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Principles of Finance, a la Shmoop. The five principles of Finance. Why is

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there always a number like this, like the Four Horsemen of the Apocalypse, the six

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wives, of Henry the eighth's, the three musketeers, the seven Habits of Highly

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Effective People. Finance more, or less has five wheels under its chassis and [car with five wheels]

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that fifth wheel sort of explains why the markets and the economy so often you

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know go off the rails. Anyway just know these five bad boys. Here we go.

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Principal one, the time value of money. Mantra, a dollar today is worth more than

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a dollar tomorrow. Why? Well because you can in theory, always invest that dollar

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and get a positive financial return from that investment. If you picked quote, the

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safest bet in the world, unquote. Well by investing in American Treasury bills,

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which are guaranteed more, or less by the American government's ability to tax its

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hardworking people. Well then you'd get a small return on your [man talking in dark room]

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investment. For a more practical example think about you investing a thousand

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bucks to buy a t-bill yielding three percent.

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Well bonds like this usually pay twice a year, so six months later you'd get what?

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Well if your total interest per year was three percent, on a grand invested then

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you'd get thirty bucks, a year, for doing a whole lot of nothing. Other than let[money in bank vault with American flag]

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your grand sit with the Gov. So twice a year you'd get a check for fifteen bucks.

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But it's about two lattes, but it's a positive investment return that's pretty

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much guaranteed. Silly example, but there were about a hundred eighty two point

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five days, that made up the six months, that yielded to you, your $15. So how much

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did you earn per day, based on that figure? Well about fifteen dollars,

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divided by one hundred eighty point five, or about eight cents a day. Well the gist

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here is that, the thousand dollars today, was worth more than the thousand dollars [January calendar]

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tomorrow. That is invested in the form of a very safe 3% T bill. The dollar today was

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worth about eight cents more than the dollar tomorrow.

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Well time values a pretty dull concept when it's three percent a year, on a

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relatively small amount of money. But let's calculate something more fun. Okay,

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our idea of fun, sorry. We netted a hundred million dollars after tax, after

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an IPO of a company we founded. We want some toys and bling. First off we want

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to shrink the world, so let's buy a jet. A

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shiny new cj3, cost about twelve million dollars and another fortune to operate,

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to ensure, to store, to gas up, to pilot and so on, but don't let's ignore all that. So

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we plan to keep it 20 years. After 20 years, the plane will be worth, [jet flying]

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not much. Figure four million dollars, at auction, so we'll lose eight million

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dollars over twenty years, or four hundred grand a year, so yeah that jet

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was expensive. But it gets way, way, worse. With a 20 year time frame, we could have

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felt pretty good about putting our money in the stock market in equities, in the

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form of an index fund. Over the hundred and fifty or so years that the modern

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stock market has been tracked over most 20-year periods the markets gone up,

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about eight, or nine percent. And with dividends reinvested, maybe a little [stock graph incline]

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bit more. And yes there were bad periods where performance was flattish, but there

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were also really good periods, where performance was way better than that

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eight or nine percent figure. So let's just pick the middle of the curve for

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now. If all we did with our twelve million dollars, was put it in the market

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and get it back 20 years later in a bad stock market era. Well we'd have done

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way better financially, than if we had bought that new jet outright. Right? We

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lost eight million dollars for the pleasure, plus maintenance, gas and risk

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and the comparable cost to fly commercial would have been massively [man in commercial airline]

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less, that we won't even bother with that now. Let's bet that the market does what

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it usually does on average over this 20 year period. It goes up 8.2% a year, well

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had we invested in our index fund, which charged us point two percent a year for

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maintaining that index. We would have had a ton more dough.

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How much more? Well the magic formula, take the dollar amount you invested and

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multiply it by one, plus the rate of return and take that quantity to the power of years.

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Looks like this, in this case the formula would be, twelve million dollars, times [man presenting in dark room]

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one, plus point zero eight, to the 20th power and note that the market went up

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8.2% a year, but we only kept eight point zero percent of it because we had point

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two percent a year in fees. This is a big deal when you look at mutual funds which

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carry are R rated fees and then hedge funds which carry triple X's, but we'll

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get into that later. Anyway, 1.08 to the twentieth powers about five, so gulp if

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you would put your twelve million dollars into an index [man presenting in conference room]

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fund twenty years later, it would be worth sixty million dollars. Instead of the

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four million dollars, you got. And yes that's the right math we checked it twice.

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Jets are nearly the worst investment you can make and life's short and the super wealthy,

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well they want, what they want. As Marie Antoinette said, let them eat jet fuel.

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Well one other note, worth noting here, is a cute little formula called the rule of

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72. Read it, know it, know how to use it, it saves lives.

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Well it doesn't really save lives, but it'll make yours a lot better,

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our lawyers made us say this. All right moving on, principle two, risk and reward

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are related. Popcorn question, why do you get eight percent returns from the stock [movie theater]

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market in equities and you only get three percent from safe bonds. Well a

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bunch of things affect rates, of investment returns. But the biggest issue

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revolves, around whether you'll get your money back, or not. And/or a positive

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multiple of your money back over time. Okay here's a chart of bond performance,

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it's flat. Basically it's a dead man's pulse. Very few bonds don't pay back what [money on table]

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they promised and yes a few go bust but compared with equities, bonds are a

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massively safer investment. But you pay a big price for that safety over time. That

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twelve million dollar jet money, invested in a bond over 20 years at 3%, well

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ignoring taxes, which are also generally worse for bonds, than stocks. Well it gives

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you just about twenty one point six million. Way better than owning that jet

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and think about how many first-class commercial tickets that dough would have

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bought. He had a lot of pretzels. Anyway with stocks, you turned your dough into

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sixty million dollars in twenty years, so for that bond safety you just paid [finance chart]

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almost forty million dollars, in net difference over those twenty years for

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that safety. How's that feel? You feel safe for now, or just less wealthy? Well

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things could have gone the other way, had you bought at the worst time. Say

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late 1973, held them to the worst period in 1993, with dividends reinvested. Well

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you would have compounded at only about six percent, about ten percent with

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dividends reinvested, albeit well with a lot of headache.

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Look at how stocks declined from 73, to 83, brutal. But also look how dividend [stock graph chart]

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rates went up. That is when companies stocks declined,

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they don't usually just cut their dividends, they keep paying them. And

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investors who need and/or want the cash returned to them from their initial

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investments are happy to get checks four times a year, because while equity

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dividends are paid quarterly, unlike bonds, which are paid twice a year. But

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look at the chart, could you have stomached being down almost 50 percent

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from 73 to 79? Would you have panicked at just the [bond action site]

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wrong time and sold all of your stocks and moved into bonds at just the wrong

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time? Well taking on risk is a lot about personality and liquidity, ie

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you don't need that investment to be cashed out tomorrow and well it's about

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courage too. But over time as you take bigger risk you would expect to be

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rewarded incrementally, for taking on that risk. And there are times to not

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take a lot of risk, of course as well. Like if you're planning on buying a home [pink house]

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in six months, well you likely don't want to be invested in the market. In a bad

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six month period, things can go down a lot. The big fat hairy idea here, well

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it's that time bails you out of risk when you're investing in stocks. If you

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can hold an investment a very long time, historically it's made no sense to own

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bonds instead of stocks. All right moving on principle three, the market as a

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popularity contest, versus being a weighing machine. Warren Buffett, the [man walking out of pool]

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Michael Phelps of public investing said, in the short term the market is a

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popularity contest. In the long term it's a weighing machine. Well what on earth

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does that mean? Well he's referring to short-term and long-term thinking in

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investing and Buffett is a famously long-term greedy investor. That is

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Buffett likes to buy things and stick them in a drawer for decades, not weeks.

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Over time market prices are truth, they are accurate, they are honest. But in

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short periods of time the market can go crazy. Later in this course we'll get

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into the internet bubble of the late 1990s, where companies would go public on

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very little revenue, with valuations of billions of dollars, many of them died, or [graveyard with tombstones]

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simply had aweful investing returns, due to the schmuck, or speculative buyers who

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bought them. A few did really well, a little company called Google's one of

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them, Amazon's another, eBay, PayPal another. But most ended up doing poorly if

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you held them 20 years. Conversely toward the end of the

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2008 nine mortgage crisis, a ton of companies were trading the other way, Ie

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crazy cheap. And these were stable always gonna be there companies, like

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coca-cola and Pepsi. Which traded down to below, ten times earnings at one point. [soda market graph chart]

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Like the market in the short term, was telling you that the odds of people

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drinking drinks, not just soft drinks was kind of an iffy proposition.

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Well things normalized, with Coke and Pepsi trading at right around there

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adjusted historical price, to earnings ratios in the low 20s, eventually. Key

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takeaway, be sensitive to the sentiment the market is feeding you, but when you

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buy stocks for the long haul just buy good companies and good industries, right.

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Even if you overpay in the short run, good companies bail you out in the long

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run. All right, principle four, cash is king. Ever hear of Hollywood accounting, [Hollywood sign]

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profits, well they don't exist when the talent in the movie participates, or gets

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a percentage of them. Let's go through a simple example with something a bit more

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tangible. The company, We're Nuts about lug Nuts, has four hundred million

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dollars in revenues, in a given year, and 300 million dollars in expenses. Leaving

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a hundred million dollars, to be taxed. Tack on a 30 percent tax rate and after

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30 million dollars in taxes, the company is left with seventy million bucks in

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earnings. Well the shady mystical figure, in all of [man silhouette]

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these calculations is the notional definition of expenses. Let's say the

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company spent three hundred million dollars on a factory, to stamp out its

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lug nuts more efficiently. Well the accounting rules might require that all

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that money be expensed, in three years or it might be in 30, or it might be viewed

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as an investment and it just stays static forever, held that Book value. If a

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company had to expense everything in three years, well then the company would

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be required to expense a third of that hundred million dollars of that 300

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million each year. If they had to expense the capital expenditure of the lugnut [robot working in factory]

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roboto stamper in three years then a hundred million dollars of profits in

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that year in the two subsequent years would be fully wiped out. The company

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would essentially pay no taxes and well end of story.

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Alternately the company might have had to amortize that cost over 30 years,

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taking off 10 million dollars a year, in expenses. From an accounting perspective

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then the company would show 90 million of profits and pay 27 million bucks in [white board with expenses and profits]

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taxes. For now don't worry about the numbers too much the key idea, is that in

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order to fairly evaluate the value of a company, you have to follow the cash, or

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cash earnings and look through accounting tricks, which can change the

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bottom line in earnings, dramatically. All right well the magic word in all of this

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is GAAP. that's GAAP and you're supposed to say it like that. It stands for

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generally accepted accounting principles, and it basically just tolds that when you

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practice accounting, you always present your numbers in the most reasonably

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conservative manner possible. In doing so, you take away the risk of you know

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puffing out your feathers, saying that your company is in fact more profitable

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than it really is. For example think about the case where

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your lugnut Roboto stamper really does wear out in ten years and it has to be [robot breaking down]

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replaced. Well in that case the 300 million dollars spent to build it should

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in fact be taken away in some form, amortize, depreciated in a sinking fund,

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whatever, so that it surprises nobody when in 10 years, you owe another 300

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million dollars to go buy, or build a new one. All right moving on, principle five,

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last one, here stick with us. Agency problems, all right well what is an agent? [man in office room]

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For most people when they hear that term they think about a guy in a slick suit

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in the Hollywood office selling clients time into a studio system with a lot of

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let's do lunch you know that regular catchphrase and that really is what

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financial agency is about. When a client hires an agent, a relationship structure

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is formed. That is there are legal requirements around the behavior of that

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agent, specifically the agent has to look out for the best interests of his client

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and he has to put his own best interests on the backburner. This structure is a [bacon cooking on stove]

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really big deal in the financial world, because so many poor unsuspecting,

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uneducated, people have been screwed over in the process by big city slickers

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taking their dough, with no comeuppance. Myriad laws, regarding disclosure and

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appropriateness of advice and other elements all have blood on their hands.

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That is each law, that you'll learn about exists because somebody, was screwed over,

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or sued and a new law was edited to cover that corner case situation. Where a

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fast-talking thief, took the money of our beloved mom and pa

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kettle. [man in conference room presenting]

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