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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, evaluation of corporations.

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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.

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So the first pass, I will do the example that is in your PowerPoint.

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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.

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And then from there, on Thursday's class, I'll take you through another one that's a little more realistic.

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The one that is in the PowerPoint is very simplified, but it is excellent for getting you started.

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This is where we get to the point where we are building pro forma income statements and balance sheets.

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Standard practice. Anyone who doesn't do it this way is just getting too darn fancy for normal analysis.

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We are just projecting. The main part of this is to project our need for capital in the years ahead.

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Now this is a hugely important thing because a company that's growing, it can fund operations to a certain extent from its sales.

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What we call internally generated equity. That's the fancy word for it.

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You're actually earning money that you spend. However, that is not nearly enough for a growing corporation's needs.

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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?

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Debt, equity, accommodation. And that's a difficult thing because, look, if you go to an IB, you've projected,

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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.

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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.

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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.

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And then we will have to set up this offering, negotiate everything with you, and talk to our power investors.

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And then we craft the terms of the offering, debt, equity, both. And that is a long procedure.

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There are accountants, lawyers involved, there's the SEC involved, there's the state securities regulators.

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This is not something that happens overnight. It doesn't happen in six months.

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It is going, so in other words, if I, I need to project what I need out there at least five years,

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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.

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And what you need next year, you should already have known that two years ago so that you have that set up,

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so that that comes in, it makes its landing on time for when you need it.

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The alternative is the companies that are foolish. They get into a desperate situation.

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They don't do proper projections, pro-forma income statements and balance sheets,

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so they don't know what their additional funds needed, their AFN is.

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And so what do they have to do? Well, they scramble.

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They end up going to short-term markets where the rates are very high.

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And some companies, eventually it just ends the company because they're always in this catch-ass, catch-can kind of situation

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where they're trying to get funds together a month before they need lots of money.

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So what do they end up doing? They pour out commercial paper.

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They pour out other kinds of short-term debt, and that's expensive scratch.

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I mean, the short-term players are going to ask for a pretty serious amount of money.

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Think about it this way. I'm going to need $10 million, and what can you do for me?

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Okay, $10 million. Okay, I'll tell you what we'll do.

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We'll lend you $9,900,000, and then you pay us back $10 million in six months.

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Okay, we got to have it. Well, if you calculate the interest on that, it's going to make your buttocks ache.

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That's a high interest rate, but you had to do it.

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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

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to get some more of that quick, easy-pay loan off the commercial paper markets.

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Some companies get so bad off that they are not in the repo and reverse repo markets just for the extra money.

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They're in it because they've got to have five days of money. So what do they do?

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They end up borrowing treasuries to sell them to the federal reserve

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with the agreement that they'll buy them back in five days to give back to who lends them to them.

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Yes, that happens. And then they started all over again five days later

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and constantly just grabbing at this ridiculously expensive money in the short-term markets.

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So we in responsible finance, this is corporate, well, actually it's kind of a cross between corporate and investments,

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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

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where they're a year away from an IPO and you're stepping into it halfway through the process.

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Yeah, we've got an IPO coming up and you do not talk about this with anyone under penalty of death.

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We're in the process right now of cranking this thing forward.

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And so you'll see that these are ongoing and you're going to see how it's done.

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But first, let's look at the numbers and have a good time seeing the markets struggling and twisting and farting about everything.

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It started out just on it. It started out in a real bear mood. It was down.

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I mean, I thought the futures market this morning before the bell, the futures market was looking really bad.

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And of course, you had these talking head pundits tapping out stuff at 6 and 7 a.m.

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Oh, it's happening now. Here comes the apocalypse.

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You know, I did see that it probably wasn't going to do that. I'll tell you one thing you can do.

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The futures markets are trading. Remember I told you futures markets trade at different hour bands.

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And the futures and equities, they trade at that clock started early late last night.

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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.

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And you can look at that and you can see, yeah, futures market is looking really down.

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But what you can also do, and this is something I was showing you last week.

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I'm going to show it to you again today. You look at the pre, the pre-market, not at futures.

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Futures people, you've got speculators from hell.

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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.

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And in that market, you'll see a lot more nuance than what you will in the futures market.

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You can see this is, and I saw it, yeah, there were some equities that were just being paddled.

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They were being potty trained. But then there were a lot of them that were showing more buy than sell orders.

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So I knew it was not one of those hell scapes of a black swan at all, nothing like that.

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As you can see, though, it's been climbing through the day.

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It did start out down, but all those orders on the buy side, they came in near the opening bell,

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and then more orders came in, and the bulls have been pulling up.

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A lot of what it looks like to me is bargain hunting.

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In other words, there's been a couple of bad days.

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Stocks have been pulled down, and good stocks are being pulled down with bad stocks.

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And stocks that did deserve to have price corrections down got pulled down more than they needed to be pulled down.

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So the bargain hunters, you just go in and you say, oh, this one's on sale.

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I'll buy it because its fundamentals are good, or they're certainly not as bad as this price is indicating they are.

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And that's something that you should always watch out for.

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One more point about the opening.

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When the market at the opening bell, you have the market makers lining up.

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They're getting orders to buy, orders to sell from the brokerage houses.

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Now, every morning, they start out with only a very thin liquidity.

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In other words, money to execute orders back and forth.

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What can happen in those first few minutes is that in order to generate liquidity,

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there can be, there will be, and I've done this myself, you can find some,

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you'll put in a price that is noticeably lower than what the opening ask is, and it will get filled.

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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.

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I'm not saying you should do this all the time, but sometimes it's a little bit of magic.

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They're trying to build liquidity, as the market makers are, so they're willing to take some orders

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and get the orders cleared in the system just to get those electronic blips of little dollar bills popping up on their screen

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so that they have their liquidity standards for the day.

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And then, you're lucky if that happens, it's happened to me with both stocks and with options.

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Once in a blue moon.

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So now, anyway, as you'll notice, the market is beginning to behave itself somewhat well.

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The Dow is climbing a little faster than the S&P.

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The S&P has finally cleared into the green, and the NASDAQ is beginning to show some decent life.

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And as you can see, those are pretty strong upsurges as the market re-corrects, for lack of a better term,

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what was happening in the overnight futures market.

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Which is very happy for me because the speculators in the futures market are getting their asses killed

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because they were taking short positions over longs a lot.

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But they're crazy mofos anyway.

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Okay, crude's finding itself up a little bit.

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Nothing really spectacular.

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There were some rumors early, well, late last night that there had been a drone attack that had done some damage in Israel.

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But those rumors just disappeared at some point.

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But it was enough to get the oil market a little bit excited.

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But notice that it's topped off and it'll probably slip back down a little bit.

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And it still seems to be liking that 70 to 72 band, a very tight band.

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But it seems to be kind of like wanting to stay there unless something really rattles it.

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But like I said, those rumors come and they go, and there's nothing you can do about them.

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You can't confirm them.

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Even when you see videos, there's so many deepfake videos that you can't tell what's real anymore.

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But unless you've got some boots on the ground there that can tell you.

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Okay, the gold bugs are having an exciting day, pushing the price up.

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I heard an estimate from a pretty respectable source that he sees 3,000 an ounce before the end of the year.

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So there's that.

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Now we've got our happy, happy bond market.

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Here's the problem that's happening.

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The Fed had cut interest rates very strongly.

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That brought the yields on bonds down.

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And we saw about 3.65 on the yield.

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Stimulates the economy.

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Well, then there was a couple of reports.

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One of them was a jobs report that showed the economy was actually showing a lot of strength.

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More than the Fed estimated, more than most analysts had estimated.

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And that made the expectations of lower interest rates, the Fed cutting the discount rate, go away.

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Now then there was concern that, well, the Fed's not going to cut the interest rate anymore

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because this looks like an inflation push, some kind of inflation.

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See, the Fed thinks that if there are too many jobs being formed, then that's a bad thing.

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We've got to hurt the economy.

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It's been a criticism of the Fed for decades.

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But the Fed's, okay, the Fed sees a strong jobs report.

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They're not going to cut interest rates anymore.

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And then we got a little blip on the inflation measures.

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And that gave more confirmation to the bond traders that there's going to be no more significant

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interest rate cuts before the end of the year.

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Well, that made the bond yields, based upon the new expectations, not lower interest rates.

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That made the yields on them go back up.

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That's what we're seeing now is that these bond yields are going up.

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The inside story is that the Fed did not want this to happen.

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They did not want the bond, the 10-year yield benchmark, 10-year Treasury to go up to this level.

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They didn't really make any indication one way or the other about what was happening to interest rates.

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This is just pure speculation by the markets, the market players themselves,

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that interest rates are not going to go down.

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They may even go back up.

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The Fed might have to recontract the money supply to squeeze out what might be a new inflation coming along.

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The Fed's saying nothing.

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This is all rumors.

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So it's in its own world right now, trading.

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And so right now you see bond investors are selling the bonds,

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and that increases the supply of those bonds in the open market because those bonds are trying to sell them.

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That also decreases the demand for the bonds.

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Those two forces together bring down the prices of bonds.

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Hence, they bring up the yields on bonds.

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So what will happen next?

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If it gets serious enough, the Fed may intervene by going into the open markets and buying bonds itself.

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The Fed, that is a type of open market operation where they go in and they do an intervention.

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They just start buying the hell out of these treasury bonds themselves.

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And as they buy them, that elevates the price.

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The demand increases, price increases, which will bring the yields back down on these.

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That's the smart money right now on what's happening in the bond market,

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is the Fed may have to shut these rumors up about the Fed increasing interest rates,

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inflation coming back, all that stuff.

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The way they'll shut it down is to just start buying the hell out of the bonds,

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driving their prices up and their yields down.

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That may be what we see in the next couple of weeks if these bond yields keep going up.

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The trigger, probably around 4.3 to 4.4% on the yield on the 10-year benchmark.

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If it gets that high, the Fed's going to intervene to stop the yields from going up,

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because the Fed is definitely not interested in the economy fizzling out at all, especially right now.

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Anyway, coming back over here.

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Yeah, the Japanese did their usual thing, a massive sell-off right at the start of the day.

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And then once that's over with, they go out and have lunch.

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And the market just, and the Nikkei just floats for the rest of the day.

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That's so odd about them, but that's what you see all the time now,

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is a big drop-off at the start of the day, sometimes even before the market opens.

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The pre has already had a pile of sell-overs in it.

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But once they've gotten that out of their system, they've barfed their brains out.

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Then for the rest of the day, they just wallow along like there's nothing going on.

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London somehow managed to pull itself out of a pretty nasty little slump that it was going through.

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It looked like the apocalypse a few hours ago in London.

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Has London closed yet? I think they're about to close.

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But it came back from that, and again, that was probably bargain hunters.

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The FTSE 100 went down severely, and some of those 100 big ticket stocks went down way too much.

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So bargain hunting began, and the bulls came in, bought up stocks, and it began to pull it right back up.

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Looks like it's going to pretty much be flat by the end of the day.

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Now, just quickly going through a couple of stocks, Citi.

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Look at that. Citi is just on a tear.

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And I think that's true of some of the other banks too. Bank of America.

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Well, I tried that, and it didn't work, so let's try it again.

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BAC.

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Come on.

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Yep. Bank of America is doing good. Wells.

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Well, let's try that again. Wells Fargo.

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Yep. Look at those bank stocks. They're just making out like bandits right now.

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And it's good news.

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Now, in the text,

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oops, Apple down, and I think Microsoft is probably going to follow it down.

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MSFT. Microsoft is going to follow it down.

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Oh, look at that. Microsoft is bucking the trend.

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Bill is going to make a few million today.

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Okay, well, that's fine. Good for him.

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But now in other sectors, just a few that are off your usual looking.

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A few smaller ones, like for example,

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this one used to be sort of a high flyer, and now it's pretty much dead.

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But it's worth a look at. Come on.

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MaxArt.

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This is a penny stock now. A long time ago, it was a pretty popular stock.

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Rumors are that they may be back in the fray here soon enough.

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As opposed to one like Sorrento,

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which at one point was insanely high priced, and now it is...

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Why do I keep doing that?

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Sorrento died. Oh, well, that's okay.

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And then Novavax.

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That one was one that survived, and it's doing well, but obviously not today.

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And then Moderna, MNRA.

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Let me see this. Really, really risky.

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And they were making...they were quite a high flyer, but now they're losing money hand over fist.

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But Yahoo is projecting that they are going to almost double in price over the next year,

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which is quite possible because they are...I think I maybe mentioned this.

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Moderna was one of the companies that used the messenger RNA technique

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for creating the antiviral medication for COVID, for SARS-CoV-2.

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They are on the path now.

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They're in clinical trials, no guarantees, for antiviral vaccines

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for several diseases that have been plaguing humanity for about a half a century now,

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including the human immunodeficiency virus, an actual vaccine against AIDS.

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So they are in the race for it, and whoever comes to the front of that one

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is going to make a freaking fortune off that one,

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considering the rampantness and the lethality of that virus.

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But anyway, enough of that.

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What I'm going to do here, I'm going to take you through just terminology today for this.

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And I've got to make a couple of corrections here.

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One of them is a rather dramatic correction.

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I'm going to do this via the PowerPoint so that the visual is up there

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as I am asked to do now for this class.

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I'm just going to walk through some of the terminology

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and reacquaint you one last time with...

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Did I do that? Yep, I sure did.

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Okay, let me pull this up here.

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Now, this is a repeat of what I said in the preamble to this lecture.

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Some of this says, no, I want this full.

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Now, when we say financial planning in a course like this,

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we're not talking about making sure that mom and dad can have their retirement home.

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This is not that kind of financial planning.

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This is financial planning, looking for planning for the future of a corporation,

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making sure that it has sufficient funds for what is coming next,

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the AFN, as we call it, the additional funds needed.

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Now, these funds, there are a couple of things to point out here,

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and I'm filling in what you'll see in the PowerPoints

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and actually what you'll see in the book too.

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First things first, I'm saying funds as opposed to capital or money

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because the additional funds needed could come from both of those sources,

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could be some of each.

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You might need, let's say, $100 million in capital,

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but you also might be projecting that you're going to have a cash deficiency of $4 million.

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So in other words, that AFN would be capital, the long-term funds,

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but it could also be money, the short-term funds,

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to maintain both the long-term capital of the company

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and also the short-term liquidity of the company.

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Now, another part of this has to do with optimal capital structure.

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Now, the optimal capital structure, and I've said this before,

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and I'll say it again, get it down.

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The optimal capital structure is the combination of debt and equity

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that comprises total assets.

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The capital structure of a company is the combination of debt and equity

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that comprises total assets.

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Now, it is the combination of debt and equity that comprises your total assets.

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Now, what that would mean, I could say a company is 20% debt, 80% equity.

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That's a low-leverage company.

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A company that would be 50% debt, 50% equity,

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we would consider to be somewhat leveraged.

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You get up there to 70%, 80% debt, and 30%, 20% equity.

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That's a highly leveraged company.

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These kinds of companies tend to have very strong ROEs

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because ROE is net income divided by the equity.

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And if you have a very small equity base compared to your debt base for assets,

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then that's going to make net income over shareholders' equity a very large number.

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Yay for our team. We've got an incredible ROE.

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But that is at the cost of extraordinary risk

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because the more debt you have in your capital structure,

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the more likely you are to have your revenues dip below,

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revenues minus cost dip below your interest expenses,

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and then you're in bankruptcy court.

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So keep that in mind.

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Now, again though, additional funds needed, you can't just say,

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well, investment banker, we want to raise $100 million,

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sell $100 million worth of stock.

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That's not how you do it.

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You raise the capital to maintain your optimal capital structure.

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The combination of debt and equity that minimizes weighted average cost of capital.

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So in other words, you can't just go out there and say,

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we want to borrow a bunch of money.

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And in that regard,

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in that regard,

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you're going to have a percent of debt from 0 to 100 percent

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and the weighted average cost of capital.

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This curve, if you don't have any debt in your capital structure,

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your weighted average cost of capital is going to be your cost of equity.

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Equity is very expensive capital.

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Equity is very expensive.

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As you begin to add debt to the capital structure,

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your weighted average cost of capital begins to fall.

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But there is a point where you borrow so much money that your lenders are going to say,

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hey, you're getting into some serious default risk,

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and so they're going to start charging you more.

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And ultimately, that will begin to pull the curve back up like that

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so that 100 percent leverage is extraordinarily expensive.

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The optimal capital structure is a combination of debt and equity

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that minimizes the weighted average cost of capital.

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So now, putting this in the context of additional funds needed.

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Okay.

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If all I do is issue debt, I have $100 million, I just issue debt,

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well, what that's going to do is move you back off your optimal capital structure

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and it's going to increase your weighted average cost of capital.

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That's a big problem.

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So you don't want to do that.

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Here's another interesting thing.

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This one is subtler.

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Suppose that your company is very profitable.

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You're making good money.

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You're making money hand over a freaking fist.

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Well, what that's going to do is that's going to increase your retained earnings, your equity.

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So by virtue of the fact that you are profitable,

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you are actually going to cause yourself to come back off your optimal capital structure.

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And it's the oddest thing, and I've seen this in prospectuses.

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The company said, we are issuing $40 million in senior subordinated debt.

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And they more or less say, we don't need it, but we've got to borrow

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so that we go back to our optimal capital structure.

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They actually borrow the money so that they get back down to the cheapest whack that they – their cheapest whack.

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And they'll be quite honest about it, too.

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Don't worry.

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We don't need this money.

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We just got to get back down to our lowest optimal – our lowest capital – our weighted average cost of capital.

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So keep that in mind.

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That AFN, additional funds needed, can have many dimensions.

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One of them, maintaining your optimal capital structure is an important one.

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Another one is also just what do you need these funds for?

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AFN isn't just public offerings.

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AFNs, you can – a one-year budget, a one-year capital budget can actually include short-term borrowings, six months, one month, a year.

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They can include short-term borrowings.

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So that's why you have to look at the nuance of what you are going to need those AFNs, those additional funds, for.

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Now, another thing.

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And that is hinted at in the financial policy issues.

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That's why the PowerPoints aren't really too comprehensive, and the book doesn't go into it much more.

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But those additional financial policy issues is what I'm talking about here in the last 10, 15 minutes.

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Now, the operating input data.

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Now, notice the key is operating.

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We do not – in our world, we separate financial issues, the financing, from the operations.

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It's an actual axiom of finance.

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I'm not sure it's a theorem, but I've heard it called a theorem.

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It's called the separation theorem.

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Operating decisions should be detached from financial decisions.

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And it's sort of like one of those old-school things that someone, some old professor is going to tell you,

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and I'm telling you now, this is what we do.

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This is our philosophy.

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Don't mix the two.

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Look at your operating issues.

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Get your data.

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Figure out what your operating costs are, how they're going to change,

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if you're going to change decisions on operating policy decisions.

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And then, okay, from these operating decisions, we make our financial decisions, from our operating decisions.

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And that's the pain of being in our world of finance, because we can look from the auditing side, okay,

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operations says they need this ginormous, expensive computer server bank.

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Okay?

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That they're saying yes to this, we do have the ability to look at it from a net present value standpoint,

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but we don't have the responsibility for saying you don't need this.

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And companies that let the finance and accounting people do that kind of thing too much, override operating decisions,

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well, they're in trouble, and they usually go belly up, because they let the tail wag the dog.

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Nevertheless, it is still fun when you get a negative net present value of a project,

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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.

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Okay. Let me get past this stuff.

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Okay, I'm going to show you one right here.

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Now, this is a simple one, and I'm going to do one of my own on Thursday,

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and I'm going to upload it so that you can do this yourself.

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It's simple, simple accounting.

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You've got a very brief accounting statement where you've got all these things going on, the cash, accounts receivable, inventory,

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and then we break it down quite simply.

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And actually, there is not, I mean, sometimes in the real world,

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they will break the balance sheet down into all these categories.

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Realistically, in our world of finance, we don't need to granularize this process too much.

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We are there to look at the operations, see what the money is needed for the operations,

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and let the operations people figure out what they're going to do with it.

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That total, the net fixed assets, well, how much of that is property?

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How much is planned? How much is equipment?

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How much is land and all those other things?

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We let them deal with that, and we deal with it more on the level of tell us how much you need.

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You work out those numbers.

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We'll come back and we'll ask you questions about them.

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But for the first round, we want to keep it on a much broader, less granular level than others would.

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So we just get simplified balance sheets.

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Actually, sometimes we just simplify the balance sheet ourselves if it's not simple.

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Now, here's one thing I want you to make a note in here,

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and I'll try to remember to change that in this PowerPoint,

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is that they put the tax rate here as 40%. It's not.

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They're calculating it at 25%.

401
00:37:24,000 --> 00:37:27,000
And realistically, that is not 25% now.

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But make a note, if I forget to get this PowerPoint corrected, there are a couple of errors in it.

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But to go back in and check that, 40% of 396 pre is not $99. 25% is.

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And my version of this will be more exacting, and it will be auto-calculating.

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So it won't just be numbers.

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You'll have the tax rate over here, and you'll see the effects over here.

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And the addition to retained earnings will be part of the calculations of the sheet.

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It's just static here.

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But it is a good place to start just to show you what the numbers are that we need.

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And going down the line, of course, keep in mind that depreciation isn't really an operating cost.

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But it is included in operating costs simply because of the tax shield effect.

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In other words, we don't write a check to depreciation expense.

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However, we do include it because it reduces the pre-tax earnings.

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And so it serves as a tax shield.

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Now, ultimately, we'll add it back in.

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We'll add it back in.

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And that is the part where we do the free cash flow.

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The free cash flow, and I think I've done this enough times.

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Sales minus costs minus depreciation expense times 1 minus the tax rate.

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And then we add back the depreciation expense.

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And the question comes up, well, why don't you just take it out here, fat boy?

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That's because it's going to shield some of our taxable income from tax.

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So we need to have it in there as if it were an operating expense, even though it isn't.

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But then once it has had that effect here, then it comes back in.

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We add it back because it didn't really happen.

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It's a mythical thing that creates an actual physical result, as it were.

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And what was I thinking here?

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Oh, and I should put here, and I apologize for that, operating expenses, S, G, and A,

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as we call it, sales, general, and administrative expenses.

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So as that sheet shows, when we say operating costs, that's usually,

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you'll see that on an actual financial statement as sales, general, and administrative expenses.

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If you are looking at financial statements from 10, 20, 30, 40 years ago,

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I rarely would have seen an S, G, and A.

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They would have broken them out, each one of them.

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But now the standard for the SEC's purposes and for reporting purposes

436
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is to just lump them together as S, G, and A, which is nice,

437
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because then you don't have to figure out all those different utility, mailing, wages, salaries,

438
00:40:58,000 --> 00:41:01,000
meals and entertainment, and all that kind of stuff.

439
00:41:01,000 --> 00:41:03,000
Okay.

440
00:41:03,000 --> 00:41:13,000
Now, again, just as a quick reminder, the current tax rate is 21% right now.

441
00:41:13,000 --> 00:41:14,000
Very generous.

442
00:41:14,000 --> 00:41:16,000
Used to be 39%.

443
00:41:16,000 --> 00:41:18,000
Here was the odd thing.

444
00:41:18,000 --> 00:41:22,000
It actually, we used to have a progressive corporate tax system.

445
00:41:22,000 --> 00:41:28,000
It would go up, up, up, and then it would top out at 39%,

446
00:41:28,000 --> 00:41:35,000
but then the very largest pre-tax would be back down to 35%.

447
00:41:35,000 --> 00:41:37,000
It was an oddity of the system.

448
00:41:37,000 --> 00:41:43,000
Some said it was the candy that was bought with campaign contributions

449
00:41:43,000 --> 00:41:45,000
by the largest companies in the world.

450
00:41:45,000 --> 00:41:50,000
But anyway, to finish this off, you have minus capital expenditures.

451
00:41:50,000 --> 00:42:00,000
I'm going to put this in parentheses, plus change in net operating working capital.

452
00:42:00,000 --> 00:42:09,000
This is the part where you separate those capital expenditures from the money expenditures.

453
00:42:09,000 --> 00:42:13,000
You see this one before, and by the way, just up here, just FYI,

454
00:42:13,000 --> 00:42:20,000
this is called NOPAT, Net Operating Profit After Taxes, NOPAT.

455
00:42:20,000 --> 00:42:22,000
You've seen it before.

456
00:42:22,000 --> 00:42:26,000
Just reminding you, this is one of our gods, NOPAT is.

457
00:42:26,000 --> 00:42:28,000
Well, what's NOPAT?

458
00:42:28,000 --> 00:42:30,000
That's big in finance.

459
00:42:30,000 --> 00:42:35,000
Okay, so just going through this, make sure that you change this over to 25%.

460
00:42:35,000 --> 00:42:42,000
I'll re-upload this table, and I'll also provide a much more comprehensive example

461
00:42:42,000 --> 00:42:44,000
down the road here.

462
00:42:44,000 --> 00:42:47,000
Now, the rest of this is pretty normal stuff.

463
00:42:47,000 --> 00:42:52,000
Your earnings per share, you just take your earnings, which is the pre-tax,

464
00:42:52,000 --> 00:43:00,000
I'm sorry, the after-tax net income, and you divide it by the number of shares outstanding, the EPS,

465
00:43:00,000 --> 00:43:02,000
and that gives you your EPS.

466
00:43:02,000 --> 00:43:05,000
Ideally positive, but there you go.

467
00:43:05,000 --> 00:43:10,000
And the dividends per share, you just take your dividends divided by the number of shares outstanding.

468
00:43:10,000 --> 00:43:12,000
You get the dividends.

469
00:43:12,000 --> 00:43:15,000
The best place to look for it is the statement of cash flows.

470
00:43:15,000 --> 00:43:21,000
Sometimes you'll see it on, there's one called statement of retained earnings,

471
00:43:21,000 --> 00:43:23,000
and you may see it there as well.

472
00:43:23,000 --> 00:43:27,000
But the go-to, just to get the number, the full number,

473
00:43:27,000 --> 00:43:33,000
just go to the statement of cash flows, and you'll get it there.

474
00:43:33,000 --> 00:43:34,000
Ending stock price.

475
00:43:34,000 --> 00:43:40,000
This takes out a couple of complications that we don't worry about at this point.

476
00:43:40,000 --> 00:43:42,000
Later we can talk about them.

477
00:43:42,000 --> 00:43:49,000
You have earnings that come from the company's operations.

478
00:43:49,000 --> 00:43:55,000
You will also have non-control interest earnings as well.

479
00:43:55,000 --> 00:44:02,000
A large company that holds other companies in its portfolio will have income

480
00:44:02,000 --> 00:44:05,000
that did not originate from the company.

481
00:44:05,000 --> 00:44:10,000
Don't look at that in this kind of analysis.

482
00:44:10,000 --> 00:44:17,000
It's simply because you don't want to see how great, okay, you sir,

483
00:44:17,000 --> 00:44:20,000
I don't want to know how great your investments are.

484
00:44:20,000 --> 00:44:22,000
You're doing great, I'm sure of that.

485
00:44:22,000 --> 00:44:24,000
I want to know what you make.

486
00:44:24,000 --> 00:44:26,000
What's your salary?

487
00:44:26,000 --> 00:44:28,000
Because those external, if you're non-controlling,

488
00:44:28,000 --> 00:44:33,000
you have no control over whether that's a great thing next year or it's gone into a

489
00:44:33,000 --> 00:44:34,000
shithole next year.

490
00:44:34,000 --> 00:44:40,000
So look only at the controlling interest that's yours, okay?

491
00:44:40,000 --> 00:44:44,000
And also there is another one off here to the side,

492
00:44:44,000 --> 00:44:47,000
and I'm giving you some of the ifs, ands, ors, and buts here.

493
00:44:47,000 --> 00:44:50,000
Companies own interest in other companies.

494
00:44:50,000 --> 00:44:52,000
They buy stock of other companies.

495
00:44:52,000 --> 00:44:56,000
There is a good reason for companies to do that.

496
00:44:56,000 --> 00:45:02,000
It's simply that when you get dividends on stock that you own in another

497
00:45:02,000 --> 00:45:06,000
corporation, this isn't personal, this is company,

498
00:45:06,000 --> 00:45:12,000
you get a tax break on those dividends for those holdings.

499
00:45:12,000 --> 00:45:14,000
You get a tax break for it.

500
00:45:14,000 --> 00:45:19,000
Another side to that, a dark side, is that a company itself,

501
00:45:19,000 --> 00:45:22,000
well, why would you ever pay dividends?

502
00:45:22,000 --> 00:45:27,000
Why wouldn't you just put money back into your own company, grow the stock price?

503
00:45:27,000 --> 00:45:28,000
Everyone's happy.

504
00:45:28,000 --> 00:45:31,000
It gets capital gains.

505
00:45:31,000 --> 00:45:38,000
A law was passed some years ago that actually assesses a penalty for companies

506
00:45:38,000 --> 00:45:43,000
that don't pay dividends.

507
00:45:43,000 --> 00:45:48,000
I think they call it excessive retention of earnings.

508
00:45:48,000 --> 00:45:53,000
So in other words, if you're a corporation that doesn't pay dividends,

509
00:45:53,000 --> 00:45:59,000
after a few years you're going to pay a penalty because you didn't pay dividends.

510
00:45:59,000 --> 00:46:01,000
Why is this the case?

511
00:46:01,000 --> 00:46:09,000
It's simply because if you pay a dividend, if I pay a dividend to you people,

512
00:46:09,000 --> 00:46:13,000
well, then that dividend gets taxed on your income tax.

513
00:46:13,000 --> 00:46:18,000
I've already paid tax on it, and now if I pay you a dividend, you get it,

514
00:46:18,000 --> 00:46:23,000
and then the IRS charges you, makes you pay a tax on it.

515
00:46:23,000 --> 00:46:28,000
So they're forcing companies to spit out dividends just so that they can double

516
00:46:28,000 --> 00:46:33,000
the taxation.

517
00:46:33,000 --> 00:46:39,000
Now, these are pretty standard.

518
00:46:39,000 --> 00:46:45,000
Just some very basic ratios that you want to use for this analysis.

519
00:46:45,000 --> 00:46:48,000
And you'll have a list of these.

520
00:46:48,000 --> 00:46:53,000
I'll make sure that there's a clear list of these in the Excel sheet that I give you.

521
00:46:53,000 --> 00:46:58,000
It's just these are the calculations off your income statement and balance sheet.

522
00:46:58,000 --> 00:47:02,000
It's a specialized, what we call the operats, or we're used to.

523
00:47:02,000 --> 00:47:05,000
The operats were the operating ratios.

524
00:47:05,000 --> 00:47:12,000
The operats, they were the ones that we use for projections.

525
00:47:12,000 --> 00:47:20,000
Now, as you can see in this example, you will compare, you will have yours,

526
00:47:20,000 --> 00:47:22,000
and then you will get the industries.

527
00:47:22,000 --> 00:47:23,000
Where do you get the industries?

528
00:47:23,000 --> 00:47:26,000
Best place is Standard & Poor's Global Net Advantage.

529
00:47:26,000 --> 00:47:31,000
You just go in there, ask for industry comps, and they'll give you every ratio

530
00:47:31,000 --> 00:47:34,000
you could possibly want.

531
00:47:34,000 --> 00:47:39,000
You revise it every year just to make sure that you're with the industry.

532
00:47:39,000 --> 00:47:44,000
Now, a warning about the ratios before we finish for the day.

533
00:47:44,000 --> 00:47:47,000
A warning about the ratios.

534
00:47:47,000 --> 00:47:55,000
An industry ratio is not the Holy Grail because your industry ratio could be formed

535
00:47:55,000 --> 00:48:03,000
by the average ratio of a bunch of companies that suck.

536
00:48:03,000 --> 00:48:09,000
Now, another thing about industry ratios, is this just add up the ratios of the

537
00:48:09,000 --> 00:48:14,000
industry and divide by the number of data points you got, or is it a weighted

538
00:48:14,000 --> 00:48:17,000
average of the industry?

539
00:48:17,000 --> 00:48:24,000
Believe it or not, you don't want a weighted average simply because if you've

540
00:48:24,000 --> 00:48:31,000
got 10 medium to small size companies and you've got one 800 pound behemoth,

541
00:48:31,000 --> 00:48:37,000
then that company's ratios are going to dominate the industry average,

542
00:48:37,000 --> 00:48:39,000
if it's a weighted average.

543
00:48:39,000 --> 00:48:44,000
And if you're a small company, you probably don't want to be like that giant

544
00:48:44,000 --> 00:48:45,000
company.

545
00:48:45,000 --> 00:48:47,000
You're not ready to be like that.

546
00:48:47,000 --> 00:48:51,000
So you have to be a little cautious to make sure that you have what is called an

547
00:48:51,000 --> 00:49:00,000
arithmetic average of the industry, not a weighted average of the industry.

548
00:49:00,000 --> 00:49:02,000
And many companies follow this.

549
00:49:02,000 --> 00:49:05,000
Well, the industry average is, and what they're doing is they're chasing

550
00:49:05,000 --> 00:49:08,000
freaking Microsoft or Amazon.

551
00:49:08,000 --> 00:49:10,000
Come on, no, you're not them.

552
00:49:10,000 --> 00:49:14,000
You probably don't even want to be like them.

553
00:49:14,000 --> 00:49:18,000
So be cautious about industry ratios.

554
00:49:18,000 --> 00:49:22,000
And some, I mean, some analysts do custom.

555
00:49:22,000 --> 00:49:27,000
They find their favorite, they specialize in one industry.

556
00:49:27,000 --> 00:49:30,000
They get the ratios of each of the companies in that industry, and then they

557
00:49:30,000 --> 00:49:32,000
pick and choose the ones.

558
00:49:32,000 --> 00:49:35,000
Now, there's another thing about it, too.

559
00:49:35,000 --> 00:49:38,000
The industry average, yay for that.

560
00:49:38,000 --> 00:49:44,000
But there's also something called the target ratio, the target.

561
00:49:44,000 --> 00:49:46,000
It may not be the industry.

562
00:49:46,000 --> 00:49:50,000
Now, the industry may be the target, the industry ratio, but you may have your

563
00:49:50,000 --> 00:49:52,000
own target.

564
00:49:52,000 --> 00:49:58,000
Don't be afraid to say we actually, as far as ROA is concerned, yeah, the

565
00:49:58,000 --> 00:50:01,000
industry average is 9.4.

566
00:50:01,000 --> 00:50:07,000
We are putting our target on 10.2 or 8.5.

567
00:50:07,000 --> 00:50:11,000
Don't be afraid to not be the industry.

568
00:50:11,000 --> 00:50:16,000
If you know your company better than the industry knows your company, and so

569
00:50:16,000 --> 00:50:18,000
you will set targets.

570
00:50:18,000 --> 00:50:23,000
And this is especially true in my FIL 340 class, it's cash management.

571
00:50:23,000 --> 00:50:30,000
You'll find these companies that, and I'm hoping, they've told me what their

572
00:50:30,000 --> 00:50:32,000
companies are, and I know some of them.

573
00:50:32,000 --> 00:50:40,000
They've got these numbers that they are supposed to find, and I'm having them

574
00:50:40,000 --> 00:50:44,000
use an artificial intelligence to help them do the whole project.

575
00:50:44,000 --> 00:50:49,000
And you can tell these companies are way out of whack in their cash management

576
00:50:49,000 --> 00:50:50,000
policy.

577
00:50:50,000 --> 00:50:53,000
Pfizer was a great example.

578
00:50:53,000 --> 00:50:56,000
I assigned that in the class two years ago.

579
00:50:56,000 --> 00:51:01,000
Pfizer, it was their cash conversion cycle.

580
00:51:01,000 --> 00:51:10,000
It should kind of a rule of thumb around 30 days should be your cash conversion

581
00:51:10,000 --> 00:51:11,000
cycle.

582
00:51:11,000 --> 00:51:19,000
Now, Pfizer, it came out of the box, this analysis two years ago, this group did

583
00:51:19,000 --> 00:51:23,000
it, and it was 93 days.

584
00:51:23,000 --> 00:51:24,000
93 days.

585
00:51:24,000 --> 00:51:29,000
In other words, their cash management people should have been taken out, forced

586
00:51:29,000 --> 00:51:34,000
to dig a grave, and then shot into the grave, and then have their dead bodies

587
00:51:34,000 --> 00:51:38,000
covered up before someone got infected by their incompetence.

588
00:51:38,000 --> 00:51:39,000
93 days.

589
00:51:39,000 --> 00:51:43,000
Okay, well, we're going to set the target for next year as 30 days.

590
00:51:43,000 --> 00:51:45,000
Like, hell you are.

591
00:51:45,000 --> 00:51:47,000
I mean, good grief.

592
00:51:47,000 --> 00:51:53,000
That's like our, you know, I went to this, I go to this gym three times a week.

593
00:51:53,000 --> 00:51:57,000
You guys said, well, I'd like to have you do 250 pounds tomorrow.

594
00:51:57,000 --> 00:52:00,000
You know, you can kiss my ass, that's not going to happen.

595
00:52:00,000 --> 00:52:05,000
I'll make myself have a hernia from my knees up to my chest.

596
00:52:05,000 --> 00:52:08,000
You don't want to force it so fast.

597
00:52:08,000 --> 00:52:12,000
You set target, if you are way out of luck, you go into a company and you see that

598
00:52:12,000 --> 00:52:17,000
it has a big problem, you don't try to solve it one year at a time.

599
00:52:17,000 --> 00:52:19,000
You say, all right, the target for next year.

600
00:52:19,000 --> 00:52:26,000
And what was cool was last year you could see that they were, they had obviously,

601
00:52:26,000 --> 00:52:29,000
they were doing a slow walk to the target.

602
00:52:29,000 --> 00:52:34,000
By last year, Pfizer was down to 73 days.

603
00:52:34,000 --> 00:52:39,000
And then they'll probably set the target somewhere around 60, 55 days.

604
00:52:39,000 --> 00:52:41,000
You'll walk to the target.

605
00:52:41,000 --> 00:52:46,000
So in other words, this ratio that you're, the golden ratio you're aiming at will

606
00:52:46,000 --> 00:52:51,000
sometimes be a multi-year step by step.

607
00:52:51,000 --> 00:52:57,000
So you'd have, your target would be moving toward the desired amount year over year.

608
00:52:57,000 --> 00:52:59,000
You don't want to get desperate.

609
00:52:59,000 --> 00:53:01,000
You don't want to do something radical and stupid.

610
00:53:01,000 --> 00:53:03,000
We're corporate people.

611
00:53:03,000 --> 00:53:08,000
We don't do that unless you're the owner of X.

612
00:53:08,000 --> 00:53:12,000
But anyway, so keep that in mind with this.

613
00:53:12,000 --> 00:53:18,000
And you can see that they do an analysis of this mythical corporation against the

614
00:53:18,000 --> 00:53:19,000
industry average.

615
00:53:19,000 --> 00:53:28,000
And you can see that you're just simply going to say, better, worse, about, and you

616
00:53:28,000 --> 00:53:33,000
just walk through each of those, the operats.

617
00:53:33,000 --> 00:53:35,000
You don't have to go through all of them.

618
00:53:35,000 --> 00:53:40,000
But the operats are sort of a place for you to start, where are we, where is the

619
00:53:40,000 --> 00:53:42,000
industry, or where is our target.

620
00:53:42,000 --> 00:53:47,000
And you just say, okay, now, we deal with these one at a time.

621
00:53:47,000 --> 00:53:49,000
The problem is that they're interrelated.

622
00:53:49,000 --> 00:53:55,000
You affect one, you affect probably a couple of other operats as you're doing that.

623
00:53:55,000 --> 00:54:02,000
So, for example, if you are trying to bring down your, well, if you're trying to

624
00:54:02,000 --> 00:54:09,000
bring down your ROA, I mean, increase your ROA, well, one of the ways you could do

625
00:54:09,000 --> 00:54:14,000
that is to increase the amount of equity in your company.

626
00:54:14,000 --> 00:54:15,000
Sell some stock.

627
00:54:15,000 --> 00:54:20,000
That will make the bottom, the total assets larger against net income on top.

628
00:54:20,000 --> 00:54:21,000
Well, that's great.

629
00:54:21,000 --> 00:54:25,000
But what that's also going to do is it's going to hurt your ROE.

630
00:54:25,000 --> 00:54:29,000
So you've got to watch it because sometimes these work together.

631
00:54:29,000 --> 00:54:32,000
One improvement helps improve another.

632
00:54:32,000 --> 00:54:34,000
But sometimes they work against each other.

633
00:54:34,000 --> 00:54:36,000
So you've got to have this balancing act.

634
00:54:36,000 --> 00:54:38,000
I remember one.

635
00:54:38,000 --> 00:54:40,000
I wish I could remember what the ratios were.

636
00:54:40,000 --> 00:54:47,000
But when we brought the one toward the industry average, that sent two all to

637
00:54:47,000 --> 00:54:48,000
hell.

638
00:54:48,000 --> 00:54:53,000
And then I looked like an idiot in that situation because I didn't think about it.

639
00:54:53,000 --> 00:54:56,000
Well, there you go.

640
00:54:56,000 --> 00:55:01,000
Now, okay, so and there are some that are absolute, absolute no-no.

641
00:55:01,000 --> 00:55:03,000
And they bring one up here to their credit.

642
00:55:03,000 --> 00:55:08,000
ROIC should be better than your WAC.

643
00:55:08,000 --> 00:55:14,000
Otherwise, you're borrowing at a rate better than your earning overall.

644
00:55:14,000 --> 00:55:20,000
ROIC, what is your return on all of your investments?

645
00:55:20,000 --> 00:55:25,000
And WAC is what did it cost to fund all of these investments?

646
00:55:25,000 --> 00:55:30,000
So if your WAC is higher than your ROIC, then that's not a good idea.

647
00:55:30,000 --> 00:55:36,000
That's really a bad idea because you're borrowing or you're raising capital at

648
00:55:36,000 --> 00:55:42,000
some cost that is above what you can make on it.

649
00:55:42,000 --> 00:55:44,000
How do you fix that?

650
00:55:44,000 --> 00:55:49,000
Well, the first obvious thing is to increase your net income, which would be to

651
00:55:49,000 --> 00:55:52,000
increase your sales and decrease your costs.

652
00:55:52,000 --> 00:55:56,000
Easier said than done, but that's one of the ways that you can do it.

653
00:55:56,000 --> 00:55:58,000
What about that WAC?

654
00:55:58,000 --> 00:56:00,000
Figure out what the hell you're doing.

655
00:56:00,000 --> 00:56:03,000
Is there a way to get down your WAC?

656
00:56:03,000 --> 00:56:09,000
Some companies, interestingly enough, they ran backwards to run forward.

657
00:56:09,000 --> 00:56:12,000
Here's what I mean by that.

658
00:56:12,000 --> 00:56:19,000
Companies had all this, they had debt that they had brought out in the time when

659
00:56:19,000 --> 00:56:21,000
interest rates were really high.

660
00:56:21,000 --> 00:56:27,000
Well, what they did was they pulled back in by getting short and intermediate

661
00:56:27,000 --> 00:56:34,000
term debt, and they paid off those high interest coupon debts.

662
00:56:34,000 --> 00:56:37,000
But of course, short and intermediate term would have higher interest rates than

663
00:56:37,000 --> 00:56:39,000
long term would.

664
00:56:39,000 --> 00:56:42,000
So why the hell would they have done that?

665
00:56:42,000 --> 00:56:45,000
Well, it was because the forecast was what happened.

666
00:56:45,000 --> 00:56:50,000
The Fed finally started to ease up on interest rates, so the long term yield

667
00:56:50,000 --> 00:56:52,000
curve began to fall down.

668
00:56:52,000 --> 00:56:59,000
So they borrowed short to pay off high long term, but that short was expensive.

669
00:56:59,000 --> 00:57:03,000
But they knew that then a few years later they could borrow long and pay off the

670
00:57:03,000 --> 00:57:05,000
short.

671
00:57:05,000 --> 00:57:10,000
So sometimes you'll run backward to get an advantage running forward.

672
00:57:10,000 --> 00:57:14,000
It's kind of a complicated trick, but I know some companies that did it, and it

673
00:57:14,000 --> 00:57:16,000
worked.

674
00:57:16,000 --> 00:57:23,000
Sure enough, the long term coupons, long term bonds, AA and AAA, began to, the

675
00:57:23,000 --> 00:57:28,000
20 year began to fall in yield, and so they could quickly get rid of that hot

676
00:57:28,000 --> 00:57:33,000
potato they had taken on in the short and intermediate term.

677
00:57:33,000 --> 00:57:36,000
So that's one of the things that are the nuances behind these numbers.

678
00:57:36,000 --> 00:57:39,000
And the numbers, we can do those with Excel.

679
00:57:39,000 --> 00:57:42,000
It's thinking about the numbers, and I've emphasized this over and over again,

680
00:57:42,000 --> 00:57:46,000
that's what makes us finance people and makes you so that you can get incredibly

681
00:57:46,000 --> 00:57:49,000
good jobs and take care of me in my old age.

682
00:57:49,000 --> 00:57:50,000
That's all I have for you today.

683
00:57:50,000 --> 00:58:04,000
Go home.