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Current time:0:00Total duration:17:29

Video transcript

in the price-to-earnings conundrum video we encountered a situation where two different entrepreneurs bought an identical asset in this case it was a pizza parlor or pizzeria but they each financed it in a different way this guy was a little bit more conservative he paid for it outright so the entire asset was his equity he had no debt well this guy he borrowed some money and he even had some non operating assets so he levered up for every dollar he put in he borrowed ten dollars from the bank in order to buy more asset that he actually brought to the table and we saw that when you did their financial statements their revenue cost of goods everything up to the operating profit line was the same and that makes sense because if we if you remember the first introduction to income statement video operating profit is really indicative of what the operating assets are generating so in this case it's what DS purple the purple area right here are generating you could also consider that the enterprise do what the enterprise is generating and everything below the operating line everything below the operating profit line is either coming from non operating assets that would be the case of non operating income and the entrepreneur on the right had some of that he had some of this non operating income $2,000 per year in that case while this guy didn't have any and then you have expenses associated with interest right in this case this entrepreneur had 5% of $100,000 of $5,000 a year and then when you have these differences in capital structure it changes what your net income is and they had slightly different net income numbers but what we saw is when we applied the same price to earnings ratio and had the same the share counts I didn't change too many variables here I just really changed how they paid for the asset but when you have when you applied the same price to earnings ratio - both - both earnings streams - both companies you got something that was reasonably unintuitive and and I you know there's no trick here really because it's not crazy to assign the same price to earnings ratio and if you try it out if you grow this guy's revenue a little bit if you actually grow both their revenues by the same amount or both of their gross profits by the same amount or if you grow both of their operating profits by the same amount you're actually going to see that this guy's earnings per share is growing faster so given that someone might say oh because of a leverage maybe I'm willing to pay even a higher multiple so it's not crazy to pay the same multiple for both of these guys but we saw at the end of the last videos when you apply let's say a ten multiple or really any any multiple to both of these earning streams you get you get a situation that first doesn't look crazy okay the market cap of this guy is 210,000 if you apply ten multiple to their earnings stream while the market cap of this guy is one hundred eighty nine thousand if you apply a ten multiple to their earning stream right ten times eighteen point nine thousand is one hundred eighty nine thousand ten times twenty one thousand is two hundred ten thousand but what was the conundrum what really got us thinking was how can this hole this equity stream right here or this equity or this earning stream be worth two hundred ten and this one be worth one hundred eighty nine when this guy only put ten thousand initially and this guy put in a hundred thousand he put it ten times as much and if you wanted to value so when you were paying two hundred ten thousand for this asset for this equity you're essentially saying that this asset is worth two hundred ten thousand but if you're saying that this equity is worth one hundred eighty nine thousand right that's what the market cap is it's the value of the equity then you're implicitly saying that this asset that all of these assets are worth the value of this market capitalization plus this debt right so that's two hundred eighty nine thousand and then if you wanted the value of this operating asset you would subtract out this much right here the cash so you got something like two hundred seventy nine thousand so when you apply the same price to earnings to the same just these similar businesses you actually got a situation where you're overpaying for this for this asset relative to this one even though they're identical so they had left off so the question is what do we do why did the why what what can we use other than a price to earnings ratio and that's what this video is for so the short answer is one you do have to use something different price to earnings ratio is a good quick way of comparing two companies relative to their growth or relative to an industry but it does lose a lot of information relative to how the companies are capitalized and you saw in the last video that how you're capitalized when I say capitalized I mean how do you pay for your assets if you have a lot of debt versus a lot of equity what actually happens on the earnings line is very very different and so you lose all of that information and so if you want to capture that information when you look at the price of a stock you have to figure out what you're actually paying for the enterprise of the company the enterprise value of the company so when I talk about the enterprise or the enterprise value I'm talking about the operating assets if it's a you know it gets a little bit more complicated if you're talking about a financial company like a bank or an insurance company but if we're talking about a widget Factory the enterprise is essentially the assets the asset value enterprise value is the asset value of the assets that allow the company to do business so whatever factories well in this case it's a pizzeria so the ovens the building the the the actual places with this the places where people actually eat their food and even the cash that's necessary to operate the business it's not the enterprise value shouldn't incorporate the cash that's surplus that's not necessary to operate the business so that that begs the question how do you calculate the enterprise value so you could go backwards and you say okay for a given price how much am I paying for an enterprise value so let's say that this stock let's say that Company A or this one let's say that stock right now is trading at let's say it's trading at 20 let's say it's trading at 20 dollars while companies B so this is the current price then you could buy it at so it's the asking price in the market is it $20 while this one is at let's say it's at 10 dollars its at 10 dollars so at first glance you might just do a quick price to earnings ratio and you'll say okay for 20 dollars I'm getting I'm getting what 2 dollars and 10 learnings per year assuming it's not growing or something so my price to earnings is approximately I don't know I don't have my calculator in front of me but 220 divided by two dollars 10 it's gonna be nine point something something right well this guy for ten dollars I am paying I'm getting a 89 of earnings per year so what's a hundred divided by 18 it's like it's five or six times it's going to be five points something five six times 18 is 60 plus yeah it's gonna be five point something something so when you superficially just look at this you can say well this is a cheaper price to earnings ratio maybe I should buy that but would you II saw in the last video is that price to earnings isn't a good relative valuation metric when two different companies are capitalized very differently so what you want to do is instead back out what these prices imply about the enterprise value so what does $20 imply about the enterprise value and what is $10 imply and how do you do that well first you say what is the market cap market cap so you take the price times the number of shares if you remember we had 10,000 shares so in this case 20 times 10,000 shares implies a $200,000 market cap in this case we have $10 times 10,000 shares so it implies a hundred thousand dollar market cap now remember the market cap is just what's left over so if let me redraw those those two diagrams because I feel like I'm so in for this entrepreneur you have the assets and all of the X and and there's no debt so the assets are kind of completely represented by the equity so if the market cap is $200,000 you're essentially saying that these assets these operating assets are worth $200,000 so in this case when the weather at a price of at a price of $20 we know that the enterprise value the market enterprise value so what the market is saying the enterprise is worth the operating assets are worth is $200,000 now in this case remember the market is saying that the equity is worth $100,000 let me draw that the market is saying that the equity is worth $100,000 but of course this company has a lot of debt it has another hundred thousand dollars of debt actually let me let me draw this a little bit different let me see how much I can erase and I can't erase it like that let me erase this thing alright so in this situation the market is saying that its market cap is $100,000 so just to be proportional let me draw it like that nope didn't want to use that one this is $100,000 this is the equity or the market capitalization or the market value of the equity that's what the market cap is and that's just the price times the number of shares and then it has debt it has if I remember correctly it has $100,000 and it has $100,000 in debt if you take $100,000 $100,000 $100,000 in debt $100,000 and so what is it saying about the assets so the equity plus the debt or the liabilities is $200,000 so saying all of the assets are worth $200,000 $200,000 all right this is all of the assets $200,000 but what we need to do we want to figure out the value of the enterprise not just all of the assets so if we remember there was some of the assets that were actually operational and some were non operational so we had $10,000 of cash right there so we have $10,000 of cash $10,000 of cash so when this stock is trading at ten dollars it implies a market capitalization of $100,000 it implies that the liabilities plus equity is $200,000 so all of the assets are 200,000 but if we were to subtract out the cash or the non operating assets what's not necessary to operate the business we get $190,000 of enterprise value so in this case they're saying that the enterprise value is $190,000 so in this case when you looked at the price to earnings like wow this is half as expensive as that this is a great deal let me buy it and I just happened to make up the numbers so that even when I did the enterprise value still but it's only 5% cheaper here it looks 50% cheaper here it looks 5% cheaper and so it might be a little unintuitive of you know to figure out the enterprise value you take and this will see this will be the formula you see in a lot of books and a prized value is equal to market cap market cap plus debt minus cash and you might be like when I'm trying to value something why should I add debt back that debt is a negative thing isn't shouldn't debt make my enterprise worth less and why am i subtracting cash because cash is a positive thing shouldn't that make my enterprise value more and the reason why well first you subtract cash is and it really should be just cash that is not associated with the enterprise and you'll see a lot of people do it in different ways some people will subtract out all cash with the argument that the company doesn't need to use any of it but what but the real idea behind it is to kind of capture the assets that are actually generating the profits of the enterprise and the enter the profits of the enterprise are the operating profits and the reason why you add debt is think about it this way if you wanted to buy out this company if you wanted to buy let's say from this company you wanted to buy his assets at the market price how would you do it well you would have to pay what you would you would have to maybe get $200,000 right if you got 200,000 dollars you could buy these guys off you could pay them $100,000 and own that and then you could buy the bank out pay them a hundred thousand dollars so you paid two hundred thousand dollars you would own all of this right this would all be your equity and then you would get a $10,000 back if you know if you wanted to to take this cash right so you would have essentially paid two hundred thousand dollars which is the market cap plus the debt that's what you would have had to do to buy out both of those I guess you could say stakeholders in the company and then you would get back the cash so you would have to pay net $190,000 to own this enterprise and hopefully that makes a little bit more sense as why the enterprise value is actually described this way now the one thing you might say okay Sal you figure how to calculate enterprise value from a share price but what if I want to go the other way around how do I figure out what a company's enterprise value should be and then figure out its what its share price should be well one metric and there's two metrics the most common metric that's used is EBIT de yi bit da I won't cover that now cuz I it's a new term for you but it means earnings before interest taxes depreciation and amortization and people look at something called an enterprise value to EBIT da ratio and I'll do that in the next video but what I like to do is just think about okay what are the real earnings from the enterprise well that's the operating profit that's the operating profit right and then you can apply a multiple to that based on what other companies are trading at or how fast it's growing so let's say in this case we're saying they're both generating thirty thousand dollars in operating profit per year let's say that I want to apply a a I don't know I want to apply a five multiple to its operating profits so let's say I want to say that that evey to operating profit which I frankly think is a better metric than evey to EBIT da and I'll cover you but on a future video let's say that I think for this industry it should be five let me say it should be six six times is a good multiple so in both those cases the operating profit operating profit was thirty thousand dollars so that means that evey should be thirty thousand dollars times six which is equal to one hundred and eighty thousand dollars now for the first guy if the if the Evie is one hundred eighty thousand dollars so I'm saying that this thing right here the market value should be one hundred eighty thousand dollars that I'm implying that the equity should be worth $180,000 and they are there's there are ten thousand shares right so what I essentially I would take that Evie and I would say well that's though all of that's equity there's no cash there there's no debt so all of this is equity so I would divide that by the shares so I would say that the market cap for the first guy should be one hundred eighty thousand and so the per share price the price I'd be willing to pay is $18 because it had 10,000 shares right $18 now let's take the second guy situation we both agree in both situations their enterprise value should be 180,000 this right here should be $180,000 but in this guy's case what is the what are the assets the assets are the enterprise 180 plus 10 plus 10k right this whole left hand side is $190,000 and then the market and then if you wanted to subtract out a figure out the market cap you would take this whole thing and then subtract out the debt to get the market cap right and then you would be left with this piece right here that right there right you were just figuring out this whole distance subtracting out this distance so essentially you say that the market cap is equal to the enterprise value plus the cash minus the debt and it's good to draw those balance sheets if you ever get confused minus the debt so the market cap is equal to one ninety minus one hundred K is equal to ninety K and so if you divide that by 10,000 shares you'd say that I'm willing to pay nine dollars per share so if you believe that the enterprise value of these pizzerias are identical and that they're both worth $180,000 you should be willing to pay $18 for Company A and if you're completely equivalent to it you should pay nine dollars for Company B and now if you're a little bit more aggressive you might like the leverage you like might like how Company B is growing etc maybe you like to play a premium for that leverage or maybe you wouldn't because it also increases your risk because you get leverage on the upside or on the downside but anyway I wanted to introduce you to enterprise value in the next video I'll introduce you to E bit de