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Video transcript

welcome to my presentation on return on capital let me write that down oh I'm using the wrong color let me use a nicer color let me go to the white let's say we had its return on capital now I want to do this presentation first because I think this this is really going to give you the big picture on how you should think about what something is worth whether you should invest your money and do it and how you should weigh the different options you have in terms of what you act you have to do with your money in terms of where you wanted to point you wanna put in the bank you want to buy a house do you want to pay off your credit cards etc etc so let's just define what return on capital or and just so you know I'm not necessarily going to be strict on the accounting conventions or the GAAP conventions that's that's kind of the kind of conventions in this country I'm going to do it more on a on a hands-on how you know Joe investors should think about their money so in this scenario I define return on capital is just the cash you get per year per year divided by the cash the total cash you put in you put in and well I don't want to just say cash I could we could we could say we could there's other ways to measure return but actually let's just sit keep it simple let's just say cash so let's think about how this works out let's say I have an idea I have a restaurant and that restaurant it'll cost a million dollars it will cost 1 million dollars investment in this restaurant it's going to be a 1 million dollar investment and let's say that per year after paying all the expenses after paying the utility after paying the employees after repairing and maintenance and after paying taxes everything let's say this restaurant makes $100,000 a year lissa and that's after taxes every that's a that's what goes in my pocket so in this situation my return on capital and the way I've defined it is $100,000 divided by 1 million or we could just say a thousand thousand dollars or equals 10 percent 10 percent pretty straightforward you're probably saying Sal this is silly why are you wasting my time well maybe it is but I think you'll find that this is going to lay a foundation that will will eventually blow your mind so let's keep going let me do another ok ok so I said the restaurant let's take it a pizza restaurant so let's just say the restaurant return on capital is equal to 10% right I could put a million dollars and I'll get in a hundred thousand dollars per year and that's where I got a 10% let me write that down I get a hundred thousand for a year off of 1 million investment now that's that's one project and let's just say I know for sure that I'm going to I'm not going to factor in things like risk and probabilities just yet let's just say for sure I know that if I put my money here I'm going to get 10% on my money and let's say the other option with my money is a a beauty parlor beauty parlor HBU b e beauty beauty parlor a beauty parlor now let's say that that also costs 1 million dollars let's say that also costs 1 million dollars well and this beauty parlor gets me $50,000 a year $50,000 a year I think it's very obvious to you already how which which investment you would rather invest in because this the return on capital on this beauty parlor is only 50,000 divided by million or 5% so this is obvious you'd rather do the restaurant than a beauty parlor and in general if you if you if you after adjusting for risk you always want to go with the project that has hot the higher return on capital and later on you know there'll be nuances in terms of when you get that return maybe you'd like to have a slightly lower return if you get the money faster or a slightly higher return if there's a if you're taking on risk etc etc or to compensate for risk so we know we want to do the restaurant but do we definitely want to do the restaurant I mean we'd rather do the restaurant than the beauty parlor right but my question to you is do we definitely want to do the restaurant and this is where the return on on capital becomes interesting because what matters before we put the money into the restaurant is to think about what the cost of that money is to us and this is what I think will be a little bit of a new concept to you so I'm going to introduce you now to the notion of a cost of capital so let me erase this okay so the restaurant costs a million dollars costed me a million dollars oh sweet 1 million dollars and it gives me $100,000 a year yep $100,000 a year and that's a 10 percent return on capital now let's say I have to borrow all the money and there's some bank that's willing to give me all the money for this restaurant and the interest rate on this alone is let's say it's a so let's say the loan the interest rate is 15 percent is it still a good idea for me to open up the restaurant well if I if I have it alone and have to borrow the whole amount so I'm gonna have a loan for $1,000,000 right to buy that same restaurant and I'm going to be charged 15 percent in interest every year and I'm not going to take taxes and the fact that you could deduct taxes etc into account just yet let's assume that my total cost is 15 percent per year in interest so I'm gonna have to spend $150,000 per year an interest so my question to you is does it still make sense for me to open up this restaurant every year I'm going to be making $100,000 from the restaurant itself but I'm going to be paying $150,000 a year in interest though you've probably seen Sal once again you have just restated the obvious no you would not want to do this restaurant because every year 50,000 dollars will be burning out of your pocket now you might think that this is obvious but I'm going to show you many many examples of where people are actively doing this people who you would otherwise assume could could do this type of math and it's especially happening in the housing market but anyway so in this situation you wouldn't want invested in a very simple way of thinking about this is you would only want to invest you only want to do a project if your return return on capital is greater than let's say we can call it your then your cost of capital cost of capital this is the only time that you want to invest in a project with that said I'm not going to go back to what we just did I just showed you something that we thought was obvious but I'm like I'm going to react uestion so we had the restaurant and we have the beauty parlor let's call it BP for short they both cost a million dollars right ROC the ROC of the restaurant we said was 10% and the ROC and the beauty parlor we said was 5% so right now superficially it looks like the restaurant is just a better project but then we said the cost of capital so the interest rate which is our how much does it cost for us to take get that million dollars the interest rate to borrow money for a restaurant is 15% and we said that this is not a good investment because our cost of capital is higher than our return on Kaplan you could do the math and figure it out but what if there is some kind of government program that they just felt that there weren't enough beauty parlors in the country and they were willing to give you a really cheap loan to buy a beauty parlor and the government program they said we're going to give you a low-interest loan of 2% huh so my question to you is now which project would you rather do superficially it looks like the restaurant was better you get you get a 10% return as opposed to a 5% but your cost of capital the interest rate you would have to pay on a loan for the beauty parlor all of a sudden looks a little bit better in fact this is actually a good investment because your cost of capital is less than your return on capital we can even do the math every year the beauty parlor will generate $50,000 and you'll be paying $20,000 in interest so you'll be netting $30,000 without having to put any money for yourself you will be borrowing all the money so clearly this is a good investment so that's it now for the intro on return on capital and cost of capital and my next presentations I'll go into a little bit more detail and do a few more nuanced examples