ShmoopTube

00:00

principles of finance a la shmoop figuring out discount rates in net

00:05

present value calculations well let's start simply people we're taking a view [Blade Runner drone company logo]

00:11

of your drone company Bladerunner a few years after its IPO tweaking the numbers [person writing numbers]

00:16

so that they you know live in this vacuum well here are the numbers you [person vacuuming room]

00:19

internally believe at this moment as they relate to your future a billion of

00:23

revenues this year 1.2 next one point for the next and one point six the year

00:28

after that cash earnings have 300 and 400 and 500 and 600 and note the big

00:33

focus on cash earnings here your company has had a ton of capex or capital

00:38

expenditure to build its own battery and assembly and other automated plant so it

00:42

has a ton of depreciation and still filtering through the income statement

00:46

right like the cash has already gone out to buy those things and now the

00:50

buildings and stuff have to be depreciated in fact in this year of 300 [white board with numbers]

00:54

million in cash earnings the GAAP accounting earnings are just a hundred

00:58

million because the company is depreciating two hundred million dollars

01:01

of previously spent capital on its battery plant will blad your Bladerunner

01:06

stock ticker is trading today such that gives you a capitalization or market

01:11

capitalization of 20 times this year's cash earnings of 300 million bucks or

01:15

market value of 6 billion dollars well the company has 500 million in cash on

01:20

the books and no debt so it's equity capitalization is 5.5 billion well the

01:25

stock used to have 20 million shares outstanding but for the purposes of

01:29

making it easier to digest in this course the company kindly split its

01:33

stock five for one so that now there are exactly a hundred million shares

01:37

outstanding and those shares today trade for 60 bucks each and just for

01:42

super-duper clarity note that what you get for that 60 bucks you get five bucks

01:46

in cash you get cash profits or cash earnings this year of 3 bucks you get a

01:51

projected 4 bucks of cash earnings next year and then 5 the next in 6 the next

01:56

so if you believe these Grothe projections will actually happen well

02:00

then you're paying 10 times cash earnings for the company 3 years from

02:04

now and you mumble as well that well at that point the company will probably

02:07

have something more like 10 or 15 or 20 bucks a share in cash beyond the 5

02:12

dollars where they have in cash today well if in the out year

02:14

the company has say 15 dollars a share in cash well then at a flat $60 stock

02:20

price like it doesn't move for three years investors will then be paying $45

02:25

for the earnings producing ability or equity value of the company at that

02:29

point when it's supposed to produce six bucks home that would then be six

02:33

dollars of cash profits against the $45 equity cap or a huge free cash flow

02:38

yield yes that's what it's called of six dollars over forty five or about

02:43

thirteen point three percent bottom line if the company hits its growth

02:48

projections big if they're all else staying the same this stock ain't gonna [stock rising]

02:52

be at sixty bucks in three years it'll be way higher so anyone yet noticed that

02:56

the projections all have even numbers magically they grow revenues by two

03:01

hundred million dollars a year in cash earnings by a hundred million dollars a

03:05

year hmm sounds like deep accurate careful thinking to you [man working on laptop]

03:09

well the idiot who put together these lazy estimates this guy just slap them [man at computer]

03:13

into a Google sheet and mumbled anyone think he surveyed a hundred retailers

03:19

and asked what they thought they'd be ordering next year and the next and the

03:23

next did he survey the Google SEO search set of terms and figure out the volumes

03:29

for qu and how many around the world are searching for keyword drone and what

03:33

about talking to competitors or suppliers of blades and battery stuff in

03:38

that food chain or drone insurance companies yeah yeah how about them did

03:42

he do any of that research no crickets yeah that's what we thought well the

03:46

goal here is to demonstrate how bad estimates are especially those you read

03:51

from stockbroker Wall Street people you know sell-side analysts who have an

03:55

agenda that doesn't necessarily revolve around being accurate with their [woman at desktop]

03:59

projections remember they're incentivized by how they get paid and

04:03

they don't get paid by being accurate and awesome with their projections if

04:07

they were good at those and good at picking stocks they do that for living

04:10

they wouldn't just live on taking commissions selling stock to other

04:13

people in the old days investment banking fees were allocated largely

04:16

around whichever stockbrokers analyst was the most bullish on the company's

04:21

future prospects ie the one who had the highest priced target or the loudest set [bull charging at audience]

04:26

of strong byes and all of that marketing

04:28

would then in theory entice the company to hire that investment bank for their

04:32

lucrative to the bank investment banking services right like banks get whopping

04:37

commissions for doing secondary sales and other mergers and acquisitions

04:40

consulting stuff so reality check what do these numbers actually mean and more

04:45

importantly for this exercise how confident are you in the growth of

04:48

20-ish percent and the increasing profit margins that in theory we're saying go

04:53

with them if you're building a discounted cash flow analysis for this

04:57

set of numbers you'll set a risk-free rate from US government paper that

05:01

number's easy to find and doesn't carry a whole lot of relevant debate like

05:05

five-year tea notes yielding in a two point six seven eight ish percent yeah

05:09

easy that's your risk-free rate you can even

05:12

call it three percent and sleep well at night but now what risk premium do you

05:16

tack on to that dinner salad if you've been watching all things finance here [Shmoop website]

05:21

shmoop and have no external hobbies friends or other activities well then [man sitting on bench outdoors]

05:25

you'll remember that we framed the total discount rate analogous to going to a

05:29

restaurant where the dinner salad is the cheapest item on the menu at three bucks [dinner menu]

05:34

and everything else on the menu is some cost premium above that like the

05:39

bacon-wrapped tater tots cost fifteen bucks then it's a dinner salad price

05:43

plus twelve dollars in premium okay so back to your financial model and yeah

05:47

I'm getting hungry too you did a billion bucks in revenue in

05:49

this year you project growth of twenty percent next year and a bit less than

05:53

twenty percent on the one point two billion the following year same with the

05:56

neck if this were a long-distance business which only declines in revenues [stock declining]

06:00

these days because everyone's using Skype and Google Hangouts and all the

06:03

other stuff that's out there well then those twenty plus percent growth numbers

06:06

would be insane crazy high numbers not going to happen if it were the

06:10

advertising business on the internet nineteen ninety-seven those would be

06:14

crazy low numbers everything estimated it's about context and in this case you

06:19

make a very luxury good that is likely pretty cyclical like in bad times people [drones on production line]

06:25

just ain't gonna shell out two grand to buy it it's basically just a relatively

06:28

expensive hardware toy mostly for nerdy techie adults who are relatively wealthy [adult playing with drone in yard]

06:33

like you know how many people really do have two grand to just throw away or and [hand drops money into bin then it washes up on ocean shore]

06:37

let it just fly away anyway the heyday of 80% of your growth

06:41

for Blade Runner is over and as you mature as a company in industry it's [white board with numbers]

06:45

understandable that revenue growth rates will decline but if you follow the

06:50

normal business cycle of most companies at this stage while profitability should

06:54

accelerate why the expense of groundwork the fixed infrastructure for building [time lapse of builders on construction site]

07:00

things distribution all that has been laid you've already spent the myriad

07:04

millions to build the infrastructure you have in place now to pump out lots of [money on table then drones in production line]

07:08

drones cheaply and efficiently so margin growth is definitely not a crazy pipe

07:12

dream here in our estimates the bottom line you really do believe in xx percent

07:16

growth rates that we're thinking through you believe in the increased profit

07:20

margins here they're neither optimistic nor pessimistic and note that since you

07:24

now have a relatively long and favorable track record the retail stores who want

07:29

you are putting in advance orders like will take 10,000 extra units a quarter

07:34

each quarter for the next year especially ahead of Christmas so you

07:37

have even more confidence in your sales numbers okay so the revenue growth is

07:41

tangibly there at least in theory and you'd feel a lot better about it if [man typing on laptop]

07:45

you've done more survey and research homework and queried your various

07:49

distribution partners as to what they thought they'd sell in your merchandise

07:53

in the next few years but you're lazy and Wall Street e so you just kind of [man snoozing at laptop]

07:57

sort a guest so that's revenue for better or worse as quality data driven [white board with numbers]

08:01

guesstimate sand yeah let's dial in a little bit here on profits what about

08:05

them well note that you used C e or cash earnings as your delimiter here

08:10

depreciation took your 300 million of cash earnings down to just a hundred

08:14

million in gap earnings so accounting in this sense even following the law

08:18

following the rules actually distorts your real earnings or you're certainly

08:23

your real earnings power and the depreciation rules here are kind of

08:26

vague yours is a new industry with new techy product not yet really tested over [views of high tech cameras]

08:31

time having put up a state-of-the-art battery and assembly plant well you

08:35

don't really know how long it'll last should it be depreciated over ten years

08:39

like the accounting law say should it be 20 50 100 you just have no idea so being

08:44

a conservative little accounting geek and a friend of schmoops you chose 10 [man with broken glasses with Shmoop friend]

08:48

years to depreciate that plant 90 percent that is you'll hole [numbers on white board]

08:53

in ten years the value of the two billion dollars you spent on that

08:56

battery plant to be just 200 million that means that you'll reduce your

08:59

earnings a total of 1.8 billion by a hundred eighty million straight line a

09:03

year over ten years another 20 million in other depreciation items brought you

09:08

down to that subtracted depreciation of 200 million against the cash earnings of

09:13

300 million to give you just that hundred million in gap earnings so yes

09:17

all of this is conservative but it also makes your net income look smaller and

09:22

who cares about that well investors care but they're smart

09:26

enough to look through the accounting earnings they do it all the time and

09:29

they look at your cash earnings who else cares it rhymes with SHM IRS yeah the

09:34

IRS by showing a hundred eighty million less a year in earnings or 200 million [numbers on white board]

09:39

you pay less in taxes that two hundred you subtracted from the three hundred

09:43

your cash collected however is two hundred million dollars higher than that

09:47

figure because depreciation is a non-cash expense and note that if the

09:51

plant in factory lasts in 40 years well you've then massively overly

09:55

conservatively overly depreciated your capital expenditures so that in a decade

10:00

your gap earnings should be very close to your cash earnings all else being

10:04

equal and yeah we're gonna ignore taxes at the moment well you focus heavily on

10:08

where the cash is flowing because clever accountants can't really do much to hide [water slide]

10:12

change or manipulate the actual cash in your coffers so how confident are you in

10:17

the cash cost to produce these loads of drones well pretty confident in fact

10:21

two-thirds of the costs are already booked years in advance contracts are [hand signs document]

10:25

signed plastic goes from five grand a ton next year to forty eight hundred the

10:30

next and then forty six and then forty four the other inputs follow the same

10:34

volume-based caustic limes you know like semiconductors and control systems and

10:39

guidance systems and probably even insurance well why are you going into

10:43

all of this quote confidence checking unquote well because it affects the

10:46

discount rate you apply to the future value of cash flows you think you'll be

10:51

earning if the risk-free rate today is about a three percent well given above [numbers on white board]

10:55

inputs you might only tack on a 5 percent risk premium which says that

10:59

there's only a 1 in 20 shot that you don't hit these numbers are better

11:02

really odds are only one in twenty that world

11:05

conditions don't suddenly change only one in 20 that rich geeky adults still [time lapse of crowded side walk]

11:10

love your toys three years from now like you know how fickle those guys are after

11:14

the divorce or that your retailers honor the contracts they've put forth and you [hand rips contract]

11:18

know they note that there is in fact an out clause on page 473 of the conical to

11:23

the conical of the contract so that the retailers can get out with no obligation

11:27

to sell anymore drones at the drop of a hat if they don't want to they can ship

11:31

you back the inventory on their shelves and you have to buy it back from them at

11:34

wholesale there's only a 1 in 20 shot that a drone lands on somebody's head [drone hits man on head]

11:38

during your wedding vows and you get sued like it was your fault the pilot [man goes to court and is jailed]

11:43

was lousy that's what the 5% risk premium says it's like it's almost a [numbers on white board]

11:47

certainty in the bag feel good too you know you're gonna make that risk premium

11:52

15 percent 20 30 some huge number and at least have some cushion here with a

11:57

three and 20 odds so what does that mean well it means that you discount back the

12:01

cash earnings to be one year away 400 million in cash our name gets divided by

12:05

the quantity 1 plus 0.18 to the first power there see it's the first power

12:10

because it's iterated one period or one year away and how do we get 18 well

12:14

there's three percent risk-free rate plus the 15 risk rate we're tacking on

12:18

there so 400 million divided by 1.1 8 there you go two years away we got 500

12:23

million in cash earnings that we're notionally expecting that we truly think

12:26

is 50/50 odds of happening all right well that gets divided by the quantity 1

12:30

plus 0.1 is 1.1 it squared and then 3 years away got 600 million kasher and

12:35

gets divided by the quantity 1.1 a yeah there you go well you think that by this

12:39

time your company will be trading for a lower multiple than it trades today well

12:43

because growth should be slowing and you guessed it it'll be trading for 15 times [stock growing]

12:47

the following year's cash earnings of 600 million dollars or 9 billion bucks [numbers of white board]

12:52

and you think the odds of that happening carry the same discount rates as you

12:55

applied when evaluating whether or not you'd hit your operating metrics so that

12:59

9 billion that eventual number gets divided by 1 plus 0.01 to the third

13:04

power there and the math looks like this so we're gonna add them up and you get 6

13:08

5 4 1 there are about six and a half billion dollars and note that during

13:13

that time period your company will have generated well over a billion dollars in

13:17

cash that will probably just sit on your

13:19

balance sheet or maybe it'll be used to buy back stock or to buy another

13:23

competitor or to add a water misting feature to your drones and you know for

13:27

which customers will pay a very high profit margin additional hundred bucks a [drone sprays man]

13:31

unit so yeah the discounting for time and risk here is high

13:35

without that discounting and in an unfiltered vacuum the stream of cash

13:38

flows would be notionally valued at you know almost eleven billion dollars so

13:43

this math claims that the net present value of that stream of cash flows is [numbers on white board]

13:48

not eleven billion it's six point five billion you discounted the cash flows at

13:53

totally made-up but reasonably well thought out risk premiums to account for

13:58

the myriad factors that affect your progress as a company from world [drones on store shelf]

14:02

conditions in macro to the micro issues of a drone not working properly and you [world map]

14:07

know turning I do into just [drone ruins wedding]

Full Transcript