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Current time:0:00Total duration:13:41

Video transcript

that we have two entrepreneurs and they are both interested in buying a pizzeria and eventually turning it into a public company so let's compare the two so let me draw a dividing line here between the first and the second entrepreneurs and they're actually going to buy identical assets so they're gonna buy a pizzeria with the ovens inside of them and the same amount of cash and the cash register everything they need to operate the pizzeria and it's and there may be an identical locations maybe right next to each other at the same intersection or across the street from each other so it's the same asset let me draw that out I don't want to draw it as a box so that's the asset and it costs a hundred thousand dollars that includes the building it includes the the the oven it includes the the places where the customers come sit and it even includes the cash needed to operate the business so you need some cash to pay vendors just to get started and to pay for things like dough and to have some money in the cash register and to have a little bit of a bank account things like that so that's all inclusive all of the assets needed to start the the the firm the the pizzeria so this is the assets and they both buy identical assets so let me copy and paste that see okay let's see copy and paste there you go they buy identical assets now the first entrepreneur he's very conservative and he's been saving on his whole life to do this so he actually has $100,000 of cash to buy his pizzeria so he buys it outright so he owns it outright so all of the hundred thousand dollar of asset value is actually his equity I'm doing it equity in a different color it's all his equity so that's all his equity this guy here maybe he's a little bit earlier in his career he just not as good at saving money so he has to he doesn't have quite have $100,000 he actually only has $10,000 in his pocket but he's a smooth talker he's a smooth talker so he goes to the local bank and say hey I have this great idea for let me write this down ten thousand of equity that's what he has but he tells the guy at the bank and he buys him lunch she says I have this great idea for a pizzeria and they agree to give him not just ninety thousand this guy he's a little ambitious - he thinks not just besides a pizzeria in the name of the pizza a he's gonna borrow some money and then maybe invest that in stocks or something so he gets a sweetheart deal on on the loan and he's able to actually borrow a little bit more than what he even needs he only needs 90 K but let's say he borrows a hundred gay so he borrows a hundred thousand dollars of debt a hundred thousand dollars of debt that's right there a hundred thousand of debt 100k a debt and so he has a hundred ten thousand dollars to play with he buys a hundred thousand dollar pizzeria and then he has another ten thousand dollars left over to do with what as he wants he puts it in the pizzerias name in the pizzerias bank account because he has to show the bank that's going towards the pizzeria but his real intent is to maybe gamble with it on the side and the pizza Ria's name and maybe invest in stocks or speculate on on pork belly futures or something like that but let's just for all general purposes or for all intents and purposes it's it's cash right and so they go off and they start their pizzeria and so let's see what happens so let's look at them over the course of let's look at on the course of one year of one year so let's say revenue its revenue so let's say the first year they're identical they both make 100k in revenue 100k 100k let's say their cost of goods sold is roughly 50% of that so let's say it's 50k I'll put a minus there because it's an expense - 50k so they're both of their gross profit is 50k 50k and then their SGA is the same and if you've watched the video on if you watch the video on depreciation and amortization this might even include the depreciation on some of the physical assets they've bought or maybe the amortization on the rights to the name you know super pizzeria in either case maybe that both the brands are identical so that's that's another 20 K minus 20 K minus 20 K so far they look very very identical and that's because they they have the same exact asset so their operating profit operating profit 50 minus 20 is 30 K 50 minus 20 is 30 K and now we will start to see a little difference and and this goes back to the very first video we saw so if you have an identical asset if the asset it's being managed identically which it is in this case they will generate an identical amount of operating profit but when I talk about the asset I'm talking about the only the operating assets right this guy has some non operating assets although it's officially part of the company he doesn't need it to operate it this is cash above and beyond what's needed in the cash register and you know we could happen we might have a little bit of cash here in this asset that's needed for the cash register and for I'll teach you more about working capital but in order to pay vendors and things like this this is a cash and above and beyond what's necessary this guy has a little bit of cash just to operate the business he just doesn't have this gambling cash out here so now we add an interesting line non operating income so non up income this guy doesn't make anything he's not gambling this guy is pretty good with this $10,000 of speculation cash she makes let's say 20% on it in this first year so he makes $2,000 and then we have interest expense interest expense this guy has no debt very prudent he has no interest so his pre-tax pre-tax income is $30,000 this guy he does have interest right let's say that on that hundred thousand dollars of debt he got a really good deal let's say that the Fed thought that he was systemically important to the future of our financial system so he gave them a sweetheart I don't know two percent debt deal just because he was afraid that if if if if this pizzeria were to fail it would bring down the entire financial system so given that so two percent on a hundred thousand dollar debt that's two thousand of debt a year so - mm I'll make it a little bit more realistic let's say it's four percent let's say it's I'll make it even more let's say it's five percent 5% 5% debt on that so 5% on $100,000 is 5k per year and interest so that's his interest expense let me write that's interest this was non op non-op income this was operating profit just to see just you just have to carry the lines over and so his pre-tax income pre-tax is now 30 plus two minus five is twenty seven K they both paid 30% in taxes taxes and so this guy is paying $10,000 or let's say well actually $9,000 would be 30% and this guy 30% of two to 27 so see tax is see it's three six thousand plus it's eight thousand one hundred minus eight thousand one hundred that right yeah that's nine thousand and then if you have three thousand less you should be nine hundred less yeah that's right and so we're finally at the net income line net income net income this guy makes 21 K this guy makes what is this this is 19 thousand nine eighteen thousand nine hundred thousand net income and of course the difference is is is the money that he had to spend on tax on or not just on interest expense right if you net out all of his little financial engineering has paid three thousand more in interest if you net out his profit he made on his little cash bets on his side bets and and that was able to be a tax deduction so the actual effect ends up being two thousand one hundred right which is essentially three thousand dollars at a thirty percent tax rate so fair enough that's not what I want to do here I don't want to focus too much on the interest the tax savings on interest what I want to do here is focus on valuation and see whether the price to earnings ratio holds up to scrutiny in this situation where you have an identical asset but very different capital structures so let's say they both have 10,000 shares shares I'll arbitrarily switch colors ten thousand ten thousand shares so EPS this guy made $21,000 this year divided by 10,000 shares is two dollars and 10 per share this guy eighteen thousand nine hundred divided by ten thousand is a dollar eighty nine per share and let's say you know for all and we could have modeled out their income statements further and actually this guy even if the top line even if the revenue grew the same and on the operating profit grew the same because of his leverage he would actually grow a little bit faster I'll do another video on how that works with leverage but let's say that someone looks at this you say look is the same business everything and if anything this guy is growing a little bit faster because he's got that leverage that extra juice from from the financials from the capital structure he's got so they both deserve at least a price to earnings of ten all right so you say they both deserve a price to earnings of ten so ten price to earnings you'd say I'm willing to pay twenty one dollars for this guy and I'm willing to pay eighteen dollars and ninety cents for this guy now what is that what does that result in their valuation or in terms of their market cap so in this guy's case market cap twenty one dollars times twenty one thousand times ten thousand shares means that you are ascribing ac21 times ten you're saying that the equity in this company is worth two hundred and ten thousand dollars two hundred and ten thousand dollars in this case you're saying that the equity in this company is worth one hundred and eighty nine thousand dollars alright so this one's worth a little bit more because it's earning a little bit more money oh you might you know I don't want to complicate it but you might be willing to pay a higher multiple here so something very interesting is happening by applying the same price to earnings we're saying that the market value of this equity is two hundred and ten thousand dollars while the market value of this equity is what was it a hundred and eighty nine thousand dollars one hundred and eighty nine thousand dollars that's not the right number one hundred eighty-nine thousand dollars right something doesn't seem to make sense this guy put up a hundred thousand dollars ensure they invested it and did all that so now the markets willing to say hey you know what this is a pretty profitable more profitable than most you're making good margins and I'll do a bunch of videos on margins in the future we're willing to say that it's the market value of your equity is $210,000 which implicitly means that the market value of this asset is two hundred and ten thousand dollars right if they're saying this is worth two hundred thousand two hundred ten that's because this must be worth two hundred ten but if you look here by pricing by giving the same price to earnings because they're the same business and maybe this guy's even going faster so their needs are being conserved and by only giving this guy a ten price to earnings you get a one hundred eighty nine thousand market cap for this equity which all of a sudden this guy only put in ten K and people are saying it's worth one hundred eighty nine and if this is worth one hundred eighty nine if if this little fraction right here is one hundred eighty nine then it implies what about this asset what does it imply about the value of that asset you have one hundred eighty nine thousand is the value of this equity the value of this debt is a hundred thousand so the market is saying the right hand side of the balance sheet is what is a one hundred eighty nine plus a hundred thousand it's two hundred and eighty nine thousand dollars and let's say this cash is still it's still cash that's worth ten thousand dollars so if you subtract it out the market is saying this is two hundred and eighty nine minus this ten two hundred and seventy nine thousand dollars so something is very bizarre right here that the market is just because of how this guy has capitalized his company if they just a price of superficial price to earnings of ten to both companies it's willing to say that this asset is worth two hundred seventy nine thousand and this assets only worth two hundred ten thousand dollars even though they're identical assets so I've already used more than enough time on this video so I'll let you ponder that a little bit and in the next video I'll show you that the reason why this is kind of breaking down is because a price to earnings ratio does break down to a certain degree when you start comparing things with different capital structures and their will and in in the next video I'll introduce you other ways of comparing things with different capital structures are essentially deleveraging them that when you just talk about price to earnings or market capitalization right when you just looked at market capitalization looked okay oh there's similar businesses this one's worth a little bit more because this one has dead but then when you actually back out the implicit value of the asset all of a sudden you realize that you're really overpaying for this asset so think about that a little bit what's kind of the conundrum here what what what what went wrong in the next video we'll I'll give you some tools to actually do this right