Depreciation

WEBVTT
Kind: captions
Language: en

00:00:00.840 --> 00:00:02.200
So we have a company here.

00:00:02.200 --> 00:00:03.900
Let's just say it's
a widget factory

00:00:03.900 --> 00:00:05.530
again or a widget company.

00:00:05.530 --> 00:00:08.440
And what I'm going to do is I'm
going to actually write

00:00:08.440 --> 00:00:11.170
out its income statement over
a given number of years.

00:00:11.170 --> 00:00:15.400
What we did in the first video
on this series is we just did

00:00:15.400 --> 00:00:17.140
one snapshot of the
income statement.

00:00:17.140 --> 00:00:18.350
I think it was 2008.

00:00:18.350 --> 00:00:20.600
But here we're looking at the
income statement over a bunch

00:00:20.600 --> 00:00:22.910
of years, and in this case, I'm
just assuming that they

00:00:22.910 --> 00:00:25.730
have a very stable revenue base,
that they bring in a

00:00:25.730 --> 00:00:28.350
very stable amount of
revenue every year.

00:00:28.350 --> 00:00:32.360
Now, their cost of goods, I'm
going to split up this time,

00:00:32.360 --> 00:00:35.760
because there's two components
of cost of goods, so I'll just

00:00:35.760 --> 00:00:38.020
make a cost of goods category
right here.

00:00:38.020 --> 00:00:41.550
COGS, but that just stands for
Cost of Goods Sold, but

00:00:41.550 --> 00:00:44.250
sometimes you'll hear someone
say our COGS were this or our

00:00:44.250 --> 00:00:45.170
COGS were that.

00:00:45.170 --> 00:00:46.180
Cost of Goods Sold.

00:00:46.180 --> 00:00:48.150
So they're the variable costs.

00:00:48.150 --> 00:00:50.850
And this video isn't a video
on variable versus fixed

00:00:50.850 --> 00:00:54.460
costs, but you might learn
a little bit about it.

00:00:54.460 --> 00:00:57.150
So they're the variable costs,
and that's literally the

00:00:57.150 --> 00:01:00.830
actual costs of making
those widgets.

00:01:00.830 --> 00:01:04.370
So if the widgets are made out
stainless steel, it's the cost

00:01:04.370 --> 00:01:08.860
of buying the stainless steel
and maybe the electricity bill

00:01:08.860 --> 00:01:12.140
of melting it and reforming it
or however you have to work

00:01:12.140 --> 00:01:12.910
with stainless steel.

00:01:12.910 --> 00:01:15.870
So let's say the variable costs
each of these years--

00:01:15.870 --> 00:01:17.690
and I'm assuming stainless
steel prices

00:01:17.690 --> 00:01:21.810
don't change-- is $100,000.

00:01:21.810 --> 00:01:29.280
Minus $100,000 every year.

00:01:29.280 --> 00:01:30.760
And actually, let's
just say that also

00:01:30.760 --> 00:01:32.850
includes employee costs.

00:01:32.850 --> 00:01:37.330
They have people on hourly wages
that are forming these

00:01:37.330 --> 00:01:39.840
stainless steel widgets, so that
incorporates everything.

00:01:39.840 --> 00:01:41.490
And then the fixed costs
will essentially be

00:01:41.490 --> 00:01:43.360
the cost of the factory.

00:01:43.360 --> 00:01:47.570
And let's say that they
essentially have to build a

00:01:47.570 --> 00:01:49.920
new factory every two years, or
let's say they have to do

00:01:49.920 --> 00:01:53.500
major repairs to the factory
every two years.

00:01:53.500 --> 00:01:55.910
So let's say repairs
on factory.

00:01:55.910 --> 00:02:00.030
Because that's part of the cost
of building the widgets,

00:02:00.030 --> 00:02:03.230
because if you continue to make
widgets at this kind of

00:02:03.230 --> 00:02:07.060
$1 million a year pace, your
factory has to be retooled or

00:02:07.060 --> 00:02:08.910
revamped every two years.

00:02:08.910 --> 00:02:13.090
So let's put this fixed cost.
So the factory retooling.

00:02:16.730 --> 00:02:19.410
And most times, and we'll see
this when you look at an

00:02:19.410 --> 00:02:21.230
actual company's income
statement, they're not going

00:02:21.230 --> 00:02:23.930
to break up the variable and
fixed costs within their cost

00:02:23.930 --> 00:02:26.300
of goods sold like this, because
really, they actually

00:02:26.300 --> 00:02:27.740
want to hide it from a lot
of their competitors.

00:02:27.740 --> 00:02:29.730
They don't want their
competitors to have too much

00:02:29.730 --> 00:02:33.170
intelligence on what their
cost structure is like.

00:02:33.170 --> 00:02:35.875
It could be used against them
potentially, or maybe they

00:02:35.875 --> 00:02:37.170
don't want their customers
to know.

00:02:37.170 --> 00:02:38.370
Anyway, factory tooling.

00:02:38.370 --> 00:02:42.330
So the way I just described it,
one way to account for it

00:02:42.330 --> 00:02:45.750
is when you do the factory
retooling, you essentially

00:02:45.750 --> 00:02:47.390
just mark it as an expense.

00:02:47.390 --> 00:02:51.910
So let's say a factory retooling
costs $500,000.

00:02:51.910 --> 00:02:56.430
So let's say it's
minus $500,000.

00:02:56.430 --> 00:02:58.960
But they do it every
two years.

00:02:58.960 --> 00:03:01.000
So you did it in 2005.

00:03:01.000 --> 00:03:03.200
They didn't have to do
it in 2006, then they

00:03:03.200 --> 00:03:05.360
can do it in 2007.

00:03:05.360 --> 00:03:07.180
They don't have to
do it in 2008.

00:03:07.180 --> 00:03:08.250
Fair enough.

00:03:08.250 --> 00:03:09.815
And then we have their
gross profit.

00:03:18.500 --> 00:03:22.110
Here it's $1 million
minus $600,000.

00:03:22.110 --> 00:03:30.030
It's $400,000, then it's
$900,000, then it is $400,000,

00:03:30.030 --> 00:03:32.250
then it's $900,000.

00:03:32.250 --> 00:03:39.580
And let's say that their
SG&A-- SG&A is Selling,

00:03:39.580 --> 00:03:41.390
General and Administrative
expenses.

00:03:41.390 --> 00:03:44.120
I'll leave out marketing
for now.

00:03:44.120 --> 00:03:49.370
They're SG&A, let's say it's
another $500,000 every year.

00:03:49.370 --> 00:03:51.540
So minus $500,000.

00:03:51.540 --> 00:03:53.322
And that never changes.

00:03:53.322 --> 00:03:57.260
$500,000 every year.

00:03:57.260 --> 00:04:00.060
Minus $500,000.

00:04:00.060 --> 00:04:05.980
And so their operating profit,
the amount of pre-tax income,

00:04:05.980 --> 00:04:07.880
but you know, we're not
considering financing either,

00:04:07.880 --> 00:04:12.470
so this is their operating
profit or their EBIT.

00:04:12.470 --> 00:04:15.830
So operating profit.

00:04:15.830 --> 00:04:20.519
And this year, it's
minus $100,000.

00:04:20.519 --> 00:04:23.210
Here it's also minus $100,000.

00:04:23.210 --> 00:04:24.970
But then in these years,
they make money.

00:04:24.970 --> 00:04:29.120
It's $400,000 and $400,000.

00:04:29.120 --> 00:04:30.170
And then we could
take this down.

00:04:30.170 --> 00:04:33.605
Let's say they have no
interest expense.

00:04:33.605 --> 00:04:36.350
They have no interest expense,
because that's not the point

00:04:36.350 --> 00:04:37.460
of this video.

00:04:37.460 --> 00:04:44.870
And then their pre-tax profit is
going to be the same thing

00:04:44.870 --> 00:04:48.910
as the operating profit, so
minus $100,000, minus

00:04:48.910 --> 00:04:52.640
$100,000, $400,000--
I'll make the good

00:04:52.640 --> 00:04:55.770
years in green-- $400,000.

00:04:55.770 --> 00:04:58.810
And then, let's just say they're
in the Caribbean and

00:04:58.810 --> 00:04:59.770
they don't have to pay taxes.

00:04:59.770 --> 00:05:02.100
Because that's not the point
of this, but you can apply

00:05:02.100 --> 00:05:03.710
some tax rate to this
and figure out what

00:05:03.710 --> 00:05:04.840
their net income is.

00:05:04.840 --> 00:05:08.910
But the point of this is, even
though their business is ultra

00:05:08.910 --> 00:05:13.720
stable, they do the exact same
thing every year, when we look

00:05:13.720 --> 00:05:16.660
at the pre-tax or the operating
income, or if we tax

00:05:16.660 --> 00:05:19.950
it, or even at the net income,
we see a super lumpy business,

00:05:19.950 --> 00:05:22.625
because in one year they
lost $100,000.

00:05:22.625 --> 00:05:24.280
If you're looking at the
business, you're like, oh,

00:05:24.280 --> 00:05:25.160
what a horrible business.

00:05:25.160 --> 00:05:28.050
But then the next year they make
$400,000, and then they

00:05:28.050 --> 00:05:29.190
lose $100,000.

00:05:29.190 --> 00:05:31.190
And you're like, gee, how
is that possible?

00:05:31.190 --> 00:05:34.680
That you have such a sleepy,
stable business that's just

00:05:34.680 --> 00:05:37.790
making COGS year in year out,
and they have the exact same

00:05:37.790 --> 00:05:38.810
amount of revenue?

00:05:38.810 --> 00:05:41.860
How is it possible that their
actual income is so lumpy?

00:05:41.860 --> 00:05:45.510
And I think you know, because
you have this every other year

00:05:45.510 --> 00:05:49.610
factory retooling, where they
have to spend $500,000 to

00:05:49.610 --> 00:05:53.430
essentially rebuild their
factory because of all of the

00:05:53.430 --> 00:05:57.560
wear and tear that happened
over the last two years.

00:05:57.560 --> 00:06:00.350
So the question is, is this a
good way to account for it,

00:06:00.350 --> 00:06:02.720
where when you have to--
I guess you could

00:06:02.720 --> 00:06:03.880
say-- buy new equipment.

00:06:03.880 --> 00:06:08.790
Let's say this $500,000 is to
buy actual new stainless steel

00:06:08.790 --> 00:06:12.720
shaping tools, so is it a good
idea to account for it only in

00:06:12.720 --> 00:06:14.660
the period that you spend it?

00:06:14.660 --> 00:06:18.405
Because it's not like you're
only using these tools in this

00:06:18.405 --> 00:06:19.280
period and that period?

00:06:19.280 --> 00:06:22.060
You're using these tools
throughout the period.

00:06:22.060 --> 00:06:25.080
So the answer is, well, no,
it's not a good idea.

00:06:25.080 --> 00:06:29.150
Because the whole purpose of
accounting is to give the

00:06:29.150 --> 00:06:32.760
person reading the income
statement in this case as

00:06:32.760 --> 00:06:35.340
accurate a picture of the actual
state of the business

00:06:35.340 --> 00:06:35.940
as possible.

00:06:35.940 --> 00:06:38.660
And this, in my opinion, isn't
an accurate picture, where it

00:06:38.660 --> 00:06:41.410
creates this huge lumpiness and
it creates the impression

00:06:41.410 --> 00:06:44.110
of a volatile business even
though it's a super, super

00:06:44.110 --> 00:06:45.510
stable business.

00:06:45.510 --> 00:06:48.190
So what you do, instead of just
saying, oh, I had to buy

00:06:48.190 --> 00:06:52.670
$500,000 worth of equipment in
2005, so I literally put a

00:06:52.670 --> 00:06:56.190
$500,000 expense there, and I
didn't have to do that in

00:06:56.190 --> 00:06:57.040
2006, so I have no expense.

00:06:57.040 --> 00:06:58.710
I had to do it in 2007,
so I put the expense.

00:06:58.710 --> 00:07:01.990
Instead of doing that, what
you do is-- I'll put the

00:07:01.990 --> 00:07:06.290
balance sheet down here-- so
whatever the balance sheet was

00:07:06.290 --> 00:07:14.616
in-- so I'll draw both hand
sides of the balance sheet.

00:07:22.290 --> 00:07:27.050
So this is the asset side
of the balance sheet.

00:07:27.050 --> 00:07:29.730
And just so you don't get
confused, there's always a

00:07:29.730 --> 00:07:33.570
liability side of the balance
sheet as well.

00:07:33.570 --> 00:07:40.200
So in 2007, maybe before I spent
the $500,000, right when

00:07:40.200 --> 00:07:44.760
I do it, I probably had $500,000
of cash sitting here.

00:07:44.760 --> 00:07:45.750
Let me write that down.

00:07:45.750 --> 00:07:46.370
So I have cash.

00:07:46.370 --> 00:07:47.950
I'll just put a C there.

00:07:47.950 --> 00:07:50.750
Cash, $500,000.

00:07:50.750 --> 00:07:53.455
And instead of just using this
an expense, and we'll go in

00:07:53.455 --> 00:07:55.570
the future on kind of how you
account for things in a little

00:07:55.570 --> 00:07:57.370
bit more detail and how you
actually do the debits and

00:07:57.370 --> 00:07:59.880
credits, but a simple way to
think about it, instead of

00:07:59.880 --> 00:08:02.950
using this $500,000 as an
expense, we just transferred

00:08:02.950 --> 00:08:05.850
this $500,000 to buy an asset.

00:08:05.850 --> 00:08:10.970
So when you use cash to buy an
asset, and that asset has a

00:08:10.970 --> 00:08:13.330
useful life that's more than
just that period, you're

00:08:13.330 --> 00:08:16.650
essentially capitalizing the
expense or you're essentially

00:08:16.650 --> 00:08:18.210
creating that asset on
the balance sheet.

00:08:18.210 --> 00:08:21.190
So instead of this $500,000 just
disappearing expense, you

00:08:21.190 --> 00:08:24.690
say, no, now I have-- let's call
it F for factory tools.

00:08:24.690 --> 00:08:29.120
I have factory tools worth
$500,000, and then that cash

00:08:29.120 --> 00:08:30.080
will go away.

00:08:30.080 --> 00:08:33.039
So your assets will not have
really changed, the absolute

00:08:33.039 --> 00:08:34.059
value of the assets.

00:08:34.059 --> 00:08:36.730
You'll have just had $500,000
going from cash

00:08:36.730 --> 00:08:38.760
to new factory tools.

00:08:38.760 --> 00:08:43.280
And so this might be at the
beginning of when you do it.

00:08:43.280 --> 00:08:48.190
Let's say this is 1/1/2007.

00:08:48.190 --> 00:08:50.410
And what you say is, I'm going
to use these factory tools.

00:08:50.410 --> 00:08:52.640
They're usable over two years.

00:08:52.640 --> 00:08:54.760
So what you do is you depreciate
the tools.

00:08:54.760 --> 00:08:57.790
So the way you'd think about
this is instead of having

00:08:57.790 --> 00:09:02.530
factory retooling, you could
say factory tool.

00:09:02.530 --> 00:09:05.376
Instead of retooling I'll
call that depreciation.

00:09:10.210 --> 00:09:11.460
I don't know if you
can read that.

00:09:15.670 --> 00:09:18.180
So it essentially spreads
out the cost of

00:09:18.180 --> 00:09:19.850
that $500,000 a year.

00:09:19.850 --> 00:09:23.940
So you say, I had a $500,000
piece of capital equipment,

00:09:23.940 --> 00:09:27.570
and its useful life
is two years.

00:09:27.570 --> 00:09:29.100
So I used half of
it in year one.

00:09:29.100 --> 00:09:33.200
So instead of putting $500,000
there, the depreciation is

00:09:33.200 --> 00:09:36.010
minus $250,000.

00:09:36.010 --> 00:09:39.910
Likewise, in this year, no cash
went out the door, but my

00:09:39.910 --> 00:09:43.070
equipment got a little
bit older, so I used

00:09:43.070 --> 00:09:44.120
half more of it.

00:09:44.120 --> 00:09:46.000
So it's $250,000.

00:09:46.000 --> 00:09:48.240
And then my equipment
is worthless.

00:09:48.240 --> 00:09:50.680
So this is in 1/1/2005.

00:09:50.680 --> 00:10:03.540
I have this tool that's
worth $500,000.

00:10:03.540 --> 00:10:08.780
Then on 1/1/2006, I will have
used half of the tool.

00:10:08.780 --> 00:10:18.650
So now this balance sheet-- I
copied the numbers, too, but

00:10:18.650 --> 00:10:19.530
that's 2006.

00:10:19.530 --> 00:10:22.020
I'm going from 2005 to 2006.

00:10:22.020 --> 00:10:24.790
So now I will have used
up half of it.

00:10:24.790 --> 00:10:30.410
So according to the accounting,
this equipment is

00:10:30.410 --> 00:10:32.230
no longer worth $500,000.

00:10:32.230 --> 00:10:35.520
It's now worth $250,000.

00:10:35.520 --> 00:10:36.870
You know, that actually
might make sense.

00:10:36.870 --> 00:10:39.200
Maybe if I were to sell it in
the open market, someone might

00:10:39.200 --> 00:10:40.220
say, you know what?

00:10:40.220 --> 00:10:42.500
I'm only willing to pay
$250,000, because you've

00:10:42.500 --> 00:10:44.890
already used it for a year and
it only has one year of useful

00:10:44.890 --> 00:10:48.650
life left, so it's of $250,000
of value to me.

00:10:48.650 --> 00:10:52.240
And then the other $250,000
essentially went to an expense

00:10:52.240 --> 00:10:54.740
called depreciation, which
is right there.

00:10:54.740 --> 00:10:59.270
So every year, you're going to
have this asset go down on the

00:10:59.270 --> 00:11:02.730
balance sheets by $250,000.

00:11:02.730 --> 00:11:06.290
So here at the beginning
of this year, the

00:11:06.290 --> 00:11:08.250
asset is worth $500,000.

00:11:08.250 --> 00:11:09.570
So I'll write that up here.

00:11:09.570 --> 00:11:11.020
So this is what the
asset's valued.

00:11:11.020 --> 00:11:13.890
I'll do it in this
orange color.

00:11:13.890 --> 00:11:15.860
So over here, let's say you did
it right at the beginning

00:11:15.860 --> 00:11:18.130
of the year, the asset's
worth $500,000.

00:11:18.130 --> 00:11:20.240
Now, it's worth $250,000.

00:11:20.240 --> 00:11:22.530
Now, the asset's worth zero, but
at the beginning of this

00:11:22.530 --> 00:11:25.280
year, you buy a new asset
worth $500,000.

00:11:25.280 --> 00:11:27.270
Then it's worth $250,000
again.

00:11:27.270 --> 00:11:32.080
And this is just an arguably
long-winded way of saying that

00:11:32.080 --> 00:11:35.370
the way you account for this
is you spread out the cost

00:11:35.370 --> 00:11:38.810
over time, over its useful life,
and this spreading out

00:11:38.810 --> 00:11:41.390
is called the depreciation
of an asset.

00:11:41.390 --> 00:11:44.060
And I'm running out of time in
this video, and I'll cover it

00:11:44.060 --> 00:11:47.340
in the next, but you might have
also heard of the word

00:11:47.340 --> 00:11:50.500
"amortization." Amortization
is to spread out a

00:11:50.500 --> 00:11:53.450
non-tangible cost over
a period of time.

00:11:53.450 --> 00:11:56.110
So for example, depreciation,
this was factory equipment,

00:11:56.110 --> 00:11:59.000
and it gets old as I use it,
so I spread out its cost.

00:11:59.000 --> 00:12:00.550
That's what depreciation does.

00:12:00.550 --> 00:12:02.910
And it accurately reflects
what's actually happening in

00:12:02.910 --> 00:12:04.110
the business.

00:12:04.110 --> 00:12:05.960
It's not like I didn't
have any cost here.

00:12:05.960 --> 00:12:09.050
I did have cost. I'm
using an asset up.

00:12:09.050 --> 00:12:10.690
So therefore, I put
it down there.

00:12:10.690 --> 00:12:13.870
Amortization is the exact same
thing as depreciation, but it

00:12:13.870 --> 00:12:16.860
applies to things that
aren't equipment.

00:12:16.860 --> 00:12:19.430
It applies to-- and I'll do it
in the next video-- but let's

00:12:19.430 --> 00:12:22.600
say I had one big expense in
terms of I had to pay a bunch

00:12:22.600 --> 00:12:26.160
of fees to the bank, but the
benefit of those fees are

00:12:26.160 --> 00:12:26.980
going to be over time.

00:12:26.980 --> 00:12:28.580
Then I would amortize
those fees.

00:12:28.580 --> 00:12:29.930
I'll do that in the
next video.

00:12:29.930 --> 00:12:32.760
Anyway, hopefully, you found
this vaguely useful.


P/E discussion

WEBVTT
Kind: captions
Language: en

00:00:00.580 --> 00:00:03.680
We now know how to calculate the
Price to Earnings ratio.

00:00:03.680 --> 00:00:07.595
Let's see if we can use it to
make a judgment about whether

00:00:07.595 --> 00:00:10.470
a company is cheap or expensive

00:00:10.470 --> 00:00:11.970
relative to another company.

00:00:11.970 --> 00:00:16.400
So let's say I have Company
A and I have Company B.

00:00:16.400 --> 00:00:17.923
And for the sake of our
discussion, let's say they're

00:00:17.923 --> 00:00:18.790
in the same industry.

00:00:18.790 --> 00:00:21.660
And that's important because
Price to Earnings really is

00:00:21.660 --> 00:00:23.260
more of a relative valuation.

00:00:23.260 --> 00:00:25.590
You kind of want to compare
apples to apples.

00:00:25.590 --> 00:00:28.240
It's hard to compare one
Price to Earnings in

00:00:28.240 --> 00:00:29.240
one industry to another.

00:00:29.240 --> 00:00:31.690
We'll talk a lot in the future
about why that is, and we'll

00:00:31.690 --> 00:00:33.200
get more into the nuance.

00:00:33.200 --> 00:00:33.930
But let's just say they're
in the same industry.

00:00:33.930 --> 00:00:35.700
Maybe they're software
companies.

00:00:35.700 --> 00:00:40.180
Maybe Company A, each share I
can buy it for, so the price

00:00:40.180 --> 00:00:46.100
per share of Company A is $10.

00:00:46.100 --> 00:00:51.090
Price per share of
Company B is $20.

00:00:51.090 --> 00:00:53.880
So remember, just this
information alone does not

00:00:53.880 --> 00:00:56.540
tell me that A is cheap
and B is expensive.

00:00:56.540 --> 00:00:59.120
We learned that in
our first video.

00:00:59.120 --> 00:01:06.080
And let's say that it's
2008 earnings.

00:01:06.080 --> 00:01:10.440
Company A made $1 per share.

00:01:10.440 --> 00:01:11.760
$1 of EPS.

00:01:11.760 --> 00:01:15.240
This is Earnings Per Share,
not total earnings.

00:01:15.240 --> 00:01:17.140
To figure out total earnings, we
would take this number and

00:01:17.140 --> 00:01:19.240
multiply by the number
of shares.

00:01:19.240 --> 00:01:23.460
And let's say Company
B made $5 per share.

00:01:23.460 --> 00:01:27.110
$5 EPS, Earnings Per Share.

00:01:27.110 --> 00:01:30.565
So what are their respective
Price to Earnings ratios?

00:01:34.710 --> 00:01:36.830
Company is 10.

00:01:36.830 --> 00:01:39.120
The price is $10, the earnings
is $1, so $10

00:01:39.120 --> 00:01:41.240
divided by $1 is 10.

00:01:41.240 --> 00:01:45.950
Company B, the price is $20,
the earnings are $5. $20

00:01:45.950 --> 00:01:49.830
divided by $5 is 4.

00:01:49.830 --> 00:01:52.670
So just when you look at it
superficially right here, when

00:01:52.670 --> 00:01:55.500
you take Price to Earnings-- and
actually just as a little

00:01:55.500 --> 00:01:58.760
aside, whenever someone says the
Price to Earnings ratio is

00:01:58.760 --> 00:02:02.060
10, or the Price to Earnings for
Company B is 4, the first

00:02:02.060 --> 00:02:05.090
thing you should ask is, what
earnings are you using?

00:02:05.090 --> 00:02:06.750
Are you using historical
earnings?

00:02:06.750 --> 00:02:09.850
Are you using the past
12 months earnings?

00:02:09.850 --> 00:02:11.820
Are you using future earnings?

00:02:11.820 --> 00:02:13.920
In this case, we use last
year's earnings.

00:02:13.920 --> 00:02:15.660
We use 2008 earnings.

00:02:15.660 --> 00:02:16.600
And that's a key thing.

00:02:16.600 --> 00:02:18.605
And we'll talk about that if we
have time a little bit more

00:02:18.605 --> 00:02:19.500
in this video.

00:02:19.500 --> 00:02:23.550
So based on 2008 earnings, the
price to 2008 earnings for

00:02:23.550 --> 00:02:24.920
Company A is 10.

00:02:24.920 --> 00:02:29.180
The price to 2008 earnings
for Company B is 4.

00:02:29.180 --> 00:02:33.870
So for every dollar of earnings
per year, if you

00:02:33.870 --> 00:02:35.940
believe that the 2008 earnings
are indicative,

00:02:35.940 --> 00:02:37.550
you're paying $4 here.

00:02:37.550 --> 00:02:40.660
For every dollar of earnings
here, you're paying $10.

00:02:40.660 --> 00:02:42.505
So based on that, this
looks cheaper.

00:02:46.440 --> 00:02:51.040
Low Price to Earnings ratio
implies that it's cheaper.

00:02:51.040 --> 00:02:53.260
For the same earnings you're
paying a lower price.

00:02:53.260 --> 00:02:55.310
For every dollar of earnings,
you're paying $4.

00:02:55.310 --> 00:02:57.760
For every dollar of earnings
here, you're paying $10.

00:02:57.760 --> 00:03:00.660
So it looks like it's cheaper.

00:03:00.660 --> 00:03:04.060
And if everything was equal, if
these companies really were

00:03:04.060 --> 00:03:07.470
equal, in terms of their capital
structure, in terms of

00:03:07.470 --> 00:03:10.530
how much debt they had, in terms
of their growth rate, in

00:03:10.530 --> 00:03:13.010
terms of their risk, in terms
of the markets they operate

00:03:13.010 --> 00:03:16.160
in, in terms of who are their
customers, and how much of a

00:03:16.160 --> 00:03:18.770
competitive advantage they have.
If all of those things

00:03:18.770 --> 00:03:22.120
were completely identical,
you would be correct.

00:03:22.120 --> 00:03:26.350
You would be correct that
Company B was cheaper.

00:03:26.350 --> 00:03:28.850
And notice that it's the
complete opposite of just the

00:03:28.850 --> 00:03:29.940
superficial price.

00:03:29.940 --> 00:03:31.630
The price here, Company
B was more.

00:03:31.630 --> 00:03:34.220
But when you look at the Price
to Earnings ratio, you say

00:03:34.220 --> 00:03:36.430
Company B is cheaper.

00:03:36.430 --> 00:03:38.570
Now, immediately if you were
to see this is the real

00:03:38.570 --> 00:03:41.880
market, where you see two
identical companies-- or you

00:03:41.880 --> 00:03:44.150
think they're identical
companies-- and one is trading

00:03:44.150 --> 00:03:47.230
at a lower multiple or a lower
Price to Earnings multiple

00:03:47.230 --> 00:03:50.120
than the other, you should
be very suspicious.

00:03:50.120 --> 00:03:52.580
There's some chance that you're
the first person to

00:03:52.580 --> 00:03:55.570
notice this discrepancy, and
then in that case you should

00:03:55.570 --> 00:03:57.550
go and buy Company B.

00:03:57.550 --> 00:03:59.260
And if you're into shorting
things, you could short

00:03:59.260 --> 00:04:00.920
Company A, and you could
make a lot of money.

00:04:00.920 --> 00:04:02.190
But you should be
very suspicious.

00:04:02.190 --> 00:04:05.210
Is kind of like the classical
two economists walking down

00:04:05.210 --> 00:04:05.900
the street.

00:04:05.900 --> 00:04:10.020
And they see a $20 bill.

00:04:10.020 --> 00:04:11.530
And one economist says,
hey, why don't I

00:04:11.530 --> 00:04:12.420
pick up the $20 bill.

00:04:12.420 --> 00:04:15.090
And he says, no you silly, how
can you be an economist?

00:04:15.090 --> 00:04:18.380
It clearly isn't a $20 bill,
because if it was, someone

00:04:18.380 --> 00:04:20.149
else would have picked
it up before us.

00:04:20.149 --> 00:04:22.820
That markets don't allow just
free money to be sitting

00:04:22.820 --> 00:04:23.400
around there.

00:04:23.400 --> 00:04:27.450
And if these companies were
truly identical, this

00:04:27.450 --> 00:04:29.140
discrepancy would
be free money.

00:04:29.140 --> 00:04:32.600
And the first person to see it
would start buying Company B,

00:04:32.600 --> 00:04:33.860
and the price would move up.

00:04:33.860 --> 00:04:36.220
And maybe people would short
Company A, and the

00:04:36.220 --> 00:04:37.160
price would move down.

00:04:37.160 --> 00:04:38.860
And that would happen
very quickly in

00:04:38.860 --> 00:04:39.900
today's public markets.

00:04:39.900 --> 00:04:43.340
And at some point, these Price
to Earnings ratios should be

00:04:43.340 --> 00:04:47.880
equal if-- and this is a big
if-- if these companies really

00:04:47.880 --> 00:04:50.360
are equal in terms of their
earnings potential and the

00:04:50.360 --> 00:04:51.860
risks and their growth.

00:04:51.860 --> 00:04:53.090
But let me ask you a question.

00:04:53.090 --> 00:04:55.500
Let's say that we don't know
that they're truly equal.

00:04:55.500 --> 00:05:01.160
Why would someone be willing
to pay a Price to Earnings

00:05:01.160 --> 00:05:05.990
ratio of 10 for Company A and
pass up, or maybe not want to

00:05:05.990 --> 00:05:09.240
buy, Company B, even though
they're paying only a Price to

00:05:09.240 --> 00:05:10.390
Earnings ratio of 4.

00:05:10.390 --> 00:05:13.940
Why would they rather pay $10
for every $1 of earnings in

00:05:13.940 --> 00:05:17.775
2008, as opposed to
$4 of every dollar

00:05:17.775 --> 00:05:21.180
of earnings in 2008?

00:05:21.180 --> 00:05:23.080
We touched on it in
the last video.

00:05:23.080 --> 00:05:25.620
Maybe they think Company
A is a lot safer.

00:05:25.620 --> 00:05:30.730
It's closer to a bank account
that-- Company B, sure it made

00:05:30.730 --> 00:05:33.540
$5 in earnings, but
that is risky.

00:05:33.540 --> 00:05:34.180
You don't know.

00:05:34.180 --> 00:05:36.950
Every year, maybe one year it
makes $5, and maybe the next

00:05:36.950 --> 00:05:38.180
it loses $5.

00:05:38.180 --> 00:05:41.580
Well Company A is more steady,
so that's one reason.

00:05:41.580 --> 00:05:44.210
And the other reason is, this
was just 2008 earnings.

00:05:44.210 --> 00:05:47.830
But just one year of earnings
really don't capture what's

00:05:47.830 --> 00:05:48.820
happening at a company.

00:05:48.820 --> 00:05:51.320
A company could do really good
one year, really bad the next.

00:05:51.320 --> 00:05:52.230
It might be shrinking.

00:05:52.230 --> 00:05:53.230
It might be growing.

00:05:53.230 --> 00:05:55.250
And this is the important
thing.

00:05:55.250 --> 00:05:57.380
There's always this temptation
in investing

00:05:57.380 --> 00:05:58.870
to always look back.

00:05:58.870 --> 00:06:02.100
To see what happened to the
stock in the past. Or how much

00:06:02.100 --> 00:06:03.670
did the company earn
in the past?

00:06:03.670 --> 00:06:04.870
Or how much did it
grow in the past?

00:06:04.870 --> 00:06:06.090
But that's all irrelevant.

00:06:06.090 --> 00:06:07.990
That's already in the stock.

00:06:07.990 --> 00:06:10.630
That's already happened,
whatever money was there to be

00:06:10.630 --> 00:06:12.030
made has already been made.

00:06:12.030 --> 00:06:14.070
You always have to be
looking forward.

00:06:14.070 --> 00:06:16.050
So we said this is
2008 earnings.

00:06:16.050 --> 00:06:18.690
But let's say 2009 earnings,
the picture looks

00:06:18.690 --> 00:06:20.540
a little bit different.

00:06:20.540 --> 00:06:21.470
Let me draw this here.

00:06:21.470 --> 00:06:31.850
So let's say in 2009 EPS-- this
is A and this is B-- A is

00:06:31.850 --> 00:06:38.610
expected to make $2 per share.

00:06:38.610 --> 00:06:47.750
And B is expected to
make $4 per share.

00:06:47.750 --> 00:06:52.180
So now if you took the Price
to Earnings ratio on 2009

00:06:52.180 --> 00:06:54.810
earnings-- some of which is
behind us because I'm making

00:06:54.810 --> 00:06:58.380
this video in August of 2009--
and so we know half the year.

00:06:58.380 --> 00:07:01.420
But the other part of this
number is kind of a

00:07:01.420 --> 00:07:02.480
projection.

00:07:02.480 --> 00:07:05.480
Hopefully diligent and
intelligent people have come

00:07:05.480 --> 00:07:06.600
up with this estimate.

00:07:06.600 --> 00:07:11.170
So oftentimes you'll see this
as a 2009 estimate EPS.

00:07:11.170 --> 00:07:12.550
This is people's best guess.

00:07:12.550 --> 00:07:18.880
But here, the Price to Earnings
for 2009 then

00:07:18.880 --> 00:07:19.430
becomes-- let's see.

00:07:19.430 --> 00:07:23.515
If I'm paying $10 today for $2
of earnings in 2009, the Price

00:07:23.515 --> 00:07:27.430
to Earnings of 5
for Company A.

00:07:27.430 --> 00:07:30.260
Well, for Company B, it's
a Price to Earnings

00:07:30.260 --> 00:07:31.210
20 divided by 4.

00:07:31.210 --> 00:07:33.010
It's also a 5.

00:07:33.010 --> 00:07:33.650
So notice.

00:07:33.650 --> 00:07:35.290
Now when you look at
2009 earnings,

00:07:35.290 --> 00:07:36.640
they look pretty similar.

00:07:36.640 --> 00:07:39.910
So although when you looked back
at 2008 earnings, Company

00:07:39.910 --> 00:07:40.680
A looked expensive.

00:07:40.680 --> 00:07:42.400
Higher Price to Earnings
in Company B.

00:07:42.400 --> 00:07:44.060
But then when you look
at the current

00:07:44.060 --> 00:07:46.180
earnings, they look similar.

00:07:46.180 --> 00:07:49.540
Now the question was, why would
someone want to pay more

00:07:49.540 --> 00:07:52.040
for Company A?

00:07:52.040 --> 00:07:54.180
Why would they choose
Company A over this?

00:07:54.180 --> 00:07:57.450
This analysis I just said said,
oh, based on 2009 it

00:07:57.450 --> 00:07:58.150
looks neutral.

00:07:58.150 --> 00:08:00.180
The Price to Earnings
ratio is the same.

00:08:00.180 --> 00:08:03.470
For every $1 in earnings,
you're paying $5.

00:08:03.470 --> 00:08:04.280
But notice a trend.

00:08:04.280 --> 00:08:07.250
In 2008, they made $1.

00:08:07.250 --> 00:08:09.620
Then they made $2 in 2009.

00:08:09.620 --> 00:08:12.640
And maybe there's some
estimates for 2010.

00:08:12.640 --> 00:08:14.500
Or maybe you can make
your own estimate.

00:08:14.500 --> 00:08:18.060
So maybe in 2010 people
are saying Company

00:08:18.060 --> 00:08:19.110
A has a great product.

00:08:19.110 --> 00:08:19.720
It's growing.

00:08:19.720 --> 00:08:20.430
The market's growing.

00:08:20.430 --> 00:08:23.980
Maybe in 2010, Company A
is going to make $2.50.

00:08:23.980 --> 00:08:28.200
It's going to grow another
25% in 2010.

00:08:28.200 --> 00:08:29.680
Maybe its growth rate
slows a little bit.

00:08:29.680 --> 00:08:30.700
But it's going to continue
to grow.

00:08:30.700 --> 00:08:35.450
While Company B went from $5 of
earnings in 2008 to $4 in

00:08:35.450 --> 00:08:38.640
2009, and maybe it shrinks
a little bit.

00:08:38.640 --> 00:08:39.480
Maybe it shrinks in half.

00:08:39.480 --> 00:08:42.690
Maybe it goes to $2 in 2010.

00:08:42.690 --> 00:08:47.950
So now if you do a Price to
Earnings on 2010 earnings-- so

00:08:47.950 --> 00:08:50.160
this is 18 months out from
when this video is being

00:08:50.160 --> 00:08:55.780
made-- all of a sudden, your
Price to Earnings relative to

00:08:55.780 --> 00:08:59.550
2010 earnings is 4
for Company A.

00:08:59.550 --> 00:09:02.110
And it's 10 for Company B.

00:09:02.110 --> 00:09:03.500
So now we switched places.

00:09:03.500 --> 00:09:07.960
Now Company B looks more
expensive on 2010 earnings.

00:09:07.960 --> 00:09:10.340
And Company A looks
downright cheap.

00:09:10.340 --> 00:09:13.110
And this is an important
thing to realize.

00:09:13.110 --> 00:09:17.410
In a present period, you are
willing to pay a higher Price

00:09:17.410 --> 00:09:20.380
to Earnings ratio if the
company is growing.

00:09:20.380 --> 00:09:22.760
And you're going to pay a lower
Price to Earnings ratio

00:09:22.760 --> 00:09:24.520
if the company isn't growing.

00:09:24.520 --> 00:09:27.280
So growth is the other reason
why you're willing to pay a

00:09:27.280 --> 00:09:28.560
higher Price to Earnings
ratio.

00:09:28.560 --> 00:09:31.870
A good exercise, let's say
you see a company.

00:09:31.870 --> 00:09:36.150
Sometimes someone might
look at a company.

00:09:36.150 --> 00:09:41.910
Company C is trading at $100.

00:09:41.910 --> 00:09:49.780
And let's say for 2009 people
expect it's going to make $1.

00:09:49.780 --> 00:09:52.620
So a lot of people immediately
will figure out the Price to

00:09:52.620 --> 00:09:55.610
Earnings based on 2009
estimated earnings.

00:09:55.610 --> 00:09:56.690
Remember, it's always
important to

00:09:56.690 --> 00:09:58.130
know what the E is.

00:09:58.130 --> 00:10:01.190
This is 2009 estimates.

00:10:01.190 --> 00:10:03.840
They'll say, this is 100 Price
to Earnings Ratio.

00:10:03.840 --> 00:10:04.980
That's crazy.

00:10:04.980 --> 00:10:05.860
I would never pay that.

00:10:05.860 --> 00:10:06.860
That's an expensive company.

00:10:06.860 --> 00:10:08.120
And maybe they'll even
short it there.

00:10:08.120 --> 00:10:10.600
Which can be a very foolhardy
thing to do

00:10:10.600 --> 00:10:12.040
if you're not careful.

00:10:12.040 --> 00:10:14.510
But you might say, oh no,
don't short it just yet.

00:10:14.510 --> 00:10:15.040
Think about it.

00:10:15.040 --> 00:10:18.400
This company's growing so fast,
based on my projections

00:10:18.400 --> 00:10:20.280
they've just really tapped
into this market.

00:10:20.280 --> 00:10:22.520
They have this intellectual
property, and no one can

00:10:22.520 --> 00:10:23.520
compete with them.

00:10:23.520 --> 00:10:27.810
In 2010 I expect this company
to double every year.

00:10:27.810 --> 00:10:29.910
I expect them to grow
100% every year for

00:10:29.910 --> 00:10:31.020
the next three years.

00:10:31.020 --> 00:10:32.040
And the other person
says, oh fine.

00:10:32.040 --> 00:10:32.350
OK.

00:10:32.350 --> 00:10:33.790
In 2010 if they're going
to double, they're

00:10:33.790 --> 00:10:35.710
going to make $2.

00:10:35.710 --> 00:10:42.290
Well that's still a Price to
Earnings based on 2010 of--

00:10:42.290 --> 00:10:44.980
100 divided by 2 is
50-- you're like,

00:10:44.980 --> 00:10:45.990
that's still expensive.

00:10:45.990 --> 00:10:48.000
That's still way more expensive
than most companies.

00:10:48.000 --> 00:10:50.940
The average Price to Earnings
ratio in the market right now

00:10:50.940 --> 00:10:52.730
I believe is 17 or 18.

00:10:52.730 --> 00:10:55.910
Why would I pay 50 times
2010 earnings?

00:10:55.910 --> 00:10:57.170
I'm really going forward.

00:10:57.170 --> 00:11:00.840
We all know if you've watched
the present value videos,

00:11:00.840 --> 00:11:03.900
money in the future, earnings
in the future are worth less

00:11:03.900 --> 00:11:05.330
than earnings today.

00:11:05.330 --> 00:11:10.020
But you say, no but these guys
are growing so fast in 2011

00:11:10.020 --> 00:11:12.050
they're going to make $4.

00:11:12.050 --> 00:11:13.975
Then all of a sudden the Price
to Earnings ratio is starting

00:11:13.975 --> 00:11:16.430
to look a little bit better.

00:11:16.430 --> 00:11:17.740
25.

00:11:17.740 --> 00:11:20.610
And then you could say, not only
that, but in 2012 I'm so

00:11:20.610 --> 00:11:24.050
confident that these guys have
tapped into this huge market,

00:11:24.050 --> 00:11:25.840
they're going to make
$8 per share.

00:11:25.840 --> 00:11:28.240
They're going to keep doubling
all the way into 2012.

00:11:28.240 --> 00:11:32.430
And now all of a sudden, you're
trading at 12.5 times.

00:11:32.430 --> 00:11:34.880
And then if that growth were to
continue-- and this is an

00:11:34.880 --> 00:11:38.330
important point-- the growth
has to continue.

00:11:38.330 --> 00:11:41.030
You can't just say, oh if
something's growing at 100%

00:11:41.030 --> 00:11:42.960
for one year, I'm willing
to pay 100 times that.

00:11:42.960 --> 00:11:45.960
Because if it grows 100% for one
year, then stops growing,

00:11:45.960 --> 00:11:48.190
there's no way that you would
want to pay 50 times earnings

00:11:48.190 --> 00:11:50.340
for something that's not
growing in the future.

00:11:50.340 --> 00:11:54.230
But if it keeps growing at 100%
per year for 5 years,

00:11:54.230 --> 00:11:56.350
then it actually might
seem interesting.

00:11:56.350 --> 00:12:00.050
So in 2013 you'll
be making $16.

00:12:00.050 --> 00:12:04.240
And then we're looking at a 6
and change Price to Earnings,

00:12:04.240 --> 00:12:06.400
which is downright cheap.

00:12:06.400 --> 00:12:09.280
So the debate on whether you're
willing to pay-- When

00:12:09.280 --> 00:12:12.160
you look at a Price to Earnings
ratio of 100, a lot

00:12:12.160 --> 00:12:13.580
of people have a knee-jerk
reaction.

00:12:13.580 --> 00:12:16.020
They say, that is unbelievably
expensive.

00:12:16.020 --> 00:12:17.370
The market is crazy.

00:12:17.370 --> 00:12:19.250
Why on earth would
anyone pay $100?

00:12:19.250 --> 00:12:21.350
And the reason that they're
paying $100, if they're not

00:12:21.350 --> 00:12:24.480
speculators, and obviously most
people in the market are,

00:12:24.480 --> 00:12:28.080
is that they believe that this
company is growing very fast--

00:12:28.080 --> 00:12:30.000
in this case 100% a year.

00:12:30.000 --> 00:12:32.630
And in order to justify this,
the company has to grow that

00:12:32.630 --> 00:12:34.510
fast for many, many,
many years.

00:12:34.510 --> 00:12:37.920
So in this case maybe at least
five or six years.

00:12:37.920 --> 00:12:40.640
Then all of a sudden this
doesn't seem that crazy.

00:12:40.640 --> 00:12:43.210
For a company that's growing
100% a year for five or six

00:12:43.210 --> 00:12:45.110
years, this is actually
a good deal.

00:12:45.110 --> 00:12:47.730
If it's growing 100% a year for
20 years, this is actually

00:12:47.730 --> 00:12:49.010
a very good deal.

00:12:49.010 --> 00:12:53.060
Obviously a 6 Price to Earnings
of 20 times 2013

00:12:53.060 --> 00:12:57.730
earnings isn't as good as a 6
Price to Earnings of 2010,

00:12:57.730 --> 00:13:00.710
because earnings in the future
aren't worth as much as

00:13:00.710 --> 00:13:01.880
earnings today.

00:13:01.880 --> 00:13:03.730
And you can watch the
present value video.

00:13:03.730 --> 00:13:07.490
But give or take, 100% growth is
much larger than what most

00:13:07.490 --> 00:13:08.430
discount rates would be.

00:13:08.430 --> 00:13:10.400
So this is a good way
to think about it.

00:13:10.400 --> 00:13:14.080
The reason why you are willing
to pay a higher Price to

00:13:14.080 --> 00:13:17.900
Earnings is for growth, and even
more for growth that will

00:13:17.900 --> 00:13:20.220
continue and that you think
has a very high

00:13:20.220 --> 00:13:21.990
likelihood of occurring.

00:13:21.990 --> 00:13:23.740
And then the other reason
is you think

00:13:23.740 --> 00:13:24.790
there's very low risk.

00:13:24.790 --> 00:13:26.730
And we touched on that in the
first video when we talked

00:13:26.730 --> 00:13:28.170
about bank accounts.

00:13:28.170 --> 00:13:30.720
And why someone's willing to
pay a 50 Price to Earnings

00:13:30.720 --> 00:13:32.560
essentially for a
bank account.

00:13:32.560 --> 00:13:35.110
And one last point-- and I'll
just touch on this at the end

00:13:35.110 --> 00:13:35.590
of the video.

00:13:35.590 --> 00:13:37.660
It's a little bit
of technical.

00:13:37.660 --> 00:13:40.460
There's kind of a general rule
of thumb that if a company is

00:13:40.460 --> 00:13:44.080
not doing anything, it's just
stable, safe, not moving up or

00:13:44.080 --> 00:13:50.740
down, that a fair or a cheap
Price to Earnings is 10 times

00:13:50.740 --> 00:13:51.730
this year or last year.

00:13:51.730 --> 00:13:53.890
10 times earnings.

00:13:53.890 --> 00:13:55.850
And you might wonder, where
does that come from?

00:13:55.850 --> 00:13:59.450
Why isn't it 9 times earnings
or 12 times earnings?

00:13:59.450 --> 00:14:00.660
And that's actually a
very good question.

00:14:00.660 --> 00:14:02.110
There's actually no obvious
reason why it

00:14:02.110 --> 00:14:04.200
isn't 9 or 11 or 12.

00:14:04.200 --> 00:14:07.080
It's just 10 because one, this
is a nice round number.

00:14:07.080 --> 00:14:09.450
And also, if you were to take
an earnings stream.

00:14:09.450 --> 00:14:17.510
So if you were to take a company
in 2009, 2010, 2011,

00:14:17.510 --> 00:14:20.560
2012, and just kept going, and
if it had an earnings stream.

00:14:20.560 --> 00:14:22.660
Let's say in every year
it's going to make $1.

00:14:22.660 --> 00:14:24.800
And if you were to discount
this back.

00:14:24.800 --> 00:14:27.100
And you should watch the present
value videos, if this

00:14:27.100 --> 00:14:28.570
makes no sense to you.

00:14:28.570 --> 00:14:30.710
But if you were to present value
this-- let's say they

00:14:30.710 --> 00:14:33.640
make $1 forever going into the
future-- and you were to

00:14:33.640 --> 00:14:36.220
present value this using
a discount rate.

00:14:36.220 --> 00:14:39.350
So 2009 money, that's
worth $1.

00:14:39.350 --> 00:14:41.130
2010 money, you want
to discount it.

00:14:41.130 --> 00:14:45.240
So you want to divide it by,
let's say we use 11% as a

00:14:45.240 --> 00:14:45.960
discount rate.

00:14:45.960 --> 00:14:48.040
And actually, roughly
10 or 11%.

00:14:48.040 --> 00:14:49.880
This is all a little
bit of hand waving.

00:14:49.880 --> 00:14:54.190
So the value of that dollar
would be 1 divided by 1.11.

00:14:54.190 --> 00:14:56.090
I've just added the 11% here.

00:14:56.090 --> 00:15:00.390
The value of that dollar would
be 1 divided by 1.11 squared.

00:15:00.390 --> 00:15:04.810
This dollar would be
1.11 to the third.

00:15:04.810 --> 00:15:07.100
If you were to add up the
present value of that income

00:15:07.100 --> 00:15:12.490
stream, you're going to get
roughly $10 or 10 times the

00:15:12.490 --> 00:15:13.490
earnings stream.

00:15:13.490 --> 00:15:16.360
So that's where it comes from.

00:15:16.360 --> 00:15:18.800
Instead of doing this present
value calculation for

00:15:18.800 --> 00:15:21.190
everything, and there's so much
error involved anyway, in

00:15:21.190 --> 00:15:23.560
terms of just estimating
earnings, people just give a

00:15:23.560 --> 00:15:24.480
rule of thumb.

00:15:24.480 --> 00:15:26.370
But obviously if interest
rates go down, then this

00:15:26.370 --> 00:15:28.480
number will go down, and you
might be able to justify a

00:15:28.480 --> 00:15:29.900
higher Price to Earnings,
but I don't want to

00:15:29.900 --> 00:15:30.850
go there just yet.

00:15:30.850 --> 00:15:33.100
Anyway, see you in
the next video.


ROA discussion 2

WEBVTT
Kind: captions
Language: en

00:00:00.770 --> 00:00:03.400
In the last video, I talk about
how there's multiple

00:00:03.400 --> 00:00:05.340
ways to define return
on asset.

00:00:05.340 --> 00:00:08.690
This is given in some textbooks
and maybe some

00:00:08.690 --> 00:00:11.490
professors would give this in
a finance class: net income

00:00:11.490 --> 00:00:12.600
divided by assets.

00:00:12.600 --> 00:00:15.410
If you look on Wikipedia, they
say it's net income plus

00:00:15.410 --> 00:00:19.030
interest minus tax savings
from interest. So notice,

00:00:19.030 --> 00:00:21.270
they're not adding back
all of the taxes.

00:00:21.270 --> 00:00:24.440
They're still taking taxes
into consideration, but

00:00:24.440 --> 00:00:26.350
they're saying you're not
getting any tax deduction from

00:00:26.350 --> 00:00:28.770
your interest. So we'll talk
about that in a second.

00:00:28.770 --> 00:00:30.860
So this kind of still does
factor in taxes.

00:00:30.860 --> 00:00:33.400
This one definitely does
and interest as well.

00:00:33.400 --> 00:00:35.280
And then there are these
two other ones.

00:00:35.280 --> 00:00:38.340
One was operating profit divided
by asset, which is

00:00:38.340 --> 00:00:39.500
what I gave in the
first video.

00:00:39.500 --> 00:00:42.070
It really just is kind of a
simplifying assumption and

00:00:42.070 --> 00:00:44.190
really to give you the intuition
in my mind of what

00:00:44.190 --> 00:00:48.560
ROA really is about, of how good
is a company at operating

00:00:48.560 --> 00:00:51.280
its assets, at actually getting
a return from them.

00:00:51.280 --> 00:00:55.090
And then a slightly more general
definition would be

00:00:55.090 --> 00:00:58.020
EBIT divided by assets. and we
talk about the fact that EBIT

00:00:58.020 --> 00:01:01.730
is just net income plus interest
plus taxes, or

00:01:01.730 --> 00:01:05.160
another way to think about it,
it's operating profit plus

00:01:05.160 --> 00:01:09.010
non-operating profit. so any
other type of profit that the

00:01:09.010 --> 00:01:12.880
company might have gotten from
some assets that it owns that

00:01:12.880 --> 00:01:14.990
actually aren't essential
to actually

00:01:14.990 --> 00:01:16.200
managing the business.

00:01:16.200 --> 00:01:18.840
But then in the last part of
the video, I talk about you

00:01:18.840 --> 00:01:21.610
have these definitions out here,
but I don't like using

00:01:21.610 --> 00:01:24.100
them as much, and then I ran
out of time, and I said I

00:01:24.100 --> 00:01:27.090
would cover in this video why I
don't like using it as much.

00:01:27.090 --> 00:01:30.510
I think the best way to talk
about it is with an example.

00:01:30.510 --> 00:01:32.095
So let's say I have
two companies.

00:01:40.230 --> 00:01:43.600
I want to do thicker lines.

00:01:43.600 --> 00:01:46.100
So I have one company here.

00:01:46.100 --> 00:01:49.050
Say they have the same
amount of assets.

00:01:49.050 --> 00:01:51.290
That's one company, and then
this is the other company

00:01:51.290 --> 00:01:53.140
right here, and I'm drawing the
left-hand side of their

00:01:53.140 --> 00:01:55.600
balance sheets.

00:01:55.600 --> 00:01:56.850
These are the assets.

00:02:02.790 --> 00:02:07.840
Now let's say that they're the
same amount, so they have $10

00:02:07.840 --> 00:02:11.230
million of assets.

00:02:11.230 --> 00:02:17.620
And let's say that these are the
actual ROA's as the way I

00:02:17.620 --> 00:02:18.760
calculated them.

00:02:18.760 --> 00:02:23.980
So this is your EBIT divided
by total assets.

00:02:23.980 --> 00:02:28.230
So if EBIT is 10% of this, that
means that this guy is

00:02:28.230 --> 00:02:36.850
spitting out 10%, which would
be $1 million of EBIT.

00:02:36.850 --> 00:02:39.840
And in a world where there's no
non-operating profit, this

00:02:39.840 --> 00:02:41.930
you could view as operating
profit.

00:02:41.930 --> 00:02:44.530
Remember, EBIT is just
Earnings Before

00:02:44.530 --> 00:02:46.450
Interest and Taxes.

00:02:46.450 --> 00:02:48.300
Let's go back to that income
statement that

00:02:48.300 --> 00:02:49.340
we started off with.

00:02:49.340 --> 00:02:53.720
EBIT is Earnings Before
Interest and Taxes.

00:02:53.720 --> 00:02:56.800
So if you add back interest and
taxes, you essentially get

00:02:56.800 --> 00:02:59.310
back to operating profit unless
there's a little bit of

00:02:59.310 --> 00:03:01.510
non-operating profit
right here.

00:03:01.510 --> 00:03:03.320
So that's the way to
think about EBIT.

00:03:03.320 --> 00:03:05.170
For most functional purposes,
unless you're talking about

00:03:05.170 --> 00:03:07.080
like a financial statement, most
firms that aren't doing

00:03:07.080 --> 00:03:09.160
anything too fancy on their
non-operating side of their

00:03:09.160 --> 00:03:11.770
balance sheet, EBIT and
operating profit are pretty

00:03:11.770 --> 00:03:13.060
close to each other.

00:03:13.060 --> 00:03:15.500
But anyway, in this case
this guy's generating

00:03:15.500 --> 00:03:17.690
$1 million of EBIT.

00:03:17.690 --> 00:03:21.150
And let's say that this company,
Company B-- we'll

00:03:21.150 --> 00:03:24.340
label these as Company
A, this is Company B.

00:03:24.340 --> 00:03:32.470
Company B, it's getting a 15%
EBIT return on its assets, so

00:03:32.470 --> 00:03:38.490
it's generating $1.5 million
in EBIT per year.

00:03:38.490 --> 00:03:41.470
So just when I look at the
left-hand sides of the balance

00:03:41.470 --> 00:03:43.940
sheet-- I haven't drawn the
right-hand side yet-- I would

00:03:43.940 --> 00:03:47.670
say that this guy is a better
manager of these assets.

00:03:47.670 --> 00:03:50.450
He's better at extracting value,
given the amount of

00:03:50.450 --> 00:03:53.410
capital that has been put
into this company.

00:03:53.410 --> 00:03:57.430
So that's why I like the
definition of EBIT divided by

00:03:57.430 --> 00:04:02.000
assets, or operating profit
divided by assets.

00:04:02.000 --> 00:04:07.580
Now, let's give a situation
where this guy

00:04:07.580 --> 00:04:08.920
has very little debt.

00:04:12.210 --> 00:04:16.350
Let's say he has no debt and
he has all equity, so the

00:04:16.350 --> 00:04:19.110
right-hand side of his balance
sheet looks like this.

00:04:19.110 --> 00:04:22.460
Let's say he has no liabilities
of significance.

00:04:28.800 --> 00:04:29.910
He has no liabilities
of significance,

00:04:29.910 --> 00:04:31.160
so this is all equity.

00:04:34.370 --> 00:04:39.680
So when you want to figure out
this guy's pre-tax income, you

00:04:39.680 --> 00:04:44.480
take EBIT minus-- actually, let
me move the window down a

00:04:44.480 --> 00:04:45.470
little bit.

00:04:45.470 --> 00:04:49.880
You take EBIT minus interest
to get pre-tax.

00:04:49.880 --> 00:04:51.960
So how much pre-tax
does he have?

00:04:51.960 --> 00:04:53.340
Pre-tax earnings?

00:04:53.340 --> 00:04:55.580
Well, he has no debt, right?

00:04:55.580 --> 00:04:59.420
So he has no interest. So his
pre-tax earnings, or you can

00:04:59.420 --> 00:05:03.060
call it, which no one else ever
does, is EBT, which you

00:05:03.060 --> 00:05:05.290
don't want to say because it
sounds like EBIT, but Earnings

00:05:05.290 --> 00:05:06.400
Before Taxes.

00:05:06.400 --> 00:05:07.420
No one ever says EBT.

00:05:07.420 --> 00:05:09.110
They always say pre-tax.

00:05:09.110 --> 00:05:12.720
But that would also
be $1 million.

00:05:12.720 --> 00:05:15.830
And then if you go even further,
and you say, this guy

00:05:15.830 --> 00:05:19.840
for some reason, he had a bunch
of tax credits this year

00:05:19.840 --> 00:05:24.090
or he had some losses last
year that he was able to

00:05:24.090 --> 00:05:26.370
offset to use against his taxes,
so this year, he also

00:05:26.370 --> 00:05:28.570
didn't have to pay any taxes.

00:05:28.570 --> 00:05:36.200
So his earnings or his net
income is also $1 million.

00:05:36.200 --> 00:05:37.440
Fair enough.

00:05:37.440 --> 00:05:44.530
So this guy has a 10% EBIT
return on his assets, but his

00:05:44.530 --> 00:05:47.110
earnings or his net income
is also this $1 million.

00:05:47.110 --> 00:05:49.790
Now let's say this guy over
here, he has a little bit more

00:05:49.790 --> 00:05:52.100
debt on his balance sheet.

00:05:52.100 --> 00:05:54.380
Let's say it's similar to the
first example we did, so let

00:05:54.380 --> 00:05:56.090
me draw that.

00:05:56.090 --> 00:06:02.600
So let's say he has $5
million of debt.

00:06:02.600 --> 00:06:04.340
But the amount isn't
necessarily the

00:06:04.340 --> 00:06:05.000
most important thing.

00:06:05.000 --> 00:06:07.780
So he has $5 million of
debt or liabilities.

00:06:07.780 --> 00:06:09.940
Liabilities could be other
things as well.

00:06:09.940 --> 00:06:12.370
It could be he owes pension
liabilities or

00:06:12.370 --> 00:06:13.740
who knows what else.

00:06:13.740 --> 00:06:15.670
So he has $5 million of debt,
but the important thing is he

00:06:15.670 --> 00:06:18.790
has interest. So every year,
let's say he has to pay

00:06:18.790 --> 00:06:22.570
$500,000 in interest.
He's paying 10%

00:06:22.570 --> 00:06:24.010
interest on his debt.

00:06:24.010 --> 00:06:26.340
10% of $5 million is $500,000.

00:06:26.340 --> 00:06:30.865
So his pre-tax-- let's do the
bottom part of his balance

00:06:30.865 --> 00:06:36.550
sheet-- his EBIT, his Earnings
Before Interest and Taxes, is

00:06:36.550 --> 00:06:42.680
$1.5 million, but then if you
want to subtract out interest,

00:06:42.680 --> 00:06:48.230
you'd subtract out minus $0.5
million, $500,000, and so his

00:06:48.230 --> 00:06:55.940
pre-tax is going to
be $1 million.

00:06:55.940 --> 00:06:59.770
And now this guy also-- so
essentially the equity holder

00:06:59.770 --> 00:07:01.420
before paying tax --this
is equity here.

00:07:01.420 --> 00:07:04.140
He has $5 million of equity.

00:07:04.140 --> 00:07:06.230
This guy had $10 million
right here.

00:07:06.230 --> 00:07:07.670
And this is pre-tax.

00:07:07.670 --> 00:07:10.800
He has to pay the 30% like we
did in the previous example.

00:07:10.800 --> 00:07:13.270
He has to pay 30% on taxes.

00:07:13.270 --> 00:07:19.500
So his net income will
be $700,000, right?

00:07:19.500 --> 00:07:21.490
Because he has $1 million
pre-tax, he has to pay

00:07:21.490 --> 00:07:25.900
$300,000 in taxes, so he has
a $700,000 net income.

00:07:25.900 --> 00:07:30.130
Now, let's look at what we would
get in terms of an ROA

00:07:30.130 --> 00:07:34.340
if we did it using this
definition that some textbooks

00:07:34.340 --> 00:07:35.790
will give you.

00:07:35.790 --> 00:07:40.200
For the first guy, his net
earnings are $1 million and

00:07:40.200 --> 00:07:42.760
his assets were $10 million.

00:07:42.760 --> 00:07:50.760
So by this definition up here,
Company A has a 10% ROA.

00:07:50.760 --> 00:07:54.140
By that definition over here,
this guy made $700,000 of net

00:07:54.140 --> 00:07:58.620
income off of $10 million, so
he is going to be making an

00:07:58.620 --> 00:08:03.800
ROA of what? $700,000
divided by 10 is 7%.

00:08:03.800 --> 00:08:06.000
So now if you just look
superficially at these numbers

00:08:06.000 --> 00:08:10.070
as defined by this ratio right
here, you'll say, oh, this

00:08:10.070 --> 00:08:12.610
guy, Company A, has a better
return on asset.

00:08:12.610 --> 00:08:15.030
He's better at managing
his assets.

00:08:15.030 --> 00:08:17.330
And you know that that's
completely false.

00:08:17.330 --> 00:08:20.660
Company A was getting
a much lower EBIT

00:08:20.660 --> 00:08:21.630
return on his assets.

00:08:21.630 --> 00:08:22.790
He was only getting 10%.

00:08:22.790 --> 00:08:24.610
This guy was getting 15%.

00:08:24.610 --> 00:08:27.960
Company A was just better at,
one, it didn't have any debt,

00:08:27.960 --> 00:08:31.140
and it was also better at
maybe this year avoiding

00:08:31.140 --> 00:08:32.230
paying taxes.

00:08:32.230 --> 00:08:36.030
So when you talk about ROA,
there are other ratios that

00:08:36.030 --> 00:08:41.159
start factoring in how good is
a company at financing its

00:08:41.159 --> 00:08:44.990
assets and how good is a
company at paying taxes

00:08:44.990 --> 00:08:47.800
efficiently, which is just
another way of evading as many

00:08:47.800 --> 00:08:49.510
taxes as possible.

00:08:49.510 --> 00:08:51.020
But that's a separate ratio.

00:08:51.020 --> 00:08:54.940
Return on asset to me says, what
does a company do with

00:08:54.940 --> 00:08:56.770
the left-hand side of
the balance sheet?

00:08:56.770 --> 00:09:00.280
And when you do the net income
version, you're factoring

00:09:00.280 --> 00:09:02.760
things in like interest and
taxes, and then you're

00:09:02.760 --> 00:09:04.320
muddying up the picture.

00:09:04.320 --> 00:09:07.950
You're not telling me which
company is better at actually

00:09:07.950 --> 00:09:11.070
giving a return just on its
assets, not how it actually

00:09:11.070 --> 00:09:13.430
pays for its assets.

00:09:13.430 --> 00:09:16.740
This definition that Wikipedia
gives-- and it's good to be

00:09:16.740 --> 00:09:18.470
aware of all of them, because
I don't want you to watch

00:09:18.470 --> 00:09:19.840
these videos and say, oh, no.

00:09:19.840 --> 00:09:22.860
Sal said it's operating profit
divided by asset, or EBIT

00:09:22.860 --> 00:09:23.900
divided by asset.

00:09:23.900 --> 00:09:26.830
It's good to know these so that
these aren't unfamiliar

00:09:26.830 --> 00:09:27.600
terms to you.

00:09:27.600 --> 00:09:32.420
What I'm telling you is that
this definition is more of a

00:09:32.420 --> 00:09:36.130
real intuitive sense of what
a company's doing with its

00:09:36.130 --> 00:09:38.930
assets, while these are kind
of textbook definitions.

00:09:38.930 --> 00:09:42.950
This one attempts to add back
interest. It adds back

00:09:42.950 --> 00:09:47.620
interest, so just the interest
part between this company and

00:09:47.620 --> 00:09:50.800
this company won't differentiate
between the two.

00:09:50.800 --> 00:09:54.490
But this one does take into
account which company is good

00:09:54.490 --> 00:09:56.210
or bad at paying taxes.

00:09:56.210 --> 00:09:57.660
And I realize I'm out of time.

00:09:57.660 --> 00:09:59.780
In the next video, maybe I'll
talk a little bit more in

00:09:59.780 --> 00:10:03.000
depth about the tax savings from
interest, because it's an

00:10:03.000 --> 00:10:04.240
interesting concept
right there.

00:10:04.240 --> 00:10:06.110
But I think I'm getting a little
bit into the weeds now,

00:10:06.110 --> 00:10:08.550
because I want to kind of get
back high level and give you

00:10:08.550 --> 00:10:11.080
an overarching view of how you
can think about investments

00:10:11.080 --> 00:10:12.490
and price to earnings
and whatever else.

00:10:12.490 --> 00:10:14.780
I'll focus back on that
on the next video.

00:10:14.780 --> 00:10:16.200
See you soon.


ROA discussion 1

WEBVTT
Kind: captions
Language: en

00:00:00.850 --> 00:00:06.270
One of the viewers pointed out
not incorrectly that one

00:00:06.270 --> 00:00:09.310
definition of return on asset--
so this whole video's

00:00:09.310 --> 00:00:12.670
going to be on return on asset--
that one definition of

00:00:12.670 --> 00:00:15.390
return on asset, and if you
look it up on some of the

00:00:15.390 --> 00:00:19.420
finance sites or even some
finance textbooks, they'll

00:00:19.420 --> 00:00:27.220
tell you it's net income
over total assets.

00:00:27.220 --> 00:00:29.310
Which is different from
what I told you.

00:00:29.310 --> 00:00:32.380
And other sources, namely
Wikipedia, will tell you that

00:00:32.380 --> 00:00:34.460
it is actually-- so this
is one definition

00:00:34.460 --> 00:00:35.690
of return on asset.

00:00:35.690 --> 00:00:38.760
Another definition
is net income.

00:00:38.760 --> 00:00:41.800
I'll just abbreviate
that as NI.

00:00:41.800 --> 00:00:46.500
Net income plus interest. So
they're adding back your

00:00:46.500 --> 00:00:51.450
interest. And then they're
subtracting out the tax

00:00:51.450 --> 00:01:01.560
savings due to interest.

00:01:01.560 --> 00:01:04.950
And we could a whole video on
the tax savings from interest.

00:01:04.950 --> 00:01:08.540
And when it makes more sense
to raise money with debt

00:01:08.540 --> 00:01:11.130
versus equity, because of the
cost of interest. But that

00:01:11.130 --> 00:01:13.880
also increases your chance
of bankruptcy, the more

00:01:13.880 --> 00:01:14.830
debt you take on.

00:01:14.830 --> 00:01:16.630
We could do a series
of videos on that.

00:01:16.630 --> 00:01:21.460
But tax savings from interest.
Divided by assets.

00:01:21.460 --> 00:01:24.090
This is a definition that
Wikipedia gives you.

00:01:24.090 --> 00:01:28.810
And then the very first
definition I gave you was

00:01:28.810 --> 00:01:36.810
operating profit over assets.

00:01:36.810 --> 00:01:40.090
And then I'll add one more
definition to this video, just

00:01:40.090 --> 00:01:41.540
because I think it's worth
talking about.

00:01:41.540 --> 00:01:44.310
And I think this is kind of a
general theme in finance, is

00:01:44.310 --> 00:01:46.490
that there's all these
formulas for things.

00:01:46.490 --> 00:01:49.100
And people memorize them.

00:01:49.100 --> 00:01:52.220
But in the process, you lose
a lot of the intuition.

00:01:52.220 --> 00:01:53.740
And it's also important to
realize that there are

00:01:53.740 --> 00:01:56.690
multiple ways of defining the
exact same terms. So people

00:01:56.690 --> 00:01:59.360
can confidently say
the ROA is this.

00:01:59.360 --> 00:02:00.045
And you know what?

00:02:00.045 --> 00:02:01.880
It's never a bad question
to ask them what

00:02:01.880 --> 00:02:03.060
they mean by ROA.

00:02:03.060 --> 00:02:05.320
And I think you'll also be
surprised by how many people

00:02:05.320 --> 00:02:07.890
won't be able to tell you
what they mean by ROA.

00:02:07.890 --> 00:02:10.580
But then the last one, if I have
time to go over, we'll

00:02:10.580 --> 00:02:12.350
call it EBIT.

00:02:12.350 --> 00:02:14.190
I know that look like
a very strange word.

00:02:14.190 --> 00:02:16.610
EBIT divided by assets.

00:02:16.610 --> 00:02:20.190
But just so you know what EBIT
is, EBIT is just Earnings

00:02:20.190 --> 00:02:22.580
Before Interest and Taxes.

00:02:22.580 --> 00:02:30.920
So this is just the same thing
as net income plus interest

00:02:30.920 --> 00:02:33.260
plus taxes.

00:02:33.260 --> 00:02:38.810
So it's kind of a pre-tax
ROA divided by assets.

00:02:38.810 --> 00:02:40.090
So these are all different
things.

00:02:40.090 --> 00:02:42.890
And you might already say, wait
if I took net income--

00:02:42.890 --> 00:02:44.500
let's actually talk about
this for a second.

00:02:44.500 --> 00:02:46.950
Let's compare EBIT to
operating profit.

00:02:46.950 --> 00:02:52.480
You might immediately say, if
I took net income-- so let's

00:02:52.480 --> 00:02:57.560
remember EBIT is just an acronym
for Earnings Before

00:02:57.560 --> 00:02:59.440
Interest and Taxes.

00:02:59.440 --> 00:02:59.970
So let's see.

00:02:59.970 --> 00:03:03.030
If our earnings are $350,000.

00:03:03.030 --> 00:03:06.280
And we were to add back the
taxes and the interest. So we

00:03:06.280 --> 00:03:09.030
add back the taxes, which
gets us to pre-tax.

00:03:09.030 --> 00:03:13.020
And we add back the interest,
at least in this example, we

00:03:13.020 --> 00:03:15.240
get to an operating
profit number.

00:03:15.240 --> 00:03:19.390
So you might say, why is there
a different term EBIT instead

00:03:19.390 --> 00:03:23.120
of, why don't people just always
use operating profit?

00:03:23.120 --> 00:03:25.960
And the reason why there's a
different term is, sometimes

00:03:25.960 --> 00:03:28.990
you can have the non-operating
profit.

00:03:28.990 --> 00:03:32.780
So let's say that out of this
$10 million of assets-- and I

00:03:32.780 --> 00:03:34.820
didn't go there in the first
example because I didn't

00:03:34.820 --> 00:03:37.050
really want to complicate the
issue, but I'll complicate the

00:03:37.050 --> 00:03:38.400
issue a little bit now.

00:03:38.400 --> 00:03:42.390
Let's say out of this $10
million of assets, let's say

00:03:42.390 --> 00:03:47.610
that $9 million are
operating assets.

00:03:47.610 --> 00:03:49.070
They're the enterprise.

00:03:49.070 --> 00:03:51.960
They're the things that are
needed to generate the

00:03:51.960 --> 00:03:53.690
operating profit.

00:03:53.690 --> 00:03:55.850
And then you had another
$1 million of

00:03:55.850 --> 00:03:58.360
assets of this $10 million.

00:03:58.360 --> 00:04:01.870
That the company really doesn't
need to operate.

00:04:01.870 --> 00:04:03.100
They just have it around.

00:04:03.100 --> 00:04:05.500
Maybe they're speculating
on oil prices.

00:04:05.500 --> 00:04:06.960
Or they're just hedging
something.

00:04:06.960 --> 00:04:10.800
Or they just have a super
flush bank account.

00:04:10.800 --> 00:04:13.610
So these assets might
be generating

00:04:13.610 --> 00:04:15.150
non-operating income.

00:04:15.150 --> 00:04:19.230
So you could have a line here
for interest income or

00:04:19.230 --> 00:04:20.200
investment income.

00:04:20.200 --> 00:04:20.670
Let me put that.

00:04:20.670 --> 00:04:23.300
Investment income.

00:04:23.300 --> 00:04:26.380
And then the company might have
made some money there.

00:04:26.380 --> 00:04:30.260
It might make $10,000 on
investment income.

00:04:30.260 --> 00:04:32.210
And of course that'll
drop to this line.

00:04:32.210 --> 00:04:34.360
This'll then become $510,000.

00:04:34.360 --> 00:04:36.790
The taxes will be $153,000.

00:04:36.790 --> 00:04:47.020
And the net income
is $357,000.

00:04:47.020 --> 00:04:48.620
Because we have a
30% tax rate.

00:04:48.620 --> 00:04:49.430
And that make sense, right?

00:04:49.430 --> 00:04:52.450
I added an extra $10,000
of income here.

00:04:52.450 --> 00:04:54.300
And then at the end of the day,
you're going to tax at

00:04:54.300 --> 00:04:57.440
30%, so this should be $7,000
more of earnings.

00:04:57.440 --> 00:04:59.690
So that makes sense. $357,000.

00:04:59.690 --> 00:05:01.370
But this is the difference
between

00:05:01.370 --> 00:05:03.420
operating income and EBIT.

00:05:03.420 --> 00:05:07.490
EBIT in this case would be the
operating profit plus this

00:05:07.490 --> 00:05:08.360
investment income.

00:05:08.360 --> 00:05:11.490
So EBIT, in the case that I
just added some investment

00:05:11.490 --> 00:05:19.600
income, would be $1,010,000,
while operating profit would

00:05:19.600 --> 00:05:21.350
be $1 million.

00:05:21.350 --> 00:05:23.150
I didn't want to go there in
the first video, and that's

00:05:23.150 --> 00:05:26.600
why I just said operating profit
divided by assets.

00:05:26.600 --> 00:05:29.910
But if you really consider all
of the assets, and if you

00:05:29.910 --> 00:05:31.740
assume that there are some
assets there that are

00:05:31.740 --> 00:05:33.420
non-operating.

00:05:33.420 --> 00:05:36.080
They're not really used to
make widgets, or to sell

00:05:36.080 --> 00:05:41.770
widgets or market widgets, or
help the CEO in any way do his

00:05:41.770 --> 00:05:43.040
or her job.

00:05:43.040 --> 00:05:45.990
Then whatever this generates
is actually

00:05:45.990 --> 00:05:47.390
non-operating income.

00:05:47.390 --> 00:05:49.290
And so EBIT factors that in.

00:05:49.290 --> 00:05:51.250
So EBIT, I kind of view that
it goes backwards.

00:05:51.250 --> 00:05:53.090
It starts with net income.

00:05:53.090 --> 00:05:55.840
And then it adds back the taxes
and interest. While

00:05:55.840 --> 00:05:59.680
operating profit, you start at
the top line and you go down.

00:05:59.680 --> 00:06:03.710
But in general if you take
EBIT and you take out the

00:06:03.710 --> 00:06:06.550
non-operating income, you get
back to operating profits.

00:06:06.550 --> 00:06:09.480
So that's what EBIT
is right here.

00:06:09.480 --> 00:06:13.950
And so you can already imagine
that both EBIT and the way I

00:06:13.950 --> 00:06:15.400
defined it initially, operating

00:06:15.400 --> 00:06:17.040
profit divided by assets.

00:06:17.040 --> 00:06:20.120
They're ways of saying, before
you consider taxes, what are

00:06:20.120 --> 00:06:21.930
your assets doing for you?

00:06:21.930 --> 00:06:23.980
So once again, if this is a
balance sheet, this is the

00:06:23.980 --> 00:06:26.590
assets, here are your
liabilities.

00:06:26.590 --> 00:06:27.620
Debt could be one of them.

00:06:27.620 --> 00:06:31.220
But in general it could be
a bunch of other things.

00:06:31.220 --> 00:06:33.270
You might owe other vendors
money or whatever.

00:06:33.270 --> 00:06:35.810
Then you have your equity.

00:06:35.810 --> 00:06:37.100
It's important whenever
you talk about

00:06:37.100 --> 00:06:38.520
any of these ratios.

00:06:38.520 --> 00:06:39.220
What context?

00:06:39.220 --> 00:06:41.640
Are you trying to pass the CFA
exam, or are you trying to

00:06:41.640 --> 00:06:43.680
impress your MBA professor?

00:06:43.680 --> 00:06:46.010
Or are you trying to get an
intuition for helping to

00:06:46.010 --> 00:06:47.600
become a better investor?

00:06:47.600 --> 00:06:50.975
And if you are an investor,
you're probably going to want

00:06:50.975 --> 00:06:52.560
to do the last of the three.

00:06:52.560 --> 00:06:56.320
And there, ROA, the Return on
Assets is telling you, how

00:06:56.320 --> 00:06:59.910
good is this company at getting
a return out of this

00:06:59.910 --> 00:07:01.290
thing right here?

00:07:01.290 --> 00:07:04.590
I don't care how they paid for
it, whether they had debt.

00:07:04.590 --> 00:07:06.930
I don't want to think
about, are they good

00:07:06.930 --> 00:07:07.940
at getting low interest?

00:07:07.940 --> 00:07:10.760
I don't want to think about, is
their CFO good at getting a

00:07:10.760 --> 00:07:12.770
better interest rate
than another CFO?

00:07:12.770 --> 00:07:16.160
Or are they better at evading
taxes than another company?

00:07:16.160 --> 00:07:20.950
All I care is the assets that
they have, how good are they

00:07:20.950 --> 00:07:22.540
at putting those
assets to work?

00:07:22.540 --> 00:07:24.800
And what type of a return
can they get?

00:07:24.800 --> 00:07:30.270
So if I calculate it using you
EBIT divided by assets, or

00:07:30.270 --> 00:07:34.960
operating profit divided by
assets, if I use either of

00:07:34.960 --> 00:07:40.600
these as my metric for ROA and
Company A has a 10% ROA and

00:07:40.600 --> 00:07:45.100
Company B has a 15% ROA, then
I say, you know what?

00:07:45.100 --> 00:07:48.120
I don't care whether B's guy
is better at getting a low

00:07:48.120 --> 00:07:48.950
interest rate.

00:07:48.950 --> 00:07:52.970
Or getting some type of tax
handout from the government.

00:07:52.970 --> 00:07:56.080
Or doing something fancy
with where he keeps his

00:07:56.080 --> 00:07:56.970
subsidiaries.

00:07:56.970 --> 00:08:00.120
I just want to know which
management is better at

00:08:00.120 --> 00:08:02.030
getting a return out
of these assets.

00:08:02.030 --> 00:08:04.650
And these metrics will
tell you that.

00:08:04.650 --> 00:08:06.660
Because it tells you either how
much operating profit is

00:08:06.660 --> 00:08:09.340
being generated from here,
or it could tell

00:08:09.340 --> 00:08:10.350
you how much EBIT.

00:08:10.350 --> 00:08:13.390
In this case, an EBIT might be a
little bit more informative.

00:08:13.390 --> 00:08:16.480
Because some of income might
be generated from

00:08:16.480 --> 00:08:17.980
non-operating assets.

00:08:17.980 --> 00:08:22.410
So maybe the company holds some
stock, or it holds some

00:08:22.410 --> 00:08:23.370
gold or something.

00:08:23.370 --> 00:08:26.040
Or it holds some forward
contracts to hedge its

00:08:26.040 --> 00:08:28.720
exposure to oil or foreign
currency or something.

00:08:28.720 --> 00:08:32.299
So in general if you want to
know what I think is the best

00:08:32.299 --> 00:08:36.760
ROA, I would say it's EBIT over
assets, which is very

00:08:36.760 --> 00:08:39.950
close to operating profit
over assets.

00:08:39.950 --> 00:08:43.909
And now you say, well Sal, why
are these other things here?

00:08:43.909 --> 00:08:46.170
And why don't you like
them as much?

00:08:46.170 --> 00:08:50.460
Well, net income over assets,
I think the reason why that

00:08:50.460 --> 00:08:56.440
definition exists is because:
one, net income does factor

00:08:56.440 --> 00:08:58.620
into these things that frankly
I didn't want to

00:08:58.620 --> 00:08:59.670
think as much about.

00:08:59.670 --> 00:09:05.360
But when you talk about return,
what you get off the

00:09:05.360 --> 00:09:07.640
asset, you still are going
to pay taxes on them.

00:09:07.640 --> 00:09:10.760
And if you do have some
financing, you will be paying

00:09:10.760 --> 00:09:12.150
some interest on that.

00:09:12.150 --> 00:09:13.620
So that's why this comes out.

00:09:13.620 --> 00:09:16.440
Where they actually just
take the bottom line.

00:09:16.440 --> 00:09:19.410
When people talk about top line
and bottom line, now you

00:09:19.410 --> 00:09:20.410
know where those words
come from.

00:09:20.410 --> 00:09:21.790
Top line is revenue.

00:09:21.790 --> 00:09:23.730
It's the top line of the
income statement.

00:09:23.730 --> 00:09:26.430
And your bottom line, that's
the bottom line

00:09:26.430 --> 00:09:27.310
of the income statement.

00:09:27.310 --> 00:09:28.820
That's where the word
comes from.

00:09:28.820 --> 00:09:31.250
So that one definition takes
this and they divide by the

00:09:31.250 --> 00:09:32.250
total assets.

00:09:32.250 --> 00:09:40.380
But the reason why I don't like
that is this definition

00:09:40.380 --> 00:09:44.320
does not separate out that one
company might be better at

00:09:44.320 --> 00:09:46.380
evading taxes or paying taxes.

00:09:46.380 --> 00:09:50.660
And another company might be
better at somehow getting

00:09:50.660 --> 00:09:52.090
better financing
from the bank.

00:09:52.090 --> 00:09:53.240
And that's not what matters.

00:09:53.240 --> 00:09:55.150
I care about the assets.

00:09:55.150 --> 00:09:56.770
I care just about the
left-hand side

00:09:56.770 --> 00:09:57.670
of the balance sheet.

00:09:57.670 --> 00:10:00.530
While this is taking into
consideration some of the

00:10:00.530 --> 00:10:02.870
factors on that side of
the balance sheet.

00:10:02.870 --> 00:10:07.770
For example, let's say you have
two identical companies.

00:10:07.770 --> 00:10:10.190
This could be an interesting
example.

00:10:10.190 --> 00:10:16.250
You have one company-- Actually
I just realized I'm

00:10:16.250 --> 00:10:16.600
out of time.

00:10:16.600 --> 00:10:19.200
I'll continue the example in
the next video, and I'll

00:10:19.200 --> 00:10:28.060
explain a little bit about the
tax savings from carrying debt

00:10:28.060 --> 00:10:30.690
or interest. See you
in the next video.


Introduction to the price-to-earnings ratio

WEBVTT
Kind: captions
Language: en

00:00:01.000 --> 00:00:04.810
My son has been successfully
subdued, so I think this is a

00:00:04.810 --> 00:00:08.474
good time to learn about the
Price to Earnings ratio.

00:00:17.030 --> 00:00:19.800
And a lot of times you'll
hear people talk about

00:00:19.800 --> 00:00:23.400
a stock's P/E Ratio.

00:00:23.400 --> 00:00:24.530
And it's all the same thing.

00:00:24.530 --> 00:00:26.560
It's just a faster
way of saying

00:00:26.560 --> 00:00:28.300
Price to Earnings ratio.

00:00:28.300 --> 00:00:31.720
So let's think about the Price
to Earnings ratio of the

00:00:31.720 --> 00:00:36.100
company in question, this widget
case study, I guess you

00:00:36.100 --> 00:00:37.350
could call it, that we've
been dealing with.

00:00:37.350 --> 00:00:40.370
Let's say that the market
value-- we talked before that

00:00:40.370 --> 00:00:44.170
the book value per share
of this company is $5.

00:00:44.170 --> 00:00:47.590
Because the book value of its
equity is $5 million.

00:00:47.590 --> 00:00:50.060
And there's 1 million shares.

00:00:50.060 --> 00:00:52.890
So 5 million divided
by 1 million is $5.

00:00:52.890 --> 00:00:55.860
But let's say that the market
price, let's say that this is

00:00:55.860 --> 00:01:00.800
Widgets Inc. and let's say
that its ticker symbol is

00:01:00.800 --> 00:01:12.500
WINC, for Widgets Inc. And its
price is, it's trading at--

00:01:12.500 --> 00:01:14.140
let me make up a good
number-- let's say

00:01:14.140 --> 00:01:22.640
it's trading at $3.50.

00:01:22.640 --> 00:01:24.970
And then we learned in the first
video that a price by

00:01:24.970 --> 00:01:27.170
itself doesn't tell
us a whole lot.

00:01:27.170 --> 00:01:28.700
So how may shares are there?

00:01:28.700 --> 00:01:30.305
We know there's a
million shares.

00:01:34.780 --> 00:01:38.602
So the market cap, or what the
market perceives the value of

00:01:38.602 --> 00:01:41.380
this equity is, the market
capitalization,

00:01:41.380 --> 00:01:43.100
is these two numbers.

00:01:43.100 --> 00:01:45.130
If we have a million shares,
then each of them, the market

00:01:45.130 --> 00:01:50.450
is saying, is worth $3.50, then
the equity of the company

00:01:50.450 --> 00:01:54.230
is worth $3.5 million.

00:02:02.680 --> 00:02:06.550
And this is the market value of
the equity, what the market

00:02:06.550 --> 00:02:07.610
thinks the equity's worth.

00:02:07.610 --> 00:02:09.699
So this is interesting.

00:02:09.699 --> 00:02:13.500
In our case, the book value of
the equity was $5 million.

00:02:13.500 --> 00:02:16.230
But the market is saying, no,
no, I don't necessarily

00:02:16.230 --> 00:02:17.680
believe those accountants.

00:02:17.680 --> 00:02:19.810
Maybe they're throwing some
stuff in here that's not

00:02:19.810 --> 00:02:20.720
really there.

00:02:20.720 --> 00:02:26.350
So we say it's only worth
$3.5 million.

00:02:26.350 --> 00:02:30.010
In this case, the company's
trading at a discount to its

00:02:30.010 --> 00:02:30.970
book value.

00:02:30.970 --> 00:02:34.060
And I won't go into detail on
that now, but that's actually

00:02:34.060 --> 00:02:37.970
a fairly unusual circumstance,
unless people are very

00:02:37.970 --> 00:02:41.040
suspicious about the accounting
or the actual book

00:02:41.040 --> 00:02:41.960
value of the company.

00:02:41.960 --> 00:02:49.970
Or if they think that this is
just a kind of an asset with a

00:02:49.970 --> 00:02:52.040
useful life that has
been shortened.

00:02:52.040 --> 00:02:55.060
If you owned a bunch of video
stores, then all of a sudden

00:02:55.060 --> 00:02:57.390
you say, I have $10 million of
video stores, and then the

00:02:57.390 --> 00:03:00.950
next day someone makes on-demand
videos there, all of

00:03:00.950 --> 00:03:03.040
a sudden, maybe your assets
aren't worth what you thought

00:03:03.040 --> 00:03:03.730
they were before.

00:03:03.730 --> 00:03:06.430
But we'll talk a lot more about
that when we deal with

00:03:06.430 --> 00:03:07.280
real examples.

00:03:07.280 --> 00:03:11.580
But in this case our market cap
is below our book value.

00:03:11.580 --> 00:03:13.240
And you can even look at
it from the price.

00:03:13.240 --> 00:03:14.610
I said the price doesn't
tell you much.

00:03:14.610 --> 00:03:16.440
But it tells you a decent
bit if you think

00:03:16.440 --> 00:03:17.530
of things in per-share.

00:03:17.530 --> 00:03:20.260
Because we know that the book
value per share is $5.

00:03:20.260 --> 00:03:22.990
The price per share, the market
price per share, is

00:03:22.990 --> 00:03:25.370
$3.50, so you could also
say it's trading at

00:03:25.370 --> 00:03:28.160
a discount to book.

00:03:28.160 --> 00:03:31.050
Now, what were the earnings
of the company?

00:03:31.050 --> 00:03:33.800
Well it was making $0.35.

00:03:33.800 --> 00:03:37.670
So let me write this down.

00:03:37.670 --> 00:03:45.550
Earnings was $350,000 in 2008.

00:03:45.550 --> 00:03:48.900
And let's just say we're looking
this from the vantage

00:03:48.900 --> 00:03:50.560
point that 2008 has happened.

00:03:50.560 --> 00:03:51.650
This isn't like I'm at the

00:03:51.650 --> 00:03:53.590
beginning of 2008 and modeling.

00:03:53.590 --> 00:03:57.760
So let's say we're looking at
this on January 1, 2009.

00:03:57.760 --> 00:03:59.980
And let's say the company has
already released its earnings,

00:03:59.980 --> 00:04:01.480
although it normally
takes a lot longer.

00:04:01.480 --> 00:04:05.120
Probably closer to
45 to 90 days.

00:04:05.120 --> 00:04:06.710
But let's say they released
their earnings.

00:04:06.710 --> 00:04:13.800
So we say, oh this company
made $350,000 in 2008.

00:04:13.800 --> 00:04:15.920
Or another thing that you might
see a lot when you look

00:04:15.920 --> 00:04:20.839
at companies, is that this is
trailing 12 months earnings.

00:04:20.839 --> 00:04:22.400
You'll see this TTM sometimes.

00:04:22.400 --> 00:04:25.320
Because when someone says
earnings, are those the

00:04:25.320 --> 00:04:26.460
earnings last year?

00:04:26.460 --> 00:04:27.660
Are those the earnings
that you're

00:04:27.660 --> 00:04:29.260
predicting for next year?

00:04:29.260 --> 00:04:32.060
So this is trailing 12
months earnings.

00:04:32.060 --> 00:04:40.150
And if you want to look at
earnings per share, EPS, is

00:04:40.150 --> 00:04:44.650
this number divided by the
number of shares was $0.35.

00:04:44.650 --> 00:04:47.120
So first, just to learn what
the Price to Earnings ratio

00:04:47.120 --> 00:04:48.570
is, let's just calculate it.

00:04:48.570 --> 00:04:52.000
Then we can talk about what it
actually means and if we have

00:04:52.000 --> 00:04:55.260
time, we can have a discussion
on why a company might have a

00:04:55.260 --> 00:04:57.610
higher or lower Price
to Earnings Ratio.

00:04:57.610 --> 00:05:00.320
And that discussion can actually
get quite involved.

00:05:00.320 --> 00:05:02.700
But in this case, you literally
just take the price

00:05:02.700 --> 00:05:05.260
of the stock and you divide it
by the earnings per share.

00:05:05.260 --> 00:05:09.360
So let me switch colors just
to ease the monotony.

00:05:09.360 --> 00:05:15.500
The Price to Earnings ratio
is equal to the price-- so

00:05:15.500 --> 00:05:20.260
$3.50-- divided by the
earnings per share.

00:05:20.260 --> 00:05:22.200
Divided by $0.35.

00:05:22.200 --> 00:05:26.980
So in this case, the Price
to Earnings ratio is 10.

00:05:26.980 --> 00:05:28.440
What does that tell you?

00:05:28.440 --> 00:05:31.260
well there's a couple of
ways to think about it.

00:05:31.260 --> 00:05:33.600
One is, you could kind
of flip this.

00:05:33.600 --> 00:05:36.250
No-one ever talks about the
Earnings to Price ratio, but

00:05:36.250 --> 00:05:37.780
that's an interesting thing
to even think about.

00:05:37.780 --> 00:05:40.470
Because it connects it with
a lot of other financial

00:05:40.470 --> 00:05:41.460
concepts that are out there.

00:05:41.460 --> 00:05:47.790
So this is kind of a Sal special
ratio, but it's a

00:05:47.790 --> 00:05:48.660
useful one to think about.

00:05:48.660 --> 00:05:51.870
The Earnings to Price ratio is
just the inverse of this.

00:05:51.870 --> 00:05:56.820
0.35:3.50, which is
equal to 1/10.

00:05:56.820 --> 00:06:00.470
Or 10%.

00:06:00.470 --> 00:06:06.740
And so the way to think about
it is if you're paying $3.50

00:06:06.740 --> 00:06:10.100
per share for this company, and
let's say the company next

00:06:10.100 --> 00:06:13.290
year-- so this is trailing
12 months earnings.

00:06:13.290 --> 00:06:15.110
But let's say this company, for
whatever reason, it's a

00:06:15.110 --> 00:06:16.255
really stable company.

00:06:16.255 --> 00:06:17.890
It's doing the same
thing every year.

00:06:17.890 --> 00:06:18.750
It's not growing.

00:06:18.750 --> 00:06:19.900
It's not shrinking.

00:06:19.900 --> 00:06:22.020
Let's say that not only is this
the trailing 12 months

00:06:22.020 --> 00:06:24.130
earnings, but this is also--
actually, I'll introduce

00:06:24.130 --> 00:06:25.460
terminology right here.

00:06:25.460 --> 00:06:26.810
So this is trailing 12 months.

00:06:26.810 --> 00:06:28.930
You could also have
forward earnings.

00:06:32.730 --> 00:06:33.600
What are forward earnings?

00:06:33.600 --> 00:06:34.910
You can probably guess.

00:06:34.910 --> 00:06:36.750
The earnings I just said, this
is actually what happened to

00:06:36.750 --> 00:06:37.180
the company.

00:06:37.180 --> 00:06:39.160
This was the earnings of
the company last year,

00:06:39.160 --> 00:06:40.580
or the last 12 months.

00:06:40.580 --> 00:06:43.240
Forward earnings are, you know,
there's a bunch of guys

00:06:43.240 --> 00:06:47.560
with MBAs and CFAs working for
the banks, and they write

00:06:47.560 --> 00:06:48.390
research reports.

00:06:48.390 --> 00:06:49.750
And they model the company.

00:06:49.750 --> 00:06:50.980
They meet with the company.

00:06:50.980 --> 00:06:52.420
They analyze the industry.

00:06:52.420 --> 00:06:56.440
And if they're good analysts,
they'll come up with a number.

00:06:56.440 --> 00:07:01.250
They'll say, I think
this company is

00:07:01.250 --> 00:07:02.080
not going to change.

00:07:02.080 --> 00:07:04.190
It's such a super
stable business.

00:07:04.190 --> 00:07:11.880
They're going to make $0.35
in 2009 as well.

00:07:11.880 --> 00:07:14.920
So in this case, this would
be the forward earnings.

00:07:14.920 --> 00:07:17.170
And usually if it's a
well-followed company, there

00:07:17.170 --> 00:07:19.640
might be 10 or 15
or 20 analysts.

00:07:19.640 --> 00:07:22.230
And what they do is they average
out all of the numbers

00:07:22.230 --> 00:07:23.580
from all of those analysts.

00:07:23.580 --> 00:07:26.490
And then if the average is,
let's say, $0.35, they'll call

00:07:26.490 --> 00:07:28.320
this the consensus.

00:07:28.320 --> 00:07:32.280
So the consensus is just the
average of all of the sell

00:07:32.280 --> 00:07:33.500
side analysts out there.

00:07:33.500 --> 00:07:36.530
And maybe I should do a whole
video on what sell side means,

00:07:36.530 --> 00:07:38.840
but since I said the word
I'll tell you right now.

00:07:38.840 --> 00:07:40.900
Sell side are like the
investment banks and the

00:07:40.900 --> 00:07:41.660
research houses.

00:07:41.660 --> 00:07:44.470
And the reason why they're the
sell side is because they're

00:07:44.470 --> 00:07:45.830
always selling you stuff.

00:07:45.830 --> 00:07:47.130
They're selling you stocks.

00:07:47.130 --> 00:07:49.530
They're brokering
transactions.

00:07:49.530 --> 00:07:52.210
They write these research
reports because they want to

00:07:52.210 --> 00:07:55.320
go to institutional investors
or people who have their

00:07:55.320 --> 00:07:57.880
brokerage accounts with these
banks, and essentially sell

00:07:57.880 --> 00:07:58.460
them stock.

00:07:58.460 --> 00:08:01.900
Say hey, you should buy Widgets
Inc, because it's only

00:08:01.900 --> 00:08:04.160
trading at a Price to
Earnings of 10.

00:08:04.160 --> 00:08:05.110
And we really like it.

00:08:05.110 --> 00:08:07.520
It's much better than buying
treasury bonds right now,

00:08:07.520 --> 00:08:08.965
because you're making
more money on it.

00:08:08.965 --> 00:08:12.840
You're making 10%, and that's
just to connect the dots.

00:08:12.840 --> 00:08:13.830
Price to Earnings of 10.

00:08:13.830 --> 00:08:17.760
If it's stable, you're making
the equity will grow in this

00:08:17.760 --> 00:08:19.400
coming year by 10%.

00:08:19.400 --> 00:08:21.340
And that's better than what you
get out of treasury bonds.

00:08:21.340 --> 00:08:24.260
So that's what sell
side means.

00:08:24.260 --> 00:08:25.740
So a sell side analyst
is someone who

00:08:25.740 --> 00:08:26.890
publishes these reports.

00:08:26.890 --> 00:08:31.020
A buy side analyst is someone
who works for a hedge fund or

00:08:31.020 --> 00:08:32.860
works for Fidelity
at a mutual fund.

00:08:32.860 --> 00:08:35.630
Or works for an endowment
or a pension someplace.

00:08:35.630 --> 00:08:37.690
And they're managing other
people's money.

00:08:37.690 --> 00:08:41.909
And they're trying to figure
out if they can

00:08:41.909 --> 00:08:42.929
believe what's happening.

00:08:42.929 --> 00:08:44.330
So they're going to do
their own analysis.

00:08:44.330 --> 00:08:46.140
So that's what the
buy side is.

00:08:46.140 --> 00:08:48.070
Those are the people who are
actually managing money and

00:08:48.070 --> 00:08:50.360
deciding what they want to
invest the money in.

00:08:50.360 --> 00:08:53.020
The sell side are the people who
do analysis and say, hey

00:08:53.020 --> 00:08:55.330
due to my analysis isn't
this a good stock?

00:08:55.330 --> 00:08:58.230
Don't you want to buy
or sell this stock?

00:08:58.230 --> 00:08:58.820
So fair enough.

00:08:58.820 --> 00:09:00.950
That was a bit of a diversion.

00:09:00.950 --> 00:09:03.360
Anyway, going back to Price to
Earnings, we calculated the

00:09:03.360 --> 00:09:04.020
Price to Earnings.

00:09:04.020 --> 00:09:04.910
It was 10.

00:09:04.910 --> 00:09:07.140
But the reason I wanted do to
Earnings to Price is because

00:09:07.140 --> 00:09:13.430
it connects it back to things
like yield and interest. I can

00:09:13.430 --> 00:09:15.120
do a Price to Earnings
on my bank account.

00:09:15.120 --> 00:09:19.940
Let's say in my bank account
I have $100.

00:09:19.940 --> 00:09:21.455
So this is a diversion
right here.

00:09:26.750 --> 00:09:29.670
So let's say I have $100
in my bank account.

00:09:29.670 --> 00:09:32.360
And over a year I make 2%
interest. Let's say it's

00:09:32.360 --> 00:09:33.570
guaranteed 2%.

00:09:33.570 --> 00:09:34.470
Maybe it's in the CD.

00:09:34.470 --> 00:09:38.950
So I have $102 at the
end of the year.

00:09:38.950 --> 00:09:40.960
This 2% were my earnings.

00:09:40.960 --> 00:09:42.675
So I made $2 of earnings.

00:09:45.740 --> 00:09:48.540
So the way to think about a bank
account is, well how much

00:09:48.540 --> 00:09:51.790
do I pay for that
bank account?

00:09:51.790 --> 00:09:54.560
Well in this case I paid $100
for the bank account.

00:09:54.560 --> 00:09:58.860
So the price would be $100.

00:09:58.860 --> 00:10:00.600
And the earnings on the
bank account in

00:10:00.600 --> 00:10:02.930
that year were $200.

00:10:02.930 --> 00:10:07.720
So it has a Price to
Earnings of 50.

00:10:07.720 --> 00:10:09.970
Or if you do the Earnings
to Price, if you do

00:10:09.970 --> 00:10:16.180
$2/$100, you get 2%.

00:10:16.180 --> 00:10:17.920
Which is normally how we think
about bank accounts.

00:10:17.920 --> 00:10:20.930
We say, oh I'm making 2%
interest on that bank account.

00:10:20.930 --> 00:10:24.530
Now, this actually leads to a
very interesting question.

00:10:24.530 --> 00:10:29.090
If a bank account only gives
me 2% on my money, and this

00:10:29.090 --> 00:10:31.760
company is arguably giving me--
assuming that it's stable

00:10:31.760 --> 00:10:33.980
and I believe the consensus--
it's giving me 10% on the

00:10:33.980 --> 00:10:38.760
money, why would I even hold
this bank account?

00:10:38.760 --> 00:10:40.750
Why wouldn't I just pour
all of my money?

00:10:40.750 --> 00:10:44.160
Why am I willing to pay a higher
Price to Earnings for

00:10:44.160 --> 00:10:48.310
the bank account than I
am for this company?

00:10:48.310 --> 00:10:51.080
And I think you already get the
sense that the lower the

00:10:51.080 --> 00:10:53.790
Price to Earnings, all else
equal-- and that's a big

00:10:53.790 --> 00:10:56.230
thing-- all else equal, the
lower the Price to Earnings,

00:10:56.230 --> 00:10:57.800
you're paying less
for something.

00:10:57.800 --> 00:10:59.810
You want to have a lower
Price to Earnings ratio

00:10:59.810 --> 00:11:00.870
for the same asset.

00:11:00.870 --> 00:11:02.310
Because you're getting the same

00:11:02.310 --> 00:11:04.430
earnings for a lower price.

00:11:04.430 --> 00:11:08.110
But when you lower the Price to
Earnings you are increasing

00:11:08.110 --> 00:11:09.950
the Earnings to Price.

00:11:09.950 --> 00:11:12.210
So you would increase
your yield.

00:11:12.210 --> 00:11:14.260
You want to maximize
this number.

00:11:14.260 --> 00:11:17.900
But I'll finish this video with
kind of a basic question.

00:11:17.900 --> 00:11:22.150
Why would someone ever keep
their money in the bank at 2%

00:11:22.150 --> 00:11:27.715
or a Price to Earnings of 50,
when they could have a Price

00:11:27.715 --> 00:11:30.010
to Earnings of 10 with
Widgets Inc.?

00:11:30.010 --> 00:11:32.920
And the answer is because
this is very uncertain.

00:11:32.920 --> 00:11:34.660
Who knows what happens
with Widgets Inc.?

00:11:34.660 --> 00:11:37.220
Maybe all of these guys
were-- Maybe this

00:11:37.220 --> 00:11:38.330
is a big Ponzi scheme.

00:11:38.330 --> 00:11:40.770
I mean, most companies in
this country aren't.

00:11:40.770 --> 00:11:42.730
And that's another thing to talk
about, is country risk.

00:11:42.730 --> 00:11:45.440
Because even though you're
probably suspicious of them

00:11:45.440 --> 00:11:48.720
now, the US has some of the
most transparent companies

00:11:48.720 --> 00:11:50.130
with some of the best accounting
standards.

00:11:50.130 --> 00:11:52.710
If this was in-- you know,
I don't want to state any

00:11:52.710 --> 00:11:54.490
countries because people all
over the world listen to these

00:11:54.490 --> 00:11:56.850
videos-- but if it were a
country with less solid

00:11:56.850 --> 00:11:58.940
accounting standards, you would
be like, they might be

00:11:58.940 --> 00:12:00.830
making up all of their numbers
so I don't trust it.

00:12:00.830 --> 00:12:05.180
Or you might say, you know,
Widgets Inc., even though the

00:12:05.180 --> 00:12:10.660
analysts are saying that they're
going to make $0.35

00:12:10.660 --> 00:12:12.940
this coming year, you might
say, you know, I

00:12:12.940 --> 00:12:13.590
don't believe that.

00:12:13.590 --> 00:12:17.660
I think there's actually a lot
of risk in Widgets Inc. That

00:12:17.660 --> 00:12:19.400
there's actually more volatility
here than anyone

00:12:19.400 --> 00:12:20.170
gives credit for.

00:12:20.170 --> 00:12:21.330
They might go out of business.

00:12:21.330 --> 00:12:22.990
There's a strong competitor.

00:12:22.990 --> 00:12:24.740
There's a lot of
risk involved.

00:12:24.740 --> 00:12:25.950
And the other thing is,
even if you don't

00:12:25.950 --> 00:12:26.510
think there's risk.

00:12:26.510 --> 00:12:32.290
Even if you think that this
company's going to make $0.35

00:12:32.290 --> 00:12:35.740
forever, the other reason why
you might prefer to have a

00:12:35.740 --> 00:12:39.530
bank account over Widgets Inc.
is because you're guaranteed

00:12:39.530 --> 00:12:44.250
to get $102 back for your bank
account at the end of the year

00:12:44.250 --> 00:12:44.830
if you wanted.

00:12:44.830 --> 00:12:50.950
Assuming this is a CD with
a one year duration.

00:12:50.950 --> 00:12:53.880
You're guaranteed to get your
$102 back, especially if it's

00:12:53.880 --> 00:12:55.300
FDIC insured.

00:12:55.300 --> 00:12:58.980
But in this case, even though
the earnings might be the

00:12:58.980 --> 00:13:01.610
same, something horrible might
happen to the markets and

00:13:01.610 --> 00:13:04.930
everyone just dumps their
stocks, money flows just run

00:13:04.930 --> 00:13:06.050
outside of markets.

00:13:06.050 --> 00:13:08.530
And for whatever reason people
get scared, and the price

00:13:08.530 --> 00:13:10.760
could go down a lot
from $3.50.

00:13:10.760 --> 00:13:12.240
It could be very,
very volatile.

00:13:12.240 --> 00:13:18.740
And this thing, maybe the price
goes from $3.50 to $1.75

00:13:18.740 --> 00:13:19.520
a year later.

00:13:19.520 --> 00:13:22.330
Which it seems like a really
good deal, because now the

00:13:22.330 --> 00:13:27.310
Price to Earnings is $1.75
divided by $0.35, would now be

00:13:27.310 --> 00:13:28.490
a 5 Price to Earnings.

00:13:28.490 --> 00:13:29.330
But this could happen.

00:13:29.330 --> 00:13:32.550
I mean, companies go from a 10
to a 5 Price to Earnings.

00:13:32.550 --> 00:13:34.860
And then all of a sudden, if
you want that money, if you

00:13:34.860 --> 00:13:37.540
need that money a year later,
you've lost half of it.

00:13:37.540 --> 00:13:40.020
So there's some volatility in
the price even though you're

00:13:40.020 --> 00:13:41.750
assuming that the earnings
are stable.

00:13:41.750 --> 00:13:46.070
So that's a little bit of a
taste of why someone might

00:13:46.070 --> 00:13:48.620
realistically, in this case, pay
a higher Price to Earnings

00:13:48.620 --> 00:13:49.740
for safety.

00:13:49.740 --> 00:13:53.180
Safety because you know that
this earnings stream is

00:13:53.180 --> 00:13:54.020
guaranteed.

00:13:54.020 --> 00:13:55.270
And liquidity.

00:13:55.270 --> 00:13:56.940
Liquidity because you
know you're going to

00:13:56.940 --> 00:13:57.860
get your money back.

00:13:57.860 --> 00:13:59.930
That you're going to be able to
essentially sell your bank

00:13:59.930 --> 00:14:01.340
account and get cash for it.

00:14:01.340 --> 00:14:03.810
And you know that it's
going to be $100.

00:14:03.810 --> 00:14:05.420
That there's no volatility
in price.

00:14:05.420 --> 00:14:07.930
Well in this case, you're
uncertain about

00:14:07.930 --> 00:14:09.160
the earnings stream.

00:14:09.160 --> 00:14:12.320
You're uncertain about what the
market will be willing to

00:14:12.320 --> 00:14:14.030
value it at a year later.

00:14:14.030 --> 00:14:15.950
And frankly, you might
be uncertain about

00:14:15.950 --> 00:14:16.870
liquidity in general.

00:14:16.870 --> 00:14:19.080
Maybe this is a really small
company and not a lot of

00:14:19.080 --> 00:14:20.150
people trade in it.

00:14:20.150 --> 00:14:22.510
And you might not even be able
to find anyone to buy it a

00:14:22.510 --> 00:14:23.360
year later.

00:14:23.360 --> 00:14:26.290
The epitome of an illiquid
asset is maybe a really

00:14:26.290 --> 00:14:28.490
expensive $20 million house.

00:14:28.490 --> 00:14:30.910
Even though it might be worth
$20 million, a year later you

00:14:30.910 --> 00:14:33.240
might not-- there are only so
many people who can afford a

00:14:33.240 --> 00:14:34.630
$20 million house.

00:14:34.630 --> 00:14:36.200
So it's an illiquid asset.

00:14:36.200 --> 00:14:37.530
Anyway, I want to
leave you there.

00:14:37.530 --> 00:14:40.330
In the next video we'll go into
more depth on Price to

00:14:40.330 --> 00:14:43.320
Earnings ratio, and think about
things like growth and

00:14:43.320 --> 00:14:44.650
stability and whatnot.