0:13

This section or module, and I like to think about things in modular fashion,

especially because finance just is a bunch of Legos..

Just remember, the smaller Legos start in the beginning,

then you begin to create your own designs.

And what I'm doing now is practical aspects of evaluation.

Whether it be some design elements upfront, it's going to be a little bit

tedious because it'll be conceptual, and a lot of number crunching that

0:57

First, for the first time since you know finance,

I'm going to be conceptual first and then show you some applications, okay?

Let's get started.

So, you want to value an idea, a project, a firm.

And this is basically what I like doing in finance, because if you don't

know the value of something, it's very tough to then sell it to people, or

raise funding, or put even your own money in that.

There are two basic ingredients to conducting a valuation,

the first one is cash flows.

And I keep saying this and I know it gets irritating even to me but

I think it's very important.

Cash flows belong to who?

They belong to the project manager, the firm, not as an ownership,

but as in terms of responsibility to show the cash flows.

2:04

And whenever you're thinking of cost of capital,

always think like an investor in a new idea,

a new firm you're thinking of buying the stock of, or the bonds investing in it.

Why do you want to think of it as an investor?

Because you'll then always think right,

the cost of capital always belongs to the marketplace, and

the notion of opportunity cost of capital is extremely important.

So people will be able to value your project only if they know what

the next best alternative is, well that's part number one.

Part number two, they'll invest in you only if you add value in a relative sense.

3:02

half a bottle costs two bucks, a full bottle will cost about four.

In other words, you never know why half a ketchup costs two.

We'll leave that to philosophy for the time being.

I love philosophy, but let's get started here.

The cost of capital belongs to the marketplace.

This will really liberate you because this is one confusion people have,

which is very important.

3:26

Let us assume that all your cash flows and for

simplicity are above the line,

they are earnings before interest and taxes, after tax.

Why am I saying this?

Remember, we're doing assumptions that make life simple to understand and

then complicate it by variations.

One way to think about is, everything you can do, you can do in your head.

You need spreadsheets because of numbers moving around, and

the ease of calculation.

So we'll assume your cash flows after taxes are exactly

equal to EBIT times 1 minus Tc, which is free cash flows.

4:40

We'll also assume for

the ease of calculation, that everything is perpetuity.

And when I say ease of calculation, I literally mean ease of calculation, okay?

Just to go back for a second, what does perpetuity, how does it make life simple?

Let me just write it one more time.

5:03

The only thing that will change is C of what and R of what?

So if you're looking at all your assets, what is C?

The total cashflows of the total tax.

What is R?

R, the discount rate of the firm.

When you are looking at cash flows on equity, it will be dividends and

the return or cash flows to the equity holder.

And discount rate will be return on equity.

If you're looking at cash flow through debt, it usually is interest payments and

sometimes principal too.

But discounted at which rate?

RD, if you're looking at the tax sheet, it'll have its own cash flow and

it'll have its own discount rate and a lot of that we'll talk about this time.

Discount Rates, we now need to figure the discount rate of the firm.

Suppose we have done the cash flows because it was my responsibility

as an analyst looking it a firm to figure out the cash flows first.

Or if I'm the project managers to figure out the,

now where do we get to discount rates?

6:10

You will always go to comparables and the reason is, cost of capital comes

from the best alternative an investor has, right,

not from what your alternatives are within the firm, and this is very very important.

So, suppose you have multiple divisions in a firm.

You will not look at other divisions in the firm to figure

out your discount rate for your specific project, or your division.

You'll always go to a similar firm, or

similar project, or whatever, outside in the marketplace.

Why multiple comparables?

So you look at comparables basically in the essence, the comparable has to be in

terms of the essential business it does, okay, they are also called pure plays.

Why, because you are after return on assets, you're after the discount

rates for assets because if you don't know that, you can't value any business, right?

The liability side and all that is all fine, but

you really need to know return on assets.

Why multiple comparables?

Well, remember life is data we're talking about the practical aspect.

So if you have only one comparable, so

suppose you want to start off a firm that is like, say, Walmart, and

if you only look at Walmart's balance sheet and income statements and

all that, which we'll do soon, you will have only one data point.

Even though it's been around for a while, you want as many comparables.

The problem with having too many comparables though is, and this is very,

very, very important, if you have too many comparables,

your chances of finding pure place are very few.

Because companies are very rarely doing only one kind of stuff

that you want to value.

So the matching of the comparable is extremely important.

Evaluation is about relative values, and

if you don't have comparables defined right, all your analysis is wrong.

And this applies to whichever method of evaluation you do.

8:18

Discount rates, you also should be able to go to the comparable and

figure out multiple discount rates.

Why multiple discount rates?

You're going to jump ahead, but only before we go back and

see what we did in a modular of fashion.

8:37

How many evaluation methods are there?

The three that we talked about is enterprise value,

then we talked about APV adjusted present value, and

we've talked about return, I mean sorry equity evaluation, so you need three.

For enterprise value, you should be able to calculate WACC.

For APV, you need to be

able to calculate Ra.

And for equity valuation method,

you need to be able to figure out Re, so these are the three.

Now it turns out that they're correlated, so

they're not entirely independent and we will get into this.

So, multiple comparables, multiple rates, you should be able to do.

And when you have multiple comparables,

you'll average out whichever discount rate you need and get rid of the noise.

Importance of return on assets can't be underplayed,

because Ra is key to all the methods of valuation.

9:52

And the simple way to think about is if you don't know how to value the real

assets, why are we in this business anyways?

But once you have real assets, you can then tweak and get back and

tweak and get return on that equity.

In fact to get back you have to get to return on equity anyways.

10:17

So the value of equity are on the right-hand side as I look at it.

Liabilities side value of debt is D, value of real assets,

we'll call Vu and value of the tax shield we will call TS.

And I like this way of looking at it, because it breaks thing up very cleanly.

I do not like the enterprise value method as much,

because it assumes that there's only one asset on the left hand side,

actually there are two now, because of the tax shield break.

I hope this way of looking at it helps you, because I like clean and

knowing what is happening where, okay.

So this is the values, remember all values require what?

11:14

Values of comparables, what side of the balance sheet are you interested in?

And in the interest of giving you a little bit of headache, I'll go back.

Which side of the balance sheet do you want to value?

Remember, you want to always value the asset side.

So you want to look at the characteristics of the real assets of your comparable.

11:44

So the trouble here is you want to go look at the assets directly and

the key return that you need first discount rate is return on assets, right.

But the trouble is, you want that but you can't see it.

So you want to know Vu, how can you calculate?

You know that, right?

You know the formula, you know that if you were to value the comparable,

it will look something like this.

12:16

And from it, if you could see Ra directly,

that Ra from the comparables analysis becomes your return on assets, why?

Because you've chosen the comparable based on similarity with u,

but you can't see Vu.

What is TS?

Again, so if you remember that one balance sheet,

just write it down next to you, right?

Make a note, write it down.

So Vu hidden in there is Ra, but

there'a also a tax shield, which you want to value.

Now, it turns out you can't value that easily too, because you have to first know

what the discount rate to use for that, so it becomes a little bit complicated okay.

So the tax shield, how do you calculate it?

Well there are two ways.

13:04

One you could use Rd to get to present value of tax shield, or

you could use Ra to get to the present value of tax shield.

But you can't see these, right.

You may be able to see Rd, but Ra you can't figure out.

Remember, you are looking at a comparable balance sheet.

14:03

Unfortunately, the book value of this, but the market value of equity is very easy

to observe, and the characteristics of it is very easy to observe.

So what will happen as a result is we'll catch our nose not directly.

You can't go directly to Ra, we'll have to go through the liability side.

So in other words we are kind of again,

the beautiful principle of life, it comes out over and over again.

Is, you want to get to something that's unobservable, but

you have data which you can unpack to go to the observable, and

that's what's going to be our challenge okay.

What is D, what E?

We have talked about it.

E is very easy to calculate.

E is what?

If you have a stock price multiplied by a number of shares,

this is the easiest way and D, usually you know the book value,

have that in the balance sheet.

Okay, so if you have markets, And

this is why I love markets, you can easily open up the browser today.

You're sitting at home, just open up, go to finance.yahoo.com or CNN or wherever.

And you want to know value of Apple,

price per share multiplied by number of shares, right.

And then add the debt, it's also shown.

And if you go on finance.yahoo.com, just look for

key statistics after putting in the symbol, trading symbol for the company.

So it's pretty straightforward.

But we are after what?

Remember, we are after Ra, Re, and WACC.

These are the things floating around at the back of my mind when I'm thinking

about it.

15:54

Simply because you want to figure out the return on assets, and

the return on asset is sitting with the comparable, it doesn't belong to you.

So we looked at the value sheet,

now let's look at the cash flow sheet of the comparable.

If you look at the cash flows, it's up there, please stare at it for

a little while.

18:07

So I'm going to take a pause here, let's talk to each other, think about it.

What I'm going to talk about is look at this,

figure out whether these make sense, the cash flows to each component, and

then we'll put them all together to see if it makes sense.

Remember, balance sheet always balances.

See you in a second.