $9,900,000, and then you pay us back $10 million in six months.
Okay, we got to have it. Well, if you calculate the interest on that, it's going to make your buttocks ache.
That's a high interest rate, but you had to do it.
And guess what? If you're that bad at planning into the future, you're going to go right back to those capital markets again
to get some more of that quick, easy-pay loan off the commercial paper markets.
Some companies get so bad off that they are not in the repo and reverse repo markets just for the extra money.
They're in it because they've got to have five days of money. So what do they do?
They end up borrowing treasuries to sell them to the federal reserve
with the agreement that they'll buy them back in five days to give back to who lends them to them.
Yes, that happens. And then they started all over again five days later
and constantly just grabbing at this ridiculously expensive money in the short-term markets.
So we in responsible finance, this is corporate, well, actually it's kind of a cross between corporate and investments,
but we want to make sure that you don't do that. And you'll see that this is something you may step into a company
where they're a year away from an IPO and you're stepping into it halfway through the process.
Yeah, we've got an IPO coming up and you do not talk about this with anyone under penalty of death.
We're in the process right now of cranking this thing forward.
And so you'll see that these are ongoing and you're going to see how it's done.
But first, let's look at the numbers and have a good time seeing the markets struggling and twisting and farting about everything.
It started out just on it. It started out in a real bear mood. It was down.
I mean, I thought the futures market this morning before the bell, the futures market was looking really bad.
And of course, you had these talking head pundits tapping out stuff at 6 and 7 a.m.
Oh, it's happening now. Here comes the apocalypse.
You know, I did see that it probably wasn't going to do that. I'll tell you one thing you can do.
The futures markets are trading. Remember I told you futures markets trade at different hour bands.
And the futures and equities, they trade at that clock started early late last night.
And so by the time you get to 7 a.m., 6 a.m., that futures market for equities has been on board for hours.
And you can look at that and you can see, yeah, futures market is looking really down.
But what you can also do, and this is something I was showing you last week.
I'm going to show it to you again today. You look at the pre, the pre-market, not at futures.
Futures people, you've got speculators from hell.
If you look at the pre-market, that's showing you the balance of buy and sell orders that are pending for the opening bell.
And in that market, you'll see a lot more nuance than what you will in the futures market.
You can see this is, and I saw it, yeah, there were some equities that were just being paddled.
They were being potty trained. But then there were a lot of them that were showing more buy than sell orders.
So I knew it was not one of those hell scapes of a black swan at all, nothing like that.
As you can see, though, it's been climbing through the day.
It did start out down, but all those orders on the buy side, they came in near the opening bell,
and then more orders came in, and the bulls have been pulling up.
A lot of what it looks like to me is bargain hunting.
In other words, there's been a couple of bad days.
Stocks have been pulled down, and good stocks are being pulled down with bad stocks.
And stocks that did deserve to have price corrections down got pulled down more than they needed to be pulled down.
So the bargain hunters, you just go in and you say, oh, this one's on sale.
I'll buy it because its fundamentals are good, or they're certainly not as bad as this price is indicating they are.
And that's something that you should always watch out for.
One more point about the opening.
When the market at the opening bell, you have the market makers lining up.
They're getting orders to buy, orders to sell from the brokerage houses.
Now, every morning, they start out with only a very thin liquidity.
In other words, money to execute orders back and forth.
What can happen in those first few minutes is that in order to generate liquidity,
there can be, there will be, and I've done this myself, you can find some,
you'll put in a price that is noticeably lower than what the opening ask is, and it will get filled.
If there's a market maker out there who really just wants to get some orders filled to get liquidity built up to the day's level, it can happen.
I'm not saying you should do this all the time, but sometimes it's a little bit of magic.
They're trying to build liquidity, as the market makers are, so they're willing to take some orders
and get the orders cleared in the system just to get those electronic blips of little dollar bills popping up on their screen
so that they have their liquidity standards for the day.
And then, you're lucky if that happens, it's happened to me with both stocks and with options.
Once in a blue moon.
So now, anyway, as you'll notice, the market is beginning to behave itself somewhat well.
The Dow is climbing a little faster than the S&P.
The S&P has finally cleared into the green, and the NASDAQ is beginning to show some decent life.
And as you can see, those are pretty strong upsurges as the market re-corrects, for lack of a better term,
what was happening in the overnight futures market.
Which is very happy for me because the speculators in the futures market are getting their asses killed
because they were taking short positions over longs a lot.
But they're crazy mofos anyway.
Okay, crude's finding itself up a little bit.
Nothing really spectacular.
There were some rumors early, well, late last night that there had been a drone attack that had done some damage in Israel.
But those rumors just disappeared at some point.
But it was enough to get the oil market a little bit excited.
But notice that it's topped off and it'll probably slip back down a little bit.
And it still seems to be liking that 70 to 72 band, a very tight band.
But it seems to be kind of like wanting to stay there unless something really rattles it.
But like I said, those rumors come and they go, and there's nothing you can do about them.
You can't confirm them.
Even when you see videos, there's so many deepfake videos that you can't tell what's real anymore.
But unless you've got some boots on the ground there that can tell you.
Okay, the gold bugs are having an exciting day, pushing the price up.
I heard an estimate from a pretty respectable source that he sees 3,000 an ounce before the end of the year.
So there's that.
Now we've got our happy, happy bond market.
Here's the problem that's happening.
The Fed had cut interest rates very strongly.
That brought the yields on bonds down.
And we saw about 3.65 on the yield.
Stimulates the economy.
Well, then there was a couple of reports.
One of them was a jobs report that showed the economy was actually showing a lot of strength.
More than the Fed estimated, more than most analysts had estimated.
And that made the expectations of lower interest rates, the Fed cutting the discount rate, go away.
Now then there was concern that, well, the Fed's not going to cut the interest rate anymore
because this looks like an inflation push, some kind of inflation.
See, the Fed thinks that if there are too many jobs being formed, then that's a bad thing.
We've got to hurt the economy.
It's been a criticism of the Fed for decades.
But the Fed's, okay, the Fed sees a strong jobs report.
They're not going to cut interest rates anymore.
And then we got a little blip on the inflation measures.
And that gave more confirmation to the bond traders that there's going to be no more significant
interest rate cuts before the end of the year.
Well, that made the bond yields, based upon the new expectations, not lower interest rates.
That made the yields on them go back up.
That's what we're seeing now is that these bond yields are going up.
The inside story is that the Fed did not want this to happen.
They did not want the bond, the 10-year yield benchmark, 10-year Treasury to go up to this level.
They didn't really make any indication one way or the other about what was happening to interest rates.
This is just pure speculation by the markets, the market players themselves,
that interest rates are not going to go down.
They may even go back up.
The Fed might have to recontract the money supply to squeeze out what might be a new inflation coming along.
The Fed's saying nothing.
This is all rumors.
So it's in its own world right now, trading.
And so right now you see bond investors are selling the bonds,
and that increases the supply of those bonds in the open market because those bonds are trying to sell them.
That also decreases the demand for the bonds.
Those two forces together bring down the prices of bonds.
Hence, they bring up the yields on bonds.
So what will happen next?
If it gets serious enough, the Fed may intervene by going into the open markets and buying bonds itself.
The Fed, that is a type of open market operation where they go in and they do an intervention.
They just start buying the hell out of these treasury bonds themselves.
And as they buy them, that elevates the price.
The demand increases, price increases, which will bring the yields back down on these.
That's the smart money right now on what's happening in the bond market,
is the Fed may have to shut these rumors up about the Fed increasing interest rates,
inflation coming back, all that stuff.
The way they'll shut it down is to just start buying the hell out of the bonds,
driving their prices up and their yields down.
That may be what we see in the next couple of weeks if these bond yields keep going up.
The trigger, probably around 4.3 to 4.4% on the yield on the 10-year benchmark.
If it gets that high, the Fed's going to intervene to stop the yields from going up,
because the Fed is definitely not interested in the economy fizzling out at all, especially right now.
Anyway, coming back over here.
Yeah, the Japanese did their usual thing, a massive sell-off right at the start of the day.
And then once that's over with, they go out and have lunch.
And the market just, and the Nikkei just floats for the rest of the day.
That's so odd about them, but that's what you see all the time now,
is a big drop-off at the start of the day, sometimes even before the market opens.
The pre has already had a pile of sell-overs in it.
But once they've gotten that out of their system, they've barfed their brains out.
Then for the rest of the day, they just wallow along like there's nothing going on.
London somehow managed to pull itself out of a pretty nasty little slump that it was going through.
It looked like the apocalypse a few hours ago in London.
Has London closed yet? I think they're about to close.
But it came back from that, and again, that was probably bargain hunters.
The FTSE 100 went down severely, and some of those 100 big ticket stocks went down way too much.
So bargain hunting began, and the bulls came in, bought up stocks, and it began to pull it right back up.
Looks like it's going to pretty much be flat by the end of the day.
Now, just quickly going through a couple of stocks, Citi.
Look at that. Citi is just on a tear.
And I think that's true of some of the other banks too. Bank of America.
Well, I tried that, and it didn't work, so let's try it again.
BAC.
Come on.
Yep. Bank of America is doing good. Wells.
Well, let's try that again. Wells Fargo.
Yep. Look at those bank stocks. They're just making out like bandits right now.
And it's good news.
Now, in the text,
oops, Apple down, and I think Microsoft is probably going to follow it down.
MSFT. Microsoft is going to follow it down.
Oh, look at that. Microsoft is bucking the trend.
Bill is going to make a few million today.
Okay, well, that's fine. Good for him.
But now in other sectors, just a few that are off your usual looking.
A few smaller ones, like for example,
this one used to be sort of a high flyer, and now it's pretty much dead.
But it's worth a look at. Come on.
MaxArt.
This is a penny stock now. A long time ago, it was a pretty popular stock.
Rumors are that they may be back in the fray here soon enough.
As opposed to one like Sorrento,
which at one point was insanely high priced, and now it is...
Why do I keep doing that?
Sorrento died. Oh, well, that's okay.
And then Novavax.
That one was one that survived, and it's doing well, but obviously not today.
And then Moderna, MNRA.
Let me see this. Really, really risky.
And they were making...they were quite a high flyer, but now they're losing money hand over fist.
But Yahoo is projecting that they are going to almost double in price over the next year,
which is quite possible because they are...I think I maybe mentioned this.
Moderna was one of the companies that used the messenger RNA technique
for creating the antiviral medication for COVID, for SARS-CoV-2.
They are on the path now.
They're in clinical trials, no guarantees, for antiviral vaccines
for several diseases that have been plaguing humanity for about a half a century now,
including the human immunodeficiency virus, an actual vaccine against AIDS.
So they are in the race for it, and whoever comes to the front of that one
is going to make a freaking fortune off that one,
considering the rampantness and the lethality of that virus.
But anyway, enough of that.
What I'm going to do here, I'm going to take you through just terminology today for this.
And I've got to make a couple of corrections here.
One of them is a rather dramatic correction.
I'm going to do this via the PowerPoint so that the visual is up there
as I am asked to do now for this class.
I'm just going to walk through some of the terminology
and reacquaint you one last time with...
Did I do that? Yep, I sure did.
Okay, let me pull this up here.
Now, this is a repeat of what I said in the preamble to this lecture.
Some of this says, no, I want this full.
Now, when we say financial planning in a course like this,
we're not talking about making sure that mom and dad can have their retirement home.
This is not that kind of financial planning.
This is financial planning, looking for planning for the future of a corporation,
making sure that it has sufficient funds for what is coming next,
the AFN, as we call it, the additional funds needed.
Now, these funds, there are a couple of things to point out here,
and I'm filling in what you'll see in the PowerPoints
and actually what you'll see in the book too.
First things first, I'm saying funds as opposed to capital or money
because the additional funds needed could come from both of those sources,
could be some of each.
You might need, let's say, $100 million in capital,
but you also might be projecting that you're going to have a cash deficiency of $4 million.
So in other words, that AFN would be capital, the long-term funds,
but it could also be money, the short-term funds,
to maintain both the long-term capital of the company
and also the short-term liquidity of the company.
Now, another part of this has to do with optimal capital structure.
Now, the optimal capital structure, and I've said this before,
and I'll say it again, get it down.
The optimal capital structure is the combination of debt and equity
that comprises total assets.
The capital structure of a company is the combination of debt and equity
that comprises total assets.
Now, it is the combination of debt and equity that comprises your total assets.
Now, what that would mean, I could say a company is 20% debt, 80% equity.
That's a low-leverage company.
A company that would be 50% debt, 50% equity,
we would consider to be somewhat leveraged.
You get up there to 70%, 80% debt, and 30%, 20% equity.
That's a highly leveraged company.
These kinds of companies tend to have very strong ROEs
because ROE is net income divided by the equity.
And if you have a very small equity base compared to your debt base for assets,
then that's going to make net income over shareholders' equity a very large number.
Yay for our team. We've got an incredible ROE.
But that is at the cost of extraordinary risk
because the more debt you have in your capital structure,
the more likely you are to have your revenues dip below,
revenues minus cost dip below your interest expenses,
and then you're in bankruptcy court.
So keep that in mind.
Now, again though, additional funds needed, you can't just say,
well, investment banker, we want to raise $100 million,
sell $100 million worth of stock.
That's not how you do it.
You raise the capital to maintain your optimal capital structure.
The combination of debt and equity that minimizes weighted average cost of capital.
So in other words, you can't just go out there and say,
we want to borrow a bunch of money.
And in that regard,
in that regard,
you're going to have a percent of debt from 0 to 100 percent
and the weighted average cost of capital.
This curve, if you don't have any debt in your capital structure,
your weighted average cost of capital is going to be your cost of equity.
Equity is very expensive capital.
Equity is very expensive.
As you begin to add debt to the capital structure,
your weighted average cost of capital begins to fall.
But there is a point where you borrow so much money that your lenders are going to say,
hey, you're getting into some serious default risk,
and so they're going to start charging you more.
And ultimately, that will begin to pull the curve back up like that
so that 100 percent leverage is extraordinarily expensive.
The optimal capital structure is a combination of debt and equity
that minimizes the weighted average cost of capital.
So now, putting this in the context of additional funds needed.
Okay.
If all I do is issue debt, I have $100 million, I just issue debt,
well, what that's going to do is move you back off your optimal capital structure
and it's going to increase your weighted average cost of capital.
That's a big problem.
So you don't want to do that.
Here's another interesting thing.
This one is subtler.
Suppose that your company is very profitable.
You're making good money.
You're making money hand over a freaking fist.
Well, what that's going to do is that's going to increase your retained earnings, your equity.
So by virtue of the fact that you are profitable,
you are actually going to cause yourself to come back off your optimal capital structure.
And it's the oddest thing, and I've seen this in prospectuses.
The company said, we are issuing $40 million in senior subordinated debt.
And they more or less say, we don't need it, but we've got to borrow
so that we go back to our optimal capital structure.
They actually borrow the money so that they get back down to the cheapest whack that they – their cheapest whack.
And they'll be quite honest about it, too.
Don't worry.
We don't need this money.
We just got to get back down to our lowest optimal – our lowest capital – our weighted average cost of capital.
So keep that in mind.
That AFN, additional funds needed, can have many dimensions.
One of them, maintaining your optimal capital structure is an important one.
Another one is also just what do you need these funds for?
AFN isn't just public offerings.
AFNs, you can – a one-year budget, a one-year capital budget can actually include short-term borrowings, six months, one month, a year.
They can include short-term borrowings.
So that's why you have to look at the nuance of what you are going to need those AFNs, those additional funds, for.
Now, another thing.
And that is hinted at in the financial policy issues.
That's why the PowerPoints aren't really too comprehensive, and the book doesn't go into it much more.
But those additional financial policy issues is what I'm talking about here in the last 10, 15 minutes.
Now, the operating input data.
Now, notice the key is operating.
We do not – in our world, we separate financial issues, the financing, from the operations.
It's an actual axiom of finance.
I'm not sure it's a theorem, but I've heard it called a theorem.
It's called the separation theorem.
Operating decisions should be detached from financial decisions.
And it's sort of like one of those old-school things that someone, some old professor is going to tell you,
and I'm telling you now, this is what we do.
This is our philosophy.
Don't mix the two.
Look at your operating issues.
Get your data.
Figure out what your operating costs are, how they're going to change,
if you're going to change decisions on operating policy decisions.
And then, okay, from these operating decisions, we make our financial decisions, from our operating decisions.
And that's the pain of being in our world of finance, because we can look from the auditing side, okay,
operations says they need this ginormous, expensive computer server bank.
Okay?
That they're saying yes to this, we do have the ability to look at it from a net present value standpoint,
but we don't have the responsibility for saying you don't need this.
And companies that let the finance and accounting people do that kind of thing too much, override operating decisions,
well, they're in trouble, and they usually go belly up, because they let the tail wag the dog.
Nevertheless, it is still fun when you get a negative net present value of a project,
to tell the people who wanted this project that they can't have it, because that's fun to see them cry, but that's just me.
Okay. Let me get past this stuff.
Okay, I'm going to show you one right here.
Now, this is a simple one, and I'm going to do one of my own on Thursday,
and I'm going to upload it so that you can do this yourself.
It's simple, simple accounting.
You've got a very brief accounting statement where you've got all these things going on, the cash, accounts receivable, inventory,
and then we break it down quite simply.
And actually, there is not, I mean, sometimes in the real world,
they will break the balance sheet down into all these categories.
Realistically, in our world of finance, we don't need to granularize this process too much.
We are there to look at the operations, see what the money is needed for the operations,
and let the operations people figure out what they're going to do with it.
That total, the net fixed assets, well, how much of that is property?
How much is planned? How much is equipment?
How much is land and all those other things?
We let them deal with that, and we deal with it more on the level of tell us how much you need.
You work out those numbers.
We'll come back and we'll ask you questions about them.
But for the first round, we want to keep it on a much broader, less granular level than others would.
So we just get simplified balance sheets.
Actually, sometimes we just simplify the balance sheet ourselves if it's not simple.
Now, here's one thing I want you to make a note in here,
and I'll try to remember to change that in this PowerPoint,
is that they put the tax rate here as 40%. It's not.
They're calculating it at 25%.
And realistically, that is not 25% now.
But make a note, if I forget to get this PowerPoint corrected, there are a couple of errors in it.
But to go back in and check that, 40% of 396 pre is not $99. 25% is.
And my version of this will be more exacting, and it will be auto-calculating.
So it won't just be numbers.
You'll have the tax rate over here, and you'll see the effects over here.
And the addition to retained earnings will be part of the calculations of the sheet.
It's just static here.
But it is a good place to start just to show you what the numbers are that we need.
And going down the line, of course, keep in mind that depreciation isn't really an operating cost.
But it is included in operating costs simply because of the tax shield effect.
In other words, we don't write a check to depreciation expense.
However, we do include it because it reduces the pre-tax earnings.
And so it serves as a tax shield.
Now, ultimately, we'll add it back in.
We'll add it back in.
And that is the part where we do the free cash flow.
The free cash flow, and I think I've done this enough times.
Sales minus costs minus depreciation expense times 1 minus the tax rate.
And then we add back the depreciation expense.
And the question comes up, well, why don't you just take it out here, fat boy?
That's because it's going to shield some of our taxable income from tax.
So we need to have it in there as if it were an operating expense, even though it isn't.
But then once it has had that effect here, then it comes back in.
We add it back because it didn't really happen.
It's a mythical thing that creates an actual physical result, as it were.
And what was I thinking here?
Oh, and I should put here, and I apologize for that, operating expenses, S, G, and A,
as we call it, sales, general, and administrative expenses.
So as that sheet shows, when we say operating costs, that's usually,
you'll see that on an actual financial statement as sales, general, and administrative expenses.
If you are looking at financial statements from 10, 20, 30, 40 years ago,
I rarely would have seen an S, G, and A.
They would have broken them out, each one of them.
But now the standard for the SEC's purposes and for reporting purposes
is to just lump them together as S, G, and A, which is nice,
because then you don't have to figure out all those different utility, mailing, wages, salaries,
meals and entertainment, and all that kind of stuff.
Okay.
Now, again, just as a quick reminder, the current tax rate is 21% right now.
Very generous.
Used to be 39%.
Here was the odd thing.
It actually, we used to have a progressive corporate tax system.
It would go up, up, up, and then it would top out at 39%,
but then the very largest pre-tax would be back down to 35%.
It was an oddity of the system.
Some said it was the candy that was bought with campaign contributions
by the largest companies in the world.
But anyway, to finish this off, you have minus capital expenditures.
I'm going to put this in parentheses, plus change in net operating working capital.
This is the part where you separate those capital expenditures from the money expenditures.
You see this one before, and by the way, just up here, just FYI,
this is called NOPAT, Net Operating Profit After Taxes, NOPAT.
You've seen it before.
Just reminding you, this is one of our gods, NOPAT is.
Well, what's NOPAT?
That's big in finance.
Okay, so just going through this, make sure that you change this over to 25%.
I'll re-upload this table, and I'll also provide a much more comprehensive example
down the road here.
Now, the rest of this is pretty normal stuff.
Your earnings per share, you just take your earnings, which is the pre-tax,
I'm sorry, the after-tax net income, and you divide it by the number of shares outstanding, the EPS,
and that gives you your EPS.
Ideally positive, but there you go.
And the dividends per share, you just take your dividends divided by the number of shares outstanding.
You get the dividends.
The best place to look for it is the statement of cash flows.
Sometimes you'll see it on, there's one called statement of retained earnings,
and you may see it there as well.
But the go-to, just to get the number, the full number,
just go to the statement of cash flows, and you'll get it there.
Ending stock price.
This takes out a couple of complications that we don't worry about at this point.
Later we can talk about them.
You have earnings that come from the company's operations.
You will also have non-control interest earnings as well.
A large company that holds other companies in its portfolio will have income
that did not originate from the company.
Don't look at that in this kind of analysis.
It's simply because you don't want to see how great, okay, you sir,
I don't want to know how great your investments are.
You're doing great, I'm sure of that.
I want to know what you make.
What's your salary?
Because those external, if you're non-controlling,
you have no control over whether that's a great thing next year or it's gone into a
shithole next year.
So look only at the controlling interest that's yours, okay?
And also there is another one off here to the side,
and I'm giving you some of the ifs, ands, ors, and buts here.
Companies own interest in other companies.
They buy stock of other companies.
There is a good reason for companies to do that.
It's simply that when you get dividends on stock that you own in another
corporation, this isn't personal, this is company,
you get a tax break on those dividends for those holdings.
You get a tax break for it.
Another side to that, a dark side, is that a company itself,
well, why would you ever pay dividends?
Why wouldn't you just put money back into your own company, grow the stock price?
Everyone's happy.
It gets capital gains.
A law was passed some years ago that actually assesses a penalty for companies
that don't pay dividends.
I think they call it excessive retention of earnings.
So in other words, if you're a corporation that doesn't pay dividends,
after a few years you're going to pay a penalty because you didn't pay dividends.
Why is this the case?
It's simply because if you pay a dividend, if I pay a dividend to you people,
well, then that dividend gets taxed on your income tax.
I've already paid tax on it, and now if I pay you a dividend, you get it,
and then the IRS charges you, makes you pay a tax on it.
So they're forcing companies to spit out dividends just so that they can double
the taxation.
Now, these are pretty standard.
Just some very basic ratios that you want to use for this analysis.
And you'll have a list of these.
I'll make sure that there's a clear list of these in the Excel sheet that I give you.
It's just these are the calculations off your income statement and balance sheet.
It's a specialized, what we call the operats, or we're used to.
The operats were the operating ratios.
The operats, they were the ones that we use for projections.
Now, as you can see in this example, you will compare, you will have yours,
and then you will get the industries.
Where do you get the industries?
Best place is Standard & Poor's Global Net Advantage.
You just go in there, ask for industry comps, and they'll give you every ratio
you could possibly want.
You revise it every year just to make sure that you're with the industry.
Now, a warning about the ratios before we finish for the day.
A warning about the ratios.
An industry ratio is not the Holy Grail because your industry ratio could be formed
by the average ratio of a bunch of companies that suck.
Now, another thing about industry ratios, is this just add up the ratios of the
industry and divide by the number of data points you got, or is it a weighted
average of the industry?
Believe it or not, you don't want a weighted average simply because if you've
got 10 medium to small size companies and you've got one 800 pound behemoth,
then that company's ratios are going to dominate the industry average,
if it's a weighted average.
And if you're a small company, you probably don't want to be like that giant
company.
You're not ready to be like that.
So you have to be a little cautious to make sure that you have what is called an
arithmetic average of the industry, not a weighted average of the industry.
And many companies follow this.
Well, the industry average is, and what they're doing is they're chasing
freaking Microsoft or Amazon.
Come on, no, you're not them.
You probably don't even want to be like them.
So be cautious about industry ratios.
And some, I mean, some analysts do custom.
They find their favorite, they specialize in one industry.
They get the ratios of each of the companies in that industry, and then they
pick and choose the ones.
Now, there's another thing about it, too.
The industry average, yay for that.
But there's also something called the target ratio, the target.
It may not be the industry.
Now, the industry may be the target, the industry ratio, but you may have your
own target.
Don't be afraid to say we actually, as far as ROA is concerned, yeah, the
industry average is 9.4.
We are putting our target on 10.2 or 8.5.
Don't be afraid to not be the industry.
If you know your company better than the industry knows your company, and so
you will set targets.
And this is especially true in my FIL 340 class, it's cash management.
You'll find these companies that, and I'm hoping, they've told me what their
companies are, and I know some of them.
They've got these numbers that they are supposed to find, and I'm having them
use an artificial intelligence to help them do the whole project.
And you can tell these companies are way out of whack in their cash management
policy.
Pfizer was a great example.
I assigned that in the class two years ago.
Pfizer, it was their cash conversion cycle.
It should kind of a rule of thumb around 30 days should be your cash conversion
cycle.
Now, Pfizer, it came out of the box, this analysis two years ago, this group did
it, and it was 93 days.
93 days.
In other words, their cash management people should have been taken out, forced
to dig a grave, and then shot into the grave, and then have their dead bodies
covered up before someone got infected by their incompetence.
93 days.
Okay, well, we're going to set the target for next year as 30 days.
Like, hell you are.
I mean, good grief.
That's like our, you know, I went to this, I go to this gym three times a week.
You guys said, well, I'd like to have you do 250 pounds tomorrow.
You know, you can kiss my ass, that's not going to happen.
I'll make myself have a hernia from my knees up to my chest.
You don't want to force it so fast.
You set target, if you are way out of luck, you go into a company and you see that
it has a big problem, you don't try to solve it one year at a time.
You say, all right, the target for next year.
And what was cool was last year you could see that they were, they had obviously,
they were doing a slow walk to the target.
By last year, Pfizer was down to 73 days.
And then they'll probably set the target somewhere around 60, 55 days.
You'll walk to the target.
So in other words, this ratio that you're, the golden ratio you're aiming at will
sometimes be a multi-year step by step.
So you'd have, your target would be moving toward the desired amount year over year.
You don't want to get desperate.
You don't want to do something radical and stupid.
We're corporate people.
We don't do that unless you're the owner of X.
But anyway, so keep that in mind with this.
And you can see that they do an analysis of this mythical corporation against the
industry average.
And you can see that you're just simply going to say, better, worse, about, and you
just walk through each of those, the operats.
You don't have to go through all of them.
But the operats are sort of a place for you to start, where are we, where is the
industry, or where is our target.
And you just say, okay, now, we deal with these one at a time.
The problem is that they're interrelated.
You affect one, you affect probably a couple of other operats as you're doing that.
So, for example, if you are trying to bring down your, well, if you're trying to
bring down your ROA, I mean, increase your ROA, well, one of the ways you could do
that is to increase the amount of equity in your company.
Sell some stock.
That will make the bottom, the total assets larger against net income on top.
Well, that's great.
But what that's also going to do is it's going to hurt your ROE.
So you've got to watch it because sometimes these work together.
One improvement helps improve another.
But sometimes they work against each other.
So you've got to have this balancing act.
I remember one.
I wish I could remember what the ratios were.
But when we brought the one toward the industry average, that sent two all to
hell.
And then I looked like an idiot in that situation because I didn't think about it.
Well, there you go.
Now, okay, so and there are some that are absolute, absolute no-no.
And they bring one up here to their credit.
ROIC should be better than your WAC.
Otherwise, you're borrowing at a rate better than your earning overall.
ROIC, what is your return on all of your investments?
And WAC is what did it cost to fund all of these investments?
So if your WAC is higher than your ROIC, then that's not a good idea.
That's really a bad idea because you're borrowing or you're raising capital at
some cost that is above what you can make on it.
How do you fix that?
Well, the first obvious thing is to increase your net income, which would be to
increase your sales and decrease your costs.
Easier said than done, but that's one of the ways that you can do it.
What about that WAC?
Figure out what the hell you're doing.
Is there a way to get down your WAC?
Some companies, interestingly enough, they ran backwards to run forward.
Here's what I mean by that.
Companies had all this, they had debt that they had brought out in the time when
interest rates were really high.
Well, what they did was they pulled back in by getting short and intermediate
term debt, and they paid off those high interest coupon debts.
But of course, short and intermediate term would have higher interest rates than
long term would.
So why the hell would they have done that?
Well, it was because the forecast was what happened.
The Fed finally started to ease up on interest rates, so the long term yield
curve began to fall down.
So they borrowed short to pay off high long term, but that short was expensive.
But they knew that then a few years later they could borrow long and pay off the
short.
So sometimes you'll run backward to get an advantage running forward.
It's kind of a complicated trick, but I know some companies that did it, and it
worked.
Sure enough, the long term coupons, long term bonds, AA and AAA, began to, the
20 year began to fall in yield, and so they could quickly get rid of that hot
potato they had taken on in the short and intermediate term.
So that's one of the things that are the nuances behind these numbers.
And the numbers, we can do those with Excel.
It's thinking about the numbers, and I've emphasized this over and over again,
that's what makes us finance people and makes you so that you can get incredibly
good jobs and take care of me in my old age.
That's all I have for you today.
Go home.