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Principles of finance a la shmoop a mathy evaluation of an investment all

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right you're a young financial analyst at a mutual fund company you wear a red [People standing in a cue]

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tie in a white shirt and are learning the various expressions you're supposed

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to make when whining about taxes you know from the old people there you dream

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of becoming the man well for your coverage you inherit dumbest waste of

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time ever or DWOTE yeah that's actually a company that is your research director

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or boss assigns you to cover this internet media company if you don't own

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it and it then goes up a lot you look like an idiot and vice versa so punting [Person places football on the ground]

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on even having an opinion on DWOTE is not an option meaning that you have to

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come up with a buy sell or hold recommendation on the stock at a given

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price so how do you do the math to come up with a recommendation beyond

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blindfolds dart boards and Ouija boards and a donkey and a tail there well the [Donkey appears in a field]

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key elements you note about the DWOTE story here we go they have a dollar a

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share in cash on the balance sheet no debt no big off-balance sheet assets or

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patent things that matter and they also have a dollar a share in trailing one

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year fully taxed earnings or net income the stock is currently trading at $65 a

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share or 65 times trailing earnings and yes if you subtract $1 from that you get

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an equity capitalization of 64 times but kind of a rounding error here and the

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scheme of things you think about it so we're gonna move on you heroically note

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that in order to just get your money back in cash at this rate it would take [Man discussing DWOTE in a presentation]

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your company DWOTE about 65 years to do this

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yeah 64 maybe a little less than that with interest and all that but that

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we're not gonna go there so lots of optimism lives around DWOTE trading at 65

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last year's real profit well compounding your angst on all of this you work for a

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conservative mutual fund firm who normally prefer a stocks which pay a

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dividend but this is a tech company a tech media company run by 20-somethings [Young tech workers discussing work]

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so yeah there's no dividend for you the overall markets trading at about 18

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times earnings a bit higher than its historic levels of about 14 times but

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with the Fed giving money away and we say that in quotes in the form of

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very low interest rates well the higher multiple seems fair assuming that

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everything else like growth rates margins etc are all about normal

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whatever normal is that is growth prospects fears of war risks of Europe [Soldiers prone firing guns]

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defaulting again North Korean nukes Taylor Swift accused of lip-syncing and

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so on all that's normal right so you mumble and you note that if you

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had a pizza parlor that made a million dollars a year it would be like the

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seller of that pizza parlor asking you for sixty five million dollars for that

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pizza parlor and yeah that feels like a lot of money for a pizza parlor you

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wonder how a pizza parlor could ever sell for sixty five million dollars [Man discussing pizza parlor]

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maybe if it sold the real estate along with it and that real estate that we're

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sitting directly on a gummy bear mine but yeah sixty five times earnings cool [Man holding gummy bears]

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company but wow I wouldn't be the only one in the world in love with it you

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could replicate your own pizza parlor for a hundred grand in stoves and food

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and cheese and dough and stuff and maybe a hundred grand or so for fronted costs

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of rent and labor roundup for insurance and a little local marketing and you're

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at 250 grand all-in if you wanted to start your own pizza parlor albeit from [Person taking pizza from stove]

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scratch so wait how do you get to paying 65 million dollars for 1 million dollars

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of earnings from this notional pizza parlor but first you think why would any

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idiot pay 65 million dollars for a pizza parlor well they wouldn't nobody really

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pays 65 times earnings for anything just because you see that multiple quoted by

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poorly schooled financial journalists does not mean that you should believe it [Financial journalist sitting at desk]

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if an investor is paying 65 times earnings on this year's numbers they

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must be expecting massively fast earnings growth so they're thinking

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about what multiple of earnings they're paying on next year's earnings or the

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next year's and by the way pizza parlor sell for like four times earnings maybe

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five with seller financing why because pizza parlors don't grow very fast they [Pizza growing in size]

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have limited upside like how many people can you have put through a pizza parlor

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in a year not that many you compare that to a website well it's a whole different

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deal right and who really wants to own a place where little kids scream pick [Kids screaming and running around a pizza parlor]

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their noses and the restrooms have you know poor aim but

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DWOTE yeah it ain't no pizza parlor it's a video sharing platform for your pets

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think dog Vanity Fair, squirrel selfies, platypus profiles, zebras being zazzy...

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everyone loves the site the company doesn't spend a dime on marketing

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because customers just walk in or you know click in the front door and that [Images of people clicking computer mouse]]

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clicking thing is important unlike a pizza parlor which has a limited

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capacity of maybe a thousand meals a day on a ridiculously record busy day well

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there's essentially no limit to how many clicks DWOTE conserve it could literally

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serve a billion clicks an hour if it wanted to

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anyway the customers love the product and they get addicted fast DWOTE sells [Girl looking at computer screen]

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ads and for the power users who want to market their own pet wares largely

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insurance and organic foods and training devices there's a subscription fee of a

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hundred bucks a month well the company has shockingly high margins as well the

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only have 40 employees most of whom are in Latvia and none of whom were in

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California..DWOTE hosts its site on Amazon Web Services which is super cheap [View of an office appears]

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and the company's revenues could go up a hundred X and their expenses would

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only double, wow you think that is scale way better business than the pizza

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parlor right well what are the odds you wonder that people will still be using

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DWOTE in five years hmm that's harder what are the odds people will still be

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eating pizza in five years yeah much easier different risks different rewards

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so the company has 100 million dollars in revenues this year operating expense [DWOTE financial standings appear]

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of 15 million in pre-tax profits of 85 its biggest expenses taxes which 20 mill

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oh and to make the math easier less hard they have 65 million shares outstanding

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so yeah that's 65 million dollars in earnings buck a share there and a bunch

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of thoughts come into your brain how can a little company of such ridiculously

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high margins that are sustainable these margins are higher than the profit

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margins Microsoft had in their heyday as a monopoly are these margins really

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sustainable the company grew a hundred percent from last year can it keep [Important questions appear]

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growing at that rate and it's such high margins like won't they have to spend a

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bunch of dough marketing themselves is this a real business or a fad like

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remember guitar hero pokemons go one direction yeah [One Direction band together]

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well, your boss mumbles your boss at the mutual fund there I think I have things [Boss mumbling to man]

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in my golf bag older than the CEO of this company does she know what she's

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doing and then you ask what's for dinner well you get hungry doing financial

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analysis very few six-packs in the mutual fund world all right so the [Man with six pack and cheese burger appears]

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company has 100 million dollars in trailing revenues ten million dollars

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comes from selling ads on the site and 90 million comes from subscriptions to

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power users who pay a thousand bucks a year eighty to a hundred bucks a month

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roughly but if you buy a year at a time you get the discount mainly to make the

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math easier for this problem so the company has 90,000 power users

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subscribers paying at a grand a year let's think about that is that a lot or

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a little 90,000 well eBay has like a million power sellers but you wonder how [Man with eBay briefcase for a head working out]

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big this pet market is maybe it's tapping out so you do some research and

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you find that 114 percent of the world owns a pet and many own two so that's

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how we got that math there and in most places people treat their pets better [Woman with a cat and a toddler appears]

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than they treat their human children how crazy would it be for the subscriber

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number to double like could it get to 180,000 well there's like 300 million

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people in America and change and like seven billion in the world is that

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really hard to think about could it get to a million well it almost has to have

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a clear line to a million paying subscribers because if it doesn't well

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it's not worth the risk here of 65 times earnings if the company ever missed a

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quarter that is they produced growth numbers below published or [Man discussing whisper numbers]

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whispered street expectations well the stock would fall out of love and plummet

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that is people who owned it with high growth expectations would sell and sell

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and sell and continue to sell the stock until value buyers stepped in to buy it

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and put a floor on the stock but wow that's a long way down from here in this

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market you know that a normal multiple is like yeah 20x for a software company

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something like that maybe 25 but for a value buyer to step in the stock could [Man assessing value]

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have to fall like 15 or so a share maybe less crushing and that's down $50 from

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here ugh and you picture the HR lady at your mutual fund company calling you [Man thinking of HR lady]

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down to her office telling you to bring your jacket and your little desk plant

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with you tons of risk on the downside you pull your hair

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prepping for a bigger Caesar salad that's already starting to go on up [Mans hair transforms into caesar salad]

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there and you do some research and after poking around and using Google properly

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you discover that the company is reserving massive storage space

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everywhere hmm well yeah video takes up a lot of space it wouldn't do that if

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the advance indications of demand weren't good then you meet with the CEO and [Man sits down with the CEO]

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in the meeting you notice tons of pictures of animals all over her desk

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and walls and around her neck she's kind of weird she stands to shake your hand [CEO stands up and shakes mans hand]

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but tada you see that she is pregnant you want to talk about her stock she

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wants to talk about being a parent and you have seven kids who were adopted

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when she learns of your massive fatherhood well suddenly you feel her

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liking on you a lot she's relentless and asking you all about your daily life the

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events you share how it is to be a father of seven kids you know that

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normally these interviews go the other way around with you interrogating the

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CEO but this time she's interrogating you about babies odd and then a light

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shines through the window on your Caesar salad you feel the warmth and you [Light shines on mans head]

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realize because you're smart and they hired you and they pay you a lot of

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money to work at this mutual fund company that she's about to launch a

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video product for parents to share videos of their children with their pets [Woman with child on a swing]

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a whole new market financially probably 40 times the size of the pet market you

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reckon and since this company already has a loving cute brand while who

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doesn't love baby zebras and platypuses or platypi is it more whatever you're

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willing to bet that it will be trusted and embraced by a million parents in not [Images of parents with their kids]

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too long so yeah babies wow that's a big idea the revenues from that would dwarf

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her pet revenues you take a deep breath knowing that the laws of regulation FD

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financial disclosure she cannot disclose anything to you that isn't already

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publicly broadly known and she didn't tell you she's doing a site about babies

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you're just making a big guess here and you could be wrong so you could ask flat

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out if she's launching that product on the baby's thing and watch her face lie [Man discussing baby video launch to CEO]

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or you could just let it go and buy the stock well the financial estimate

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projection math is easy ish if they got to a

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million users paying a grand a year with maybe half from the US and half from

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everywhere else because many other countries around the world do have

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babies that would be a billion dollars a year in revenues a million times a

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thousand one BFG a big fat gig even if expenses ballooned massively the company [Expenses balloon inflates]

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would still show something like 800 million dollars in pre-tax profits

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it would have generated a ton of cash for itself in the interim and the cash

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matters example in 2009 Apple is trading for about 50 bucks a share and had 40

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bucks a share in cash and no debt meaning the street valued the equity of

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Apple for just $10 a share you could have bought some how do you feel and

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after tax in this setting DWOTE would have something like 650 million dollars

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in profits on 65 million shares outstanding in that'd be earnings of

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like $100 a share now multiply that by 50 bucks and you get a company worth

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some five billion dollars in change and there's probably upside even from there [Apple and DWOTE growth numbers appear]

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so if you actually believed those growth numbers you'd be paying less than one

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times earnings if you bought the stock today even at the high multiple of

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trailing earnings $65 and albeit earnings of the stock a few years from

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now could be a whole lot different well you run not walk to the lobby and you [Man running towards lobby]

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call in a big fat buy order to your traitor at your mutual fund company and

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then you pray a lot [Man praying in church]

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