yeah at this point so hey Ria how is your IND trip you still jet lag or no but you probably would fall asleep in the night class anyway right is nothing to do with India so okay folks um at the risk of at the risk of pulling off scabs of wounds your quizzes are upstairs waiting to be picked up waiting and waiting and waiting I will leave them out there till they become recycling so it's it's in a sense it's out of my room I want it out of my room but somewhere in the next two weeks I will bring it in so I will leave it out there for a while and if you can't find your quiz it's because somebody's been playing with the alphabetical it was in perfect alphabetical order yesterday it's not in imperfect alphabetical order anymore I've already resorted it twice and I'm done so at this point it is what it is so you know but remember it's 10% it can be a throw we quiz if you did it badly it can be a keep quiz if you did it well but don't overplay it right so if you did well great you did badly it's okay there's more to come So today we're going to talk about the biggest number somewhere after we talk a little bit more about growth the biggest number in evaluation which is your terminal value number it's a number that if you don't pay attention to can very quickly take over your valuation and drive it to ruin all that work you put coming up with the earnings and the cash flows and the growth for the first 10 years gone in a second So today we're going to put you know what I call guard R in terminal value so you can you can decide what you can or cannot do and there are a whole lot of things you cannot do once you get to the terminal value calculation so I'm going to start that discussion today with a question that we're going to come back and talk about more so you projected out cash flows the next five next 10 years you get to your 10 why do we have terminal value because we need closure we can't estimate cash flows forever you're trying to come up with the terminal value which of the following is never an appropriate choice to get terminal value right so three of the four obviously are okay is liquidation value okay for a term value brance what do you think you think so let's say valuing um a business run by a 70-year-old plumber right and his son has moved on Works somewhere else and his practice is kind of going to die with them you project out the cash flows first you have to check the Actuarial tables to see how long it lives 10 years and then at the end of year 10 what are you going to do speci situation is it that special there are 90 times more valuations of personal businesses than are public companies right in those businesses liquidation value actually makes sense because the or take a ramco at the end of 50 years you get all the oil out of the ground how much is the are the Saudi sand worth nothing right liquidation value is a perfectly appropriate way of doing things we don't do it with publicly traded companies because not because there isn't a liquidation value but because a going concern value might be higher than the liquidation value right every business is a liquidation value for some the liquidation value might be higher that's okay how about a stable growth model that's what we do all the time right saying isn't that the only way to get terminal value well I mean it's in some textbooks it's presented as the only way can I get to your 10 and make it a growing anity you know what I mean by growing inity rather than assume cash flows continue forever I assume they continue for another 15 years think it's okay uh I yeah yeah what so tell me the kinds of companies we are more likely to take that path than the cash flows in perpetuity um companies that might have technology in the future that might in fact you see the the technology we're on right now recording this class Zoom great technology but if you think we're going to be sitting around 60 years from now on Zoom you have a very different perspective on this is a technology it's a great technology it to shall fade you're valuing Zoom you get to your 10 you're going to get this scaling up effect and then there's no forever 10 15 years and you're done that's okay so I kind of LED you to the one thing you should never do which 80% of banking valuations do all the time which is you get to your 10 how do you get terminal value you apply a multiple private Equity same thing you think what's wrong with it there's nothing wrong with you made your biggest value in your intrinsic value into a forward pricing right this is a forward pricing dressed up to look like a discounted cash flow valuation if we're going to have a forward pricing let's have an honest discussion about the forward pricing don't give me this front end of a DCF model fool me with cash flows and growth rates and discount rates for the next 10 years when I know the biggest number using is eight times down year 10 which you got by looking at some pure group you invented why do we think why do you think Bankers like exit multiples so much because they're pricers the game is a pricing game where making them play this discounted cash flow story when in fact hey you're a banker just take the DCF out of there let's St pricing let's do it right so a lot of discounted cash flow valuations out there are really not discounted cash flow valuation they're forward pricing with a front end of cash flows yes because I think we're all supposed to do it because you know it's become this right of hey you are a deep person you got to do DCF shallow people do pricing so here's how I show I'm a deep person I do cash flows I do discount rates I know what a free cash flow is your heart's not in it and at the end of the process you're working back to whatever you need to pay I understand the incentives that drive you there but think of how much time you spend on that cash flow front the weeks you spend with sleepless nights trying to the free cash FL on your one knowing fully well it doesn't really matter now let's make this about a Perpetual growth model let's say you're looking at a business it's already in stable growth it's got a 100 million and after tax operating income no growth in perpetuity and it cost a capital of 10% RI what's the value of this business business Nikita help out Ri so we have a cash flow constant cash flow forever discount rate of 10% since we don't have a grow wait do you not have a reinvestment number what did I give you as a growth rate 0% how much do you need to reinvest to get 0% growth 0% this is one of the few cases we can actually take after tax operating income in three free cash flow it's it's not that so basically the zero growth means zero reinvestment you numerate is therefore 100 Mil it's a free cash flow to the firm denominator is 10% the value of this business is a billion dollars everybody agree this is the McKenzie model for terminal value where you have no plat in the numerator and growth in the denominator we talk about what McKenzie assumes to get you there a billion dollars and you're not happy why are you not happy you wanted a bigger number so I'll give you a pathway let's suppose you put in a two % growth rate into this story what's going to happen to the terminal value what I'm going to let Michael jump in What do you think will happen Michael it's going to mathematically it should go up right because in the denominator now you have 10% minus 2% what's in your numerator though it can't be 100 million still because to get to that 2% growth rate what do you need to do you need to reinvest how much do you need to reinvest here's where the magic of sustainable growth kicks in right because if your return on capital is 10% you have to reinvest 20% of your after tax operate income how do it come up the 20% 2% divided by the 10% try this out take your numerator take 20% off divide by R minus C guess what your terminal value is going to do absolutely nothing it's going to stay exactly the same why because your return on capital is equal to the cost of capital it seems like magic when you ear exactly your cost of capital If This Were a capital budgeting project what's your npv going to be zero what happens if you take a project with an npv is zero zero what if the thousand times zero zero right growth becomes just running in place so today we're going to know because people often talk about the growth rate in the terminal value being the big deal you can already see that's not the real big deal it's what do you assume about excess returns in perpetu so we've already started to put some guard rails in on Terminal value we'll come back and talk about them but I want to go back to where I left you on the growth discussion I was in that long and very boring discussion of retention ratios times I they Bor I mean I was bored I don't know how you were not bored if you you know so I fully understand if you bored as well but in sustainable growth we look at two questions how much you you reinvesting how well are you reinvesting and we talked about growth in earnings per share retention ratio times return Equity we then looked at growth in net income where you looked at Equity reinvestment rates and retention ratios Rich measure of how much you're reinvesting and a non-cash return Equity let's move One Step Up the Ladder you want to get a growth in operating income you measure how much you reinvest with a reinvestment rate what's a reinvestment rate you take net capex and change in working capital with all the kavat the things we count in there right R&D and Acquisitions and you divide it by after tax operating income notice a pattern here whenever you're looking at Equity we focus on what percentage of net income you put back here we look at the percentage of after tax Opera income and when we look at how well we invest we look at return on invested Capital our perspective is about the entire business and again the sustainable growth equation is your reinvestment rate times your return on Capital is your expected growth rate so I'll take you back in time this is 1999 Cisco was on top of the world very similar to where Nvidia is right now right the architecture of the internet and it had phenomenal fundamentals in fact the reinvestment rate was 107% remember those Acquisitions that Cisco did pushed up the reinvestment rate but what was impressive is the return on Capital they were delivering again accounting numbers to the degree I trust them 34% return on Capital you reinvest 107% you have a 34% return on Capital your expected growth rate would be 36% so sitting in 1999 looked eminently reasonable right one of the great companies of the 1990s so what do you do you projected these numbers for the next 10 years what went wrong anybody yeah they can't keep well they were already big so the 106% reinvestment rate got more and more difficult they tried to keep growing at that rate but the return on Capital very quickly started to drop back down from 36% down to 10% Cisco did exactly what they did in the 1990s in the following decade but with very different consequences instead of creating value they were just running in place Cisco's market cap in 2010 was roughly what it was in 2000 same management team same model for growing and this is something we're going to come back and talk about with Acquisitions Acquisitions are almost a Time Decay strategy they work but there's a point in time where they stop working because you become too big to keep doing it so underlying all these sustainable growth models is an accounting return right return and Equity return versus capital and I think I've come across as skeptical about accounting numbers and I'm using the word skeptical to understand what I really feel it terrifies me every time I compute these numbers it terrifies me even more when I hear Consultants using these numbers to drive company decisions because I've been in the kitchen and you don't want to see the return invest Capital made if you're interested I I shouldn't say if you have trouble sleeping at night I think I have a solution I a paper I wrote on accounting returns return Equity return for scaff that was so incredibly boring I fell asleep multiple times while I was writing the paper so if you read this paper two pages and you're sleeping like a baby I did this in Portugal I couldn't go to sleep I read my own paper three pages in jetl gone it's almost like my body said I'd rather go to sleep than listen to you read me this scrap but here's what I did I took that accounting return Capital which fundamentally looks like a simple equation right after tax operate income divided by Book value of debt plus book value of equity minus cash only place in finan as I said we hold on to book value and then I started looking at all of the things accountants could do that SK that could skew return on Capital starting with two we've already talked about leases and R&D the main reason we capitalize leases and R&D is to get a better sense of invested Capital return invested Capital when a company takes a restructuring charge think of what they do to your invested Capital what happens to your invested Capital right after the restructuring charge it drops right so if I'm not aware you've done that and are you computed return Capital the next year I'm going to end up with this really high return on capital for the company thinking it's taking great projects when in fact it's been writing off its mistakes so this entire paper 64 pages is about taking what accountants do and working it through which effectively means to get the return on capital for last year for a company I can't just take the accounting numbers I've got to clean up for it but at the end of the process you can get an accounting return on Capital how much you trust it will probably vary across firms if you have a firm that's primarily intangible in its Investments the return Capital becomes shakier because you had to capitalize things you had to bring them in older firms return invested Capital becomes less trustworthy because the older assets become the less Book value actually captures what you originally invest so with all of those caveats it's still true that the return on Capital becomes this driver and the return on Capital we're talking about for the future it's not the accounting return cap for the past is what you think a company will make on its future projects one final piece of this sustainable growth and then we'll put it to sleep everything we've talked about so far is when you have a return on Equity of capital that's stable 12% but if your return on Capital changes and we talked about this a little in the last session you get this efficiency effect I'll take a very simple example let's suppose you have a company with the return on capital of 10% it reinvests nothing but it doubles its return on Capital next year dixa what's his growth rate going to be next year if you go from 10% return on Capital to 20% return on Capital 100% 100% right you see that's amazing but it's done you you get to 20% unless you can go to 40 and then 80 you're kind of stuck efficiency growth basically means as you work your way towards that end game you can get this efficiency growth adding on this is why you can't use it in the terminal value calculation is a justification for growth because you can't keep growing by just making yourself more efficient over time so as you go through time you are making assumptions on return on Capital and margins so take everything we've talked about so far because I'm going to give you five companies all of whom are growing at the same rate and I want you to rank them in terms of the quality of growth quality in the sense as an investor which of these growth rates creates the most value and which one's the least so you look across the five companies they all have 10% growth but they get there in very different ways the first three firms get there by with different combinations of reinvestment rate and return on Capital the last two get a supplementary growth from improving that return on Capital so if you're looking at the 10% growth rate which one is a complete freebie growth here look at firm five all of the growth is efficiency growth but it's just just for one year if you look at in terms of present value it's one and done and then after the first year you're going to go to 0% growth rate but if you look at long-term growth which of these firms do you rank most highly and why Gabrielle you going all of them grow at 10% but when you grow remember we're also looking at how much you have to put back into the business to grow so is it the reinvestment or the other half of the pz remember it's return on Capital times reinvestment rate gives you growth rate based on the reinvestment you're right the low reinvestment is what you want it comes from having a really high return Capital firm one is clearly a winner 10% growth very little reinvestment you can get 80% of your earnings as cash flow still grow 10% a year in contrast look at firm three it's growing at 10% but every time it grows at 10% it actually makes itself less valuable because it's earning well below the cost to Capital so when you look at return on Capital versus cost to Capital you're getting a very quick proxy on is this company growing and creating value which is what what firm one is doing nothing for Value which is firm two or destroying value in firm three other yeah I'd rather in fact I would rather The Firm three shrink right if you can get out of this business all the more power to you so I've said I've never understood airlines that tried to grow I can understand that Airline that's stuck in place can't get out but an airline that's growing what's what Universe are you in what business are you looking at I'm not seeing any of the numbers there company like Indigo right fastest growing Indian airline basically doubled its size I don't know whe this is a disaster waiting to happen or whether they've some found some new way in which they can earn more than the cost of capital long term maybe they have so when you look at growth that's basically the end game so now let's talk about the most generic definition of growth because I'll wag and none of you in this class is going to be use able to use a sustainable growth equation for the next 10 years because things will be changing margins returns so I'm going to look at the broadest possible way to think about free cash flow in the future this is what my simp fcff simple Ginsu spreadsheet is built on but I want to take you input through input so you sit down to Value company if your margins are changing you have no choice but to forecast Revenue do you see why cuz the margins are changing you can't do operating income too much stuff is happening it's Revenue growth we're going to talk about what it is that will allow some of you to be able to use high Revenue growth rates and others not to be able to get there then we're going to take a stop at margins essentially the profitability of business again some of you going to be able to Aspire for much higher margin than others we'll talk about the economics of what drives us and third you got to reinvest to get that growth and because the growth is in revenues I'm going to tie the reinvestment to the change in revenues I'm going to use a very simplistic ratio what I call sales to Capital it's like the return invest in capital but I'm looking at Revenue to invest in capital to see how much revenue I get per dollar of capital investment those are the three big numbers that drive every valuation let's look at what are the factors that will allow you to kind of give companies different numbers so I want somebody body who wants to take that in fact you can get started your valuation you haven't done it tell me what your company is and we'll use the framework to think about can we give this company high growth low growth anybody want to be Guinea P okay who you doing on okay good on is a great example on of course makes you know a niche footwear company so first stop is revenue growth there are two numbers I need I need to get a sense of the total market and what share of the market my company will get it'll be nice if the total Market itself is growing right because that gives me more room to grow first What's the total Market that on is going after footware market perhaps a sub subset of it athletic footwear because they're not obviously competing against Rockport or one of those so footware is it a big Market a pretty big Market in fact if you wanted to estimate how big that market is what's the way you're going to do it look at the revenues because most of the companies Nike rebok Adidas are publicly trade you add up the revenues and you're going to get a market that's that's large 250 billion 300 billion 400 billion how big is our On's revenues right now 800 million so already you can see you have a company that's that has revenues of less than a billion the market is 400 billion you have a lot of room I'm not suggesting it's guaranteed that you can grow but if you put in a 20% growth rate you know what Market's big enough let's say you valueing Volkswagen what's the automobile market look like it's big but it's mature right in fact you know if you think of it as gas powered automobiles it's probably going to shrink because electric cars are going to take away more of the market Volkswagen already has the largest or the second largest market share of the market so it's a large portion of a state a mature Market you give 20% growth rate for Volkswagen I have some questions right because that basically means you're wiping out Toyota you're wiping out BMW and I don't see a Universe where that is going to be sustainable so you're looking at the total Market you're looking at the growth in the market you're also looking at your market share and if your market share is Big you already start so let's take a company like Nvidia let's take the AI chip market I'll give you the bad news first the bad news for NVIDIA is they already have an 80% market share of the market what's the good news the chip Market is growing 40 50% a year so even if their market share goes from 80 to 60% their revenues are going to grow at 25 30 35% a year so when you're looking at your company you're looking at the total Market you look at how how fast it's growing and what share of the market is and you're making your best judgment to make that judgment you also have to factor in who you're competing against right if you take on who's a competition Nike it could be Reebok it could be let's face it there are other Niche companies entering the space as well right because they see what on has done say we too can do this so this is a comparative market and what sets companies apart in this market what sets companies apart brand name right so you're already thinking about what kind of brand name is on how many people recognize it how sustainable is this brand name is it going to be like Croc source and then kind of loses brand name and tries to come back it's a fad driven business there are very few companies that have had brand names that have lasted the reason we talk about Nike and Reebok and Adidas is they're the long lasting ones so you're looking at the market you're looking at the market share looking at the competition you think that's a lot of things to look at it is the world we live in right to value a company you have to know what your company does any questions on Revenue growth for any of you you have you picked a company where looking forward you might actually see negative Revenue growth what kind of give me an example of a company we're looking at the market and the market share a what a gig based economy a gig based economy that's a little too much for me to wrap my head around but I'll give you an let's say while anybody Welling Altria Philip Morris right Tobacco Company dominates its Market biggest market share but the market itself is shrinking I'm going to expect to see a negative Revenue growth rate if you put in a positive one you need a story right what's the story they're entering the vaping business they're entering the Cannabis in fact the big question is what's the biggest Advantage tobacco companies have is they know how to live in a world where everybody hates them and essentially they found a way to survive and prosper and deliver profits and the the big cannabis company has to have those characteristics as well because it's only a matter of time before we discover cannabis destroys your brain cells and people start suing you tobacco companies I've seen this movie before so if you give me a positive growth rate you have to tell me what other markets are entering so that's first stop second stop oh as we do this I'm going to take an example Airbnb went public you know when it went public most unusual IPO ever November of 2020 the word was still partially shut down from covid you have a hospitality company and I think it actually made sense to them to do it because a competition had been H hammered so much more by covid that their differential Advantage was greatest so at that time I did evaluation of Airbnb and I ran into a prom What's the total market for Airbnb it's Hotel business right anybody traveling and renting a room and in 2019 collectively Hotel companies had revenues of about 700 billion and it's a very Consolidated Market the big names Hilton so it's a business that's about 700 billion has about four or five big names and Airbnb is entry so an Airbnb filed its Prospectors you know the the people behind the company the founders the owners the you know part of writing the prospectus said estimated that their total addressable market and silicon values become very clever about this total addressable Market serviceable addressable Market essentially a big number 1.8 trillion no already that gives you pause right hotels are 700 billion collectively around the world you're telling me that there's going to be 1.8 trillion and then they went further that you add in experiences remember there was talk at Airbnb that host would add experience and you went to San Diego and you rented one your host would arrange all the nice locations nearby never quite bought into that notion of I trust an Airbnb host to also be my city guide but they said if you add that on it's 3.2 trillion first when you look at these total addressable markets Uber when they went public estimated their total addressable Market to be $52 trillion you know how they got there they added every dollar people spent not just on car service but in buying automobiles on public transit they basically took any anything that anybody spent on Transportation through it in there why do you think VC's and companies want to throw this big number out there because when you think about growth you think about hey Uber is only at 100 billion it could be 5.2 so there's a little gaming going on clearly there is zero chance that airbnb's potential Market is 3.2 trillion but I do believe that it'll be greater than 700 billion why because there will be people who travel to other places who would not have in the old hotel business but might now do it with Airbnb because you could take a family stay in a three-bedroom apartment basically not pay what you do in a hotel so when I valued Airbnb I did assume a market potential that was greater than 700 billion but well below that total addressable Market but you can see with young companies how this become comes off in the starting point what's the market I'm going after second stop oh one more thing on market share this is actually something you saw in almost every Silicon Valley sales spit the flywheel effect what it basically is is an illustration of how as you get bigger it gets easier for you to get bigger you see this with Uber you saw the Airbnb here's how the Airbnb flywheel worked right you want to list your apartment on a service where do you list it you list on the service that most people go to so Airbnb if it becomes the biggest will end up kind of pushing others up if you want to rent an apartment what do you go you go where everybody else is it's the same Phenomenon with right share what that effectively means is the end game here and this might depress people is you want have 15 different platforms you're going to consolidate into two or three it's already happened in the US there only three places you can go to rent apartments Airbnb Expedia and vbo and Expedia owns vbo so you basically have two places to go and that's in a sense the problem with these platform based businesses is competition is essentially going to get demolished and you're going to end up with winner take all which means when you value these business you can also give them a much higher market share from a valuation perspective so revenues market share you're already thinking about business economics size of the market in making those judgments so let's say you made those judgments so with on ad they might decide to give them 30% growth because they have a strong brand name it's a niche business it's going to grow now comes the second stop you have to estimate what they will make as margins and again let's go back to basic economics the biggest single driver of whether you can have high margins or low margins is unit economics something I've talked about off and on through this class what do unit economics measure they measure how much you make on that next unit you sell if you have great unit economics you're going to have high operating margins if you have terrible unit economics you can't you can you can never escape from that now you take a software company you know why we can give them 45 50% margins because the unity economics are just amazing right the next Unity cell cost you almost nothing why does Nvidia have so much higher gross margins than everybody else in the business because they don't make the chips they design the chips that are essentially almost like a software company they do the design tsmc makes it they they price it higher so you're looking at unit economics in your company and saying hey good unit if you're a manufacturing company I don't care how good you are you're never going to get to 40 50 60% margins you're going to be shooting at 12 14 15% margin second stop economies of scale every company I ever talk to talk the economies of scale they're going to be economies of scale right but how do you separate the wannab bees from the ones that actually have what is the what could you look at in the data that would tell you whether your company truly is economies of SC Jacob what do you think there's a big company in that same that operates the same business and they so you're looking AC crosssection is there something in the cross time comparison that will take what's the definition of economies scale that costs are growing at a lower rate than revenues right so if I gave you 10 years of financials on my company my revenues grow at 11% a year my costs are also growing at 11% a year I have no business talking about economies of scale the best giveway in economies of scale is look at Revenue growth over time look at cost over time and if you have economies of scale what does it mean when you project margins for this company as they get bigger there'll be this output pressure and margins the unit economics economies of scale so let's say your economies of scale you're cutting cost down right this is good for your margins before you make that judgment what's the wild card if you have three competitors are also scaling up they're also reducing costs your margins might not go up because you'll have to cut prices to keep up with them so competition matters it's great to have economies of scale and great Unity economics in a market where you don't have much competition a market with competition you know who's going to walk away with the benefits you and I as consumers because it's going to get pass through on the question of when will I get there you know what I mean by when will I get there I'm at 3% I think I can get to 25% the numbers in a spreadsheet say can I get there in your two you'd rather get there earlier rather than later right but to make that judgment you have to first start with your current number if your current number is minus 55% my guess is you're not getting to plus 25% in two years there's a lot of work to do the second is what the business model for this company is is it focused on growth or is it focused on actually becoming profitable your worst case scenario is you invest in a young Growth Company but the management has completely forgotten about the fact that they need to make money all they do is scale up and get Scaled up again I valued PTM and they went public the biggest mistake I made was I thought they were run by rational people what was PM's biggest sales pitch when they went public what made them what was the most impressive number about pum 330 million people on their platform that's the advantage Indian and Chinese companies start off with right 330 million people oh my God I will never get that no European payment platform will get to 330 million because that'll require every person in Europe including the Childs and pets to be list listed on the platform that was the most impressive thing but if you a payment processor remind me again how you make money when people transact on your platform you keep a slice of it's called the takeway this is not something that technology created credit card companies this is basically so if you look at if you use an American Express at a restaurant you transact how much goes to American Express so the highest percentage of any credit cards 3 and a half to 4% which is one reason a lot of merchants don't take American Express right then you go to Master Guard one of the great franchises of all time if you see a company that's actually been able to keep the competition away and still manage to grow MasterCard is it they make about 2 and a half% but it's huge gross transaction value PayPal is about 2 to 2 and a half% as well you know what the PTM take rate was when they went public 3% why because they were giving away I made the mistake of actually putting the PTM app on my phone because I wanted to see what it was I had to take it off very quickly because they kept sending me free offers every day more free stuff for you more free I don't want free stuff but you can see how they get people on the platform I'll give you free stuff if Starbucks gave free lattes would they sell a lot of lattes yeah that's a terrible business model I assume that now they had 330 million people that the management of PTM would turn their attention towards improving the take rate and there are two things I underestimate one is the capacity of management to stay in denial because the paytm management seems to have absolutely no idea that profitability is a part of a business model so you know what they did when they had 330 million they wanted to go to 400 million for they not stop sending more free stuff to me and there's the second problem and this I should have factored in more carefully when I did my valuation alipay has a take rate of 1.5 1.6% it's lower in Asia than in Europe but India has a particular problem if you're a Payment Processing Company there is a free Payment Processing service in India UPI which a lot of people can use so you're competing in somebody it's a government structured Payment Processing system you it's not going to be completely good for a shopkeeper right it's designed for you know for really small businesses but it's there which effectively means La as an anchor pulling down the take rate my guess is in steady state PTM is going to be lucky to have a one 1.2 even if they do things right the way they run they'll never do things right so when you assess this not only looking at the business model and what the company is doing you're looking at how focused the management is on actually delivering profits the day I was willing to look at Uber as an investment was the day in 2019 when Dar Kowski would just come in as CEO to replace Travis gnik would leav in a whole host of Scandal he got in front of the Uber employees and he said hey guys we need to figure out a way to make money and I dropped to my knees said thank you God finally after 12 years of scaling up and billions and billions of dollars of capital you finally woke up to that realization and you can actually argue that Uber's been run differently they're trying there Uber one where you can actually get a membership they're trying to make the model more sticky and that's all you can do Uber is in my portfolio bill it's in Bill amman's portfolio I think part of it is they are finally figuring out it's not adding another city that I want you to do I want you to take your existing cities maybe shed some of the Cities you're in maybe they're not worthy of being in and think about ways of making money so all of those things feed into your margins so yes I'm thinking about the the the payment companies like in Europe there are many players they just up most of them will not live right because right now all they're doing is scaling up going going to venture capitalist raising more cap I'm bigger than I was before you have to I mean I the blame here has to go to V capitals who funnel money to businesses encourage them to scale up and never stop and ask the question what business model are you in if I'm a Founder I'm a tech person I need somebody helping me on the business model side right but these VES this it's almost like that drug dealers feeding you more drug scale up scale up scale up and in fact you need addiction treatment programs you say okay we scaled up enough now come back to this program so we can talk about making money it's a different mindset right every day you wake up how do I get more users how do I get more subscribers and that's so you I'll safely predict at the end of the game this is a Consolidated business they're going to be two or three players no matter where you are there's a reason credit card companies Consolidated the way they did right if you had 50 different credit cards think of how much trouble shopkeepers have figuring out you pull out a credit card you've ever seen it before whether in fact they can trust the credit card it's a business consolidate and Europe being Europe I'm not sure when that cleaning up process will be but there will be a cleaning up process years they are keeping like growing up but ultimately they have to grow up they have to they have to go through what I what I call the bits for a moment right if you're Jewish you know bit moment these companies need to grow up they need to look you know it's not like you grow up overnight right after your B mitz but you know it's a it's a ceremony say hey you know what you're growing up you need to think about more than what your after school specials look like and I think these companies need that barwidth you know take take that moment more serious so with the Airbnb in November 2020 here's what my numbers look like I projected that when they were in steady state the gross bookings when ultimately Airbnb makes money when you book something gross bookings would be $155 billion you know what Marriott's revenues were last year 25 billion so Airbnb will have six times more and the reason I feel pretty comfortable is you look at bookings.com or Expedia they have big numbers because it's a Consolidated business so that's how I get the revenues for the margins in steady state I gave them 25% margins you think you're making that up I might have but here again I look not at hotel businesses very different business model I was lucky at two publicly traded companies Expedia and booking.com out there booking.com at 30% margins Expedia at 8 to 12% margins you know why I was surprised Expedia actually has a segment of the business model where they buy hotel rooms from hotels they keep it in inventory and then they try to sell them at a higher price it's a different business model not a better or a worse it's a different one that's pulling the margins down Airbnb is never going to buy your apartment for you pay you up front and keep it so I don't think they will enter the Expedia model there's a story there I'm telling about by Airbnb but it reflects the business or businesses I think they're in Revenue growth margins any questions about the margins part of your story so what kind of margins are you going to give on what are you aspiring to be first they're making money already right so what are their margins right now so they're already pretty solid right Nike's margins are pretty close right so there might not be much room on the margins you're hoping and praying you can hold on to your margins so almost all all of their increase has to come from revenue scaling up and if they introduce a cheaper shoot to be able to get even more in revenues you got to build that in into your margin story saying I will now be able to double my growth rate but margins will go to 12% from 15% third and final input and this is the one that gives me the most trouble because it's the most shaky number it's a number where I'm asking for every dollar of capital I invest how many dollars of revenues can I get the higher that number the more efficiently I'm delivering growth so when I look at the things that go into it I'll obviously start with what your history tells me about so in fact for Airbnb I looked every year at the change in sales and the change in invested Capital the number was like $1.5 of Revenue I was surprised how low it was because I was told this is a low Capital intensity business but it turns out they have to do Acquisitions and this is the thing to remember about a lot of technology companies that claim to be low capital intensity they don't build factories they don't have fixed assets but they have to do Acquisitions just to keep going Airbnb has done like 25 Acquisitions over their lifetime of Technologies sub platforms so they got about one point so I'm going to look at that if I can I'm going to look at the business as well but there are three things about this company I'm going to look at one is as they get bigger is it going to get more easier for them to scale that that sales Capital will it go up or not in some businesses it might you could argue that as you get bigger you can be more efficiently start to deliver revenues because you're drawing in your existing infrastructure if your company is in one of those businesses you can increase the sales to Capital ratio over time most companies though you'd be surprised how quickly you re hit a ceiling and so don't take your sales to Capital ratio of two and make it 17 just because you feel like it it's very difficult to pull that off but once in a while you will be a able in your company to be able to scale up with very little invested capital I talked a little bit about boing in the last session right so you're valuing boing you're catching it at a really bad time in its history they sold fewer aircraft last year than in decades why multiple factors let's say you map out a pathway back to Grace for boring where their growth is coming from not just you know increasing aircraft to some high number but going back to pre 2000 pre 737 max levels you put in a 20% growth right which will in about 5 years get them do you need any reinvestment relatively little why because their existing you know if you look at their assembly lines and plans are they have more than 50% excess capacity this will actually be using the excess capacity you might have to R too so if you give me a really high sales to Capital ratio for the next five years I'm going to step back and say you know what that makes sense this is something I run into with Tesla with each new Factory they build right after they build a factory they get about a three or four year window where they can grow with relatively little reinvestment so when I they only had the Fremont plant I had to think about new plants now they you know they have a plant every two or three years you get this window where you can grow and it's a limited window it's not forever where you can give them a high sales Capital ratio yes reinvestment is all of it so don't ever break it down reinvestment is all you know net cap change in working capital so if you have a very high working capital driven business it just means you'll have no scaling up effects as you grow and everything has to grow with it so it's captured all in that number right so my reinvestment is everything Acquisitions net capex change in working capital so look at your business model and see what drives it maybe for on it's a working capital it's a big part of invested Capital worst part about that it's very difficult to break out of that cycle right as you grow your invested Capital has to grow with it and finally there are some businesses where there's a lag between when you reinvest and when you grow let's take no NOK fastest growing large farmer company right now driven by what OIC and wovi when did they do the R&D for zic and wovi decade ago for a diabetes drug right this is purely providential it turned out that you lost weight if you're valuing a farmer company you see what this is going to mean right the sales to Capital ratio will not be wased on the change in revenues this year it'll be the change in revenues 10 years from now and even 10 years from now your compan is going to be a mature company you can live off past fat for a while and if you look at why Eli Lily is priced the way it is because they've been successful with the Obesity drugs they've done the hard work already so you can give them a high sales to cap ratio low reinvestment and still give them high growth rates so in the case of Airbnb I did give them a sales to Capital ratio of two roughly where they are because I don't see a scaling benefit here that's going to kick in on the reinvestment side what is that mean I take the change in revenues each year of just their revenues not the gross bookings and I divide by two and I'm done that's my reinvestment eacher the end result is you look at my free cash flows of firm this is in my upbeat optimis story there are my free cash flows the next 6 years negative negative negative eventually the numbers turn you need that for value is this a pessimistic view it's incredibly optimistic view but because I'm so optimistic the cash flows are actually more negative the pharmaceutical company how do you the regulation the pricing right right because what once you developed a drug you got to sell it the reason us pharmaceutical business is so much more valuable than the pharmaceutical business elsewhere in the world is not Demand right there are far more need there's far higher need for insulin in India because there are more people on the face of the Earth but in India I think an insulin dose could cost you $2 $3 here with the even with the price caps was like 3840 this is a business where there's pricing power which we all complain about in healthcare because it is the cost to us and that pricing power is what keeps these companies valuable so you show it as higher margins for a company where which has pricing power than for a company that doesn't that's why Niche farmer companies can end up with really high margins because you're and it sounds morbid but you're going after a small portion of the population you can charge outlandish prices and get away with it I'm not talking Martin Shelli business model if you have no idea what I'm talking about type in Martin Shelli into Google and you'll find out but I'm talking even legitimate farmer businesses are built on pricing power in in fact one more thing as you reinvest something we don't think about reinvestment is actually a delta in invested Capital so you can actually track what you're doing to your invested Capital over time and because your after tax operate income is coming from your Revenue growth and margins you can compute what I call an imputed return on Capital saying what am I going to do with it you're building a company in your spreadsheet here right you got to ask yourself can I live with the company I've created this kind of gives you a sanity check that's why in the Excel spreadsheet I send you I computed your imp imputed return on Capital over 10 if you get a 5,000% return on Capital in your 10 there's a message in your spreadsheet what's the message you're getting you're not reinvesting enough how do you fix it Go lower your sales to Capital ratio there's feedback loops in your spreadsheet that if you're listening to you can make your valuation much more robust one final Point whenever we talk about return on capital or sales to Capital or whatever other number you do in valuation you're talking about marginal numbers you know what I mean by that it's what you will earn on your new projects not what you've historically earned only problem is all our data is based on aggregated data for the whole company and that can sometimes be deceptive and here why let's say have a company the 25% return on Capital that's total after tax operate income divide by total invested Capital right but if I look looked at what they actually took last year as projects is it possible they earn a return Capital well below 25% absolutely and what's hiding it the fact that you have this great and glorious history Coca-Cola could take terrible Investments for the next 5 six seven years you wouldn't even notice it till you get your six or seven because they have such a legacy return on Capital to build on so when you think about marginal returns there a way to compute it but it's incredibly noisy I actually reporting that EX in the Ginsu spreadsheet that take the change in revenue and change in invested Capital it's all over the place but they might be a pattern if you can compute it over time to see if your company is moving away from or towards this historical return on Capital brings me to the last piece of the puzzle first let's be clear why do we need a terminal value to get closure we can't estimate cash flows forever so it's your cash flows are in perpetuity saying what do I do you stop in your five or 10 you estimate a terminal value right and if you accept that that's why we have it then the question becomes how exactly do you get there so let me lay out the four approaches including the one I said should not be done the first three are all intrinsic value approaches they're perfectly compatible you can do liquidation value how do you get the liquidation value of a company what would you do any ideas look at what the they own and if it's land and building and Equipment you got lucky land and building especially it's real estate if it's patn you got a little Messier analysis but liquidation values think of it as eBay basically you're taking your company you're putting every asset on eBay and getting the best price you have liquidation value for finite life companies of companies where there's a personal component to the business where when that person passes on the business dies liquidation works good for going concern you can either have the perpetuity which is what we tend to see in most textbooks including mine or and I think we need to emphasize I need to emphasize this more in my textbooks that you can compute terminal value by assuming that you get to your 10 and then you have 20 more years of cash flows because your technology is going to die after 20 years it's a present value problem and as I mentioned the one way you cannot do this is to take your terminal year whatever number Revenue e and the reason has is is not that it's a bad thing or a good thing it makes your biggest intrinsic value number into a pricing you have a forward pricing and you create the charade the front end of cash flows so I'm going to put in a series of guard rails on intrinsic value calculations that hopefully if you follow you will not get into those side alleys that analysts often get into first let's stay with the Perpetual growth model cash flow in the next period divide by R minus J right you get to year 10 you get the cash flow in year 11 it's always has to be one one year after why is that it's a present value rule present value needs next year's cash flow not this year so it's not specific to terminal value it's any kind of present value equation the First Cash Flow should be one year from now so to get the year 10 terminal value you need year 11's cash flow divide by Rus C take a look at the denominator because that's the most dangerous place valuation right R minus G and if you if I let you play with the G you're going to get your terminal value to whatever number you want but this is a growth rate you're going to be able to maintain in perpetuity let me lay some know set some rules on the table you tell me whether you agree with them this growth rate cannot cannot exceed the growth rate of the economy in urine it's a matsh right this is not a finance rule it's not an economics rule you can't let one number grow at a higher rate than the other number because that first number is going to become larger than the second number your company will become the economy should it be nominal terms or real terms you'd be surprised how often I get asked this question when I get to stable growth should I go to use a real growth rate forever or a nominal growth rate what's the answer for that ask them what they've done for the first 10 years because by the time you got to year 10 you did something for the first 10 years right did you do ninal cash flows if you if you did ninal you got to stay with normal if you did real cash flows you do real what currency well he chose again right you did your cash flows in dollars for the first 10 years don't switch to Euro growth rates it's got to be in the same currency so it's a consistency issue now of course I've replaced one problem with another one right because now value a company what do you have to do project out what the growth rate will be in the global economy in US dollar terms after 2035 good luck on that one you know how much time spend on trying to get this number finessed what's the right answer if in fact you go down this there's zero chance you can reason your way to a number so I'm going to use a shortcut that works for me you're welcome to use it you're welcome to abandon it and I'll tell you why I use it when I get to year five or year 10 my cash flows and I want to put my company at a stable growth rate I put a cap on that growth rate and my cap is my risk free rate remember this valuation has a risk free rate in the denominator let me explain my justification for this I don't know whether any of you remember this equation called the Fisher equation I saw it in my econ class way back in time Fisher equation is actually very simple it says a noral interest rate is composed of two numbers an expected inflation rate and an expected real interest rate what's a nominal growth rate in the economy expected inflation rate plus an expected real growth rate right set the equations next to each other the expected inflation cancel out the question becomes what is the relationship between real interest rates and real growth rates I'll tell you how I was start real interest rates in my econ class my professor kept talking about apples he said if you borrow 100 apples today you got to return 102 apples a year from now you know why when you talk about real interest rates you have to talk in terms of goods and services rather than dollars is you're borrowing something today you're returning it a year from now a real interest rate is in terms of real goods and services and that actually is going to allow me to break this deadlock let's say I go around promising people a 3% real interest rate but my economy is growing in real terms by only 2% I'm going to have a problem you see what what it is where the heck am I going to make up that extra 1% so your real interest rate cannot be greater than the real growth rate in the long term because things are going to blow up the other side is a little more difficult to prove can a real interest rate be less than the real growth rate for extended periods but eventually the real interest rate will start creeping up because there's s so much room in the economy to make great Investments people will start to desire to consume more now so either direction there's convergence between the two numbers and when you get to the terminal value you don't need this to happen next year two years from now but eventually it's going to happen you're not convinced I can tell so I'm going to try a second pl we want a ninal growth rate in the economy right so here's the experiment I ran I went back in time to 1954 looked up the t- bond rate at the start of each year looked at the ninal growth rate in the next 10 years I was trying to figure out is the t- bond rate a good predictor of normal growth and for the last 50 years I was able to run a contest of the t- bond rate versus the consensus growth rate you got from the 50 top economists in the US this is no contest you know which metric went out con you know continuously over the the T bond rate was a far better predictor of nominal growth rate in the economy than the 50 top economists in the country with all of their tools and their models and I'm not surprised here's the problem when you get four cast tting from economists or Market timers there's no money behind I can get on CNB saying I think the economy will grow 6% a year what if I'm wrong doesn't really matter I'm not going when you're in the bond market I'm asking you to put money behind your backing and the t- bond rate is backed up by trillions of dollars of money so I'm not surprised that t-bond rates are better predictors of noral growth so if you don't buy to the Fisher equation argument maybe the empirical argument does prettyy well in terms of and that's actually terrible news if you're in an economy with negative interest rates right because what is the bond market sending as a message deflation and negative growth and that's basically more likely to be true than not if the history holds on if you're not convinced by that either I have a third argument for why the risk free rate is a good proxy valuation is all about being consistent you get to your year 10 or year 11 you estimate a risk free rate you also estimate a growth rate in perpetuity right could it be is it possible interest rates are too low yeah it could be but if interest rates are too low you know what you do you also keep growth rates low and if you're wrong in the same direction in both it cancels out if interest rates are too high again not a problem discount rate will be too high but I'll give you a higher growth rate it keeps your valuations from going off the rails this was a big issue in the last decade because as you know Le three or four currencies had negative risk- free rates Euro the Swiss frank the Japanese Y and it freak people up and here's the reasoning they said if risk-free rates turn negative my valuations are going to become really really high do you see the reason for that right risk free rates become negative you have a low cost of capital and if I use the growth rates I've historically been using 2 3 4% my valuations are blowing up and that constantly push and they would try to normalize risk Rees and do neat things with it so there's an easier fix here and I'll show you what the fixes by showing a valuation I did of hinin in September of 2019 I did this in Munich and there were three people in the audience from the hinin finance group so initially when I went through the cost of capital they were actually very happy that I left the risk free rate where it was minus .5% why because it gave them a cost of capital of about 5% see patting each other back this is a great word we live it then I got to the numerator and I had to estimate growth and remember what's the message I'm getting from the negative three R you're living in a deflationary low growth economy so I gave them a low growth rate 3% year were a little disappointed but what I did on the terminal value freaked them out when I got to the teral value take a look at the growth rate I assumed in perpetuity I'm following this Ru Capital the RIS rate I gave them a minus5 and they said this is not fair I said you weren't complaining when I gave you a really low cost of capital right what one hand gives you the other hand takes away in spite of risk-free rates being negative hinin came out as overv Valu so it cuts against the grain of low risk free rates are good because the cash flows are actually worse affected than the discount rate by this phenomenon so as long as you connect your risk free rate your growth rates your ter what got people into trouble in the last decade is they continue to use growth rates in the terminal value based on what they learned in school in the 1990s or what they learned of their jobs in the previous decade while lowering the risk free rate to what it was in 2017 18 192 that's a mismatch that can cause your terminal value to explode yes Jacob but like in the US currently the 10e T bond is like 4 and a half% you're saying 4 and half that's your cap it doesn't have to be that the growth rate is at 4 and a half% right that's your cap you can give any number lower but you can't go above 4 and a half% you saying what if it's just a little bit more no still not right you still need to give away the cap so obviously you get a lot more room on your stable growth rate now than you did three years ago and rates 1 and a half% but it also comes with the catch right you now have a much higher discount rate you're going to be using for that terminal value and a much higher discount to bring the terminal value back net are you better off or worse off I'm not sure right so it kind of cuts both ways and that's the way it should be it's kind of know compensating effects in your cash flows and your discount rates so your valuing on one of the question you're going to face is when will my company be a mature company and on has 800 million in revenues the business is huge it's well regarded now and you're saying can I give it a 25 year growth period can I give a 20- year growth and often with companies that are Star companies young companies you why can't I give it 15 20 25 years okay so here are a couple of things to keep in mind as to how long you can let your company grow before things start to mature first is if you're a small company in a very large Market clearly you have more room to wait longer till you make your company mature on can grow for a long time not end up dominating the market but also remember growth creat value only if you earn more than your cost to Capital so the other half of this picture you're asking is not just whether I can grow but whether I can earn a return that exceeds my cost of capital and that is tied to what kind of sustainable advantages you have as a company we'll talk more and more about storytelling for your company but part of your story has to be about what happens after your attent does your company become a commoditized company earning its cost to Capital or is a company like Coca-Cola or amen that might have competitive advantage that spill over forever because that's going to determine whether you can keep the return on capital above the cost of capital so as you think about you know how long don't wait too long most companies buture far faster than you then so about 20 you know 30 or 40 years ago I started collecting data and growth companies I've never updated them too lazy and I just chronicled how long growth lasted at a typical us Growth Company 3 to 5 years before you kind of become very much like the industry you say but there are companies out there that have grown for more than 5 years absolutely and we can name any of these companies that have grown for long periods which tells you a lot about the exception not the rule third remember that when you put in a growth rate or change the growth terminal value something has to change in the numerator and to show you the effect of this I took that example we started with remember $100 million after tax operating 10% cost of capital and I said what if the growth rate is 2% with a growth rate of 2% you know what the value would be a billion dollars if the return on capital is equal to the cost of capital could it be higher than a billion not because the growth is high but because you earn more than the cost of capital if you're a bad business and I putting a 2% growth rate in your terminal value calculation I will demolish your terminal value each time I raise the growth rate cuz what you will lose in the numerator will be far greater than what you give what you gain in the denominator so when analyst push back and say this growth assumption my terminal value making a huge effect in value they're already confessing to what they're doing right what are they doing they taking the terminal value keeping everything in it fixed and taking the growth rate from 1 to two to two and a half to three of course your value is exploding because you're creating growth magic you're putting in a growth rate without telling me what happens to your cash flows now my my valuation book was published in 198 my very first valuation book came out in the late 1980s perhaps 1998 around the same time that McKenzie's valuation book also came out and they were both published by John Wy and the McKenzie valuation book you get to the terminal value chapter the terminal value at least in the original version of the book was no plat which is just ebit * 1- they invented this word no plat for it divide by cost of capital there was no growth in the equation for years I would get emails from people reading the McKenzie book saying I'm reading the terminal value chapter I noticed there is no growth in the terminal value why which my response is why aren't you writing to McKenzie why you writing to me but we both published they thought I probably hung out at a bar with the McKenzie guys and we chatted about terminal value all day hugely depressing thought if you think about it but I you the reason was actually in the book what McKenzie assumed is once you get to stable growth you earn your cost of capital and the reasoning is in the long term no company earns more than its cost of capital therefore you get to year 10 we're going to make the return and if you make the return on Capital equal to the cost of capital what do we say about growth it doesn't matter so might as well use a zero growth rate but McKenzie in its own research came up with data that countered the assump they were making in the valuation a publication from McKenzie called McKenzie quar it's a great publication it's free it's of lower quality than it used to be because it does a lot of crappy stuff in the middle but you know they have lots of data proprietary data from their clients that they look at to answer questions so one of the questions they were looking at is if you track companies over time what happens to the growth rate no surprise as you track them the growth rate starts to move towards the growth rate of the economy which is what we assume then there has a question as you track companies over time what happens with return on Capital and notice the return on Capital doesn't drop to the cost of capital in the real world there are quite a few companies out there that earn well above the cost of capital and will continue to do so for decades partly because of existing Investments that are not going to become neutral Investments at the end of year 10 I don't like the McKenzie Assumption of return on capital is equal to cost of capital for every mature company because it takes away degree of freedom I want to maintain in my story when I value Coca-Cola I want to give Coca-Cola this is the only way I can reward great companies when I get to your 10 right I can't let them grow a rate faster than the economy but I can give them Returns on Capital that are in excess of the cost of capital but that has to then become part of my story what is it about this company that will give it long sustainable advantages I know how many of you worked in private company appraise or even public companies I'm going to give you a collection of assumptions that you will see all the time in real world valuation so you have a analyst projecting cash flow the next 10 years at the end of year 10 they'll tell you the company is a mature company so far so good right they say it grows at 2% a year is that okay right now yeah 4.7% is the cap 2% is fine and then they would say because it's a mature company I am going to assume I being the analyst I'm going to assume that capex offsets depreciation what's what what does it what does that make Net capex Zero and working capital requirements are negligible which makes a change in working capital Zer what's 0 plus 0 Z what's 0 divided by any number zero so the reinvestment rate is zero you see the the the these are valuation models that are built to blow up what's the inconsistency you've assumed a zero reinvestment rate and you're telling me and of course the push back you get is but what if I said it at the inflation rate sounds alluring right because you don't need excess capacity what's the problem with even if it's just the inflation rate no you can't make the cost of capital it's got to be a reinvestment rate what is reinvestment when you say the capex offset depreciation what are you doing you're replacing old machines with new machines you're not building new capacity right and if you have inflation helping you on the revenues guess what it doesn't go away when you replace the old machine you said look you know what the inflation is only for my Revenue stuff it's no your same machine will cost you more which effectively means even if you grow just at the inflation rate this reinvestment assumption will still kick in There's No Escape Hatcher if anybody tells you they can have zero reinvestment and growth that's valuation m practice there is no justification for it but people do it all the time so now you have the ammunition the next time you run into this combination about half of all DCFS I see have this combination and they're able to get away with it now push back finally what are you doing to your company you're making it a mature company right what does that mean you're bringing your growth rate down that's a bad news but is there any good news to being middle-aged you see first you have more wealth so you're more stable right which your cost of capital will show up as a cost of capital decreasing now you also can probably have a more settled set of return on Capital so but so what I'm trying to say is if you make your growth rate when you make your company mature company not just the growth rate that changes your cost of capital should start to move towards the cost of capital of a typical company that's why I do that histogram of cost of capital median cost of capital 9 so as I look at the know year 10 I'm trying to push your company towards a media will your return on Capital probably decrease as you get probably you're a great company you're going to become less great doesn't mean you're cost you get to the cost of capital but you're earning a 30% return on Capital now I can almost guarantee you that if you scale up fivefold that that return on capital is going to come under pressure you're going to move it towards the cost of capital and because your growth rate is much lower you can't this is exactly why you can't take your year 10 cash flow and put a 1 plus G on it to get your cash flow year Lev you're looking at me like that's what I was planning to do what's the problem with taking year 10 cash flow and putting a One Plus on it you're taking the reinvestment rate you had in year 10 and essentially locking it in for perpetuity right so let's say a growth rate in your 10 is 5% and beyond your 10 it's going to be 2% you need to recompute your reinvestment rate for your terminal value calculation cuz you 10 number will give you too lower cash flow give your company the characteristics of a mature company and if you do that effectively it's going to play out last piece and this is just a kind of wrapping up piece lots of talked about lots of different ways you can value a company right let's look at the choices you can you know at this stage you got cash flows you got growth rate cost of equity but he's saying which cash flow should I discount dividends free cash Equity free cash for the firm which disc discount rate should we use cost of equity cost of capital what kind of growth pattern should I add when I think about valuation I think of three big boxes of Lego that you're trying to put together to get different discounted cash flow models so let's start with the first block which cash flow should I discount for firms which have stable leverage they probably better off using Equity because you can do the shortcut to get to free cash R which means for most of you what do I mean by stable leverage you have a debt ratio to and you think your company's going to stay at that debt ratio in perpetuity you do conad yeah probably stuck in the ways you do on and you put in the debt ratio today make it the debt ratio for you're probably going to be in trouble right so when you and for financial service clubs and we'll talk about why you end up with Equity valuation alone for financial service flubs for everybody else it's better off Val the entire firm so let's say you come to this fork in the road you've decided to go the equity valuation route there are two cash flows you can discount in equity right you can use the dividend discount model or the free cash Equity model so with which one should I pick if the dividenden it's not stable go if it's stable you going to take the dividends you you're going to walk right into a trap there right because every Dividends are always stable why the stable because they're sticky right it's not that whether they're stable but whether they reflect my free cash FL Equity if a company pays out roughly what it can afford to which also means then then might as well use a free cash Equity model right unless you cannot estimate free cash flow Equity you say why would I not be able to do it I've taken this class remind me again what I need for free cash FL Equity I need net income and add depreciation subtract capex subtract change in working capital and subtract change in debt I'll give you an assignment take any bank and I challenge you to estimate the free cashlo equity for a bank net income you can get right but everything below it I have no idea what's amortization for a bank what's capex for a bank what's working capital for a bank what's debt issuances and debt repayments for a bank so for as long as we've been doing valuation people give up on banks they I can't estimate free cash Lo Equity so what are you left with desperation you do the dividend discount because you've given up and I'll make a confession until 2008 that's what I did I no longer do it because I think we can dig ourselves into a hole when we use the dividend discount model but that's why we use dividends it's not because we think that some are better for banks but because we can't estimate free cash so second fork in the road Equity value free cash if you can estimate free cash Equity just stay with the free cash or Equity model what discount rate should I use well I've already chosen the cash flow right right the discount rate is really not even a choice you pick the the the cash flows to be cash flows to equity your discount rate has to be cost of equity remember can CAU and first Boston cash flow to the firm cost to Capital what currency again tell me what currency did the cash flows in so the discount rate choice is out of your hands once you made the cash flow choice and final piece can I get away using a stable growth model can you what kinds of companies you know some of you might have picked these companies what has what are you going to check to see if you can because a stable growth model means you don't need the front end of 10 years of cash flows you can just go right now and get cash flow next year R minus G you can be done with your DCF valuation in 5 minutes you say I'm tempted I'm going to take my company first it has to be a stable Growth Company so what's what are you going to check the growth rate to see if it's less than the risk Freer right be few hundred companies in the US but that's good second stop you got to look to see if it's behaving like a stable Growth Company in what sense if this company is reinvesting a lot no matter what the growth rate it thinks it can have higher growth that gets in the way your margin have everything has to have settled in I'll say one in 25 companies I look at stable Growth Company I can just go directly to the terminal value equation conet I'm going to Value later on the class with a stable growth model but if you have any growth that still rece idual there for even mature companies have some growth Levi Strauss is a mature company but it has potential growth in Asia Asians don't wear as you know genes as much as the rest of the world maybe it can convince them that could give you a little growth but for that's a two-stage model and if every other company you need some kind of a transition two-stage models work fine if you have 7% growth for the next 5 years and you're going to make it 3% but you have 70% growth going from 70 to 3 it's a little too much to ask you create a transition ultimately every discounted cash flow model you see out there so when people talk about hundreds of DCF models break it down what's the cash flow what's a discount rate what's the growth patter right it's the same model playing out in different disguises so I'm going to stop there when we start on Monday we're going to talk about the loose end you have everything you need to do your basic discounted cash flow valuations so I'll I'll send you that Excel spreadsheet again because as I said I'd like you to use my spreadsheet not because it's better but this is the time to kind of you know while the while the iron is still hot basically know do your valuation do a first round and then you can always so to just I would think that so I rather than go all the way and then allow it care discount rate when stage it's truey I can borrow money pay divs right I can in your application and fre hope and that it's to equity I talk about Equity now for okay and other question on the terminal free see I mean most of the time like Bankers they do this Dee equal so T that okay because you haven't put in any two days before you can't selectively maity but there's inflat there should be inflation in that item as well it's not a good justification for notif okay so I use reinvest I can I'll do that then don't say being conservative and what a lot of e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e e