0:00:00.000,0:00:00.440 0:00:00.440,0:00:03.370 In the last couple of videos[br]we saw that looking just 0:00:03.370,0:00:06.800 purely at market capitalization[br]can be a little 0:00:06.800,0:00:09.190 bit misleading, when you look at[br]companies that have a good 0:00:09.190,0:00:11.380 bit of leverage or companies[br]that have a good bit of debt. 0:00:11.380,0:00:14.530 For example, if that's the[br]assets of the company, and 0:00:14.530,0:00:18.181 let's say that they have[br]this much debt. 0:00:18.181,0:00:19.810 And this is their equity. 0:00:19.810,0:00:24.430 0:00:24.430,0:00:26.180 And then let's say they[br]have some excess cash. 0:00:26.180,0:00:28.420 Cash that's not necessary to[br]actually operate the business. 0:00:28.420,0:00:30.150 I'll draw that up here. 0:00:30.150,0:00:31.520 So this is excess cash. 0:00:31.520,0:00:34.850 Some cash is necessary, and[br]oftentimes people don't make 0:00:34.850,0:00:35.220 the distinction. 0:00:35.220,0:00:37.800 And they'll just view this[br]as all the cash. 0:00:37.800,0:00:41.420 But we really want to separate[br]the value of the enterprise 0:00:41.420,0:00:45.620 out of the market value[br]of the equity or the 0:00:45.620,0:00:46.720 value of the debt. 0:00:46.720,0:00:47.900 So let me just write[br]all this down. 0:00:47.900,0:00:50.230 So this right here, this is[br]the value of the business. 0:00:50.230,0:00:51.480 The enterprise value. 0:00:51.480,0:00:54.500 0:00:54.500,0:00:58.160 Here is the debt. 0:00:58.160,0:00:59.490 There's the debt. 0:00:59.490,0:01:01.175 And this is the equity. 0:01:01.175,0:01:03.920 0:01:03.920,0:01:06.870 And this is a little bit of[br]a slight, I would say, 0:01:06.870,0:01:07.190 technicality. 0:01:07.190,0:01:08.950 And you don't have to worry[br]about this if it 0:01:08.950,0:01:10.100 confuses you at all. 0:01:10.100,0:01:12.780 When I write the enterprise[br]here, this is the value of the 0:01:12.780,0:01:13.730 business itself. 0:01:13.730,0:01:18.060 So it's kind of the operational[br]assets net of the 0:01:18.060,0:01:19.230 operational liabilities. 0:01:19.230,0:01:21.560 It's literally-- if you had[br]to go out in the past two 0:01:21.560,0:01:24.500 examples and buy the pizzeria--[br]how much net would 0:01:24.500,0:01:26.150 you have to pay for[br]that pizzeria? 0:01:26.150,0:01:29.150 And that's what we're trying to[br]figure out right here when 0:01:29.150,0:01:31.440 we're talking about the[br]enterprise value. 0:01:31.440,0:01:33.585 And we saw in the last couple[br]of videos how you calculate 0:01:33.585,0:01:35.370 it, but it never hurts[br]to review it. 0:01:35.370,0:01:38.070 This is actually one of those[br]less intuitive calculations 0:01:38.070,0:01:40.380 the first few times you[br]see it, so it doesn't 0:01:40.380,0:01:41.970 hurt to do it again. 0:01:41.970,0:01:43.950 So the first thing to figure out[br]is, how do you figure out 0:01:43.950,0:01:45.680 the market value[br]of the equity? 0:01:45.680,0:01:47.400 The book value of the[br]equity is very easy. 0:01:47.400,0:01:49.570 You could go into a company's[br]balance sheet and they'll 0:01:49.570,0:01:50.070 write down a number. 0:01:50.070,0:01:54.120 They'll say, this is what our[br]accountants say that the book 0:01:54.120,0:01:55.730 value of our equity is worth. 0:01:55.730,0:01:58.260 But the market value, figure it[br]out from what the market's 0:01:58.260,0:01:59.580 willing to pay for a share. 0:01:59.580,0:02:07.670 So the market value of equity or[br]the market cap is equal to 0:02:07.670,0:02:11.520 price per share times the[br]number of shares. 0:02:11.520,0:02:14.040 0:02:14.040,0:02:16.240 And that's the market value[br]of this equity. 0:02:16.240,0:02:18.800 And you can see, just even from[br]this diagram, that the 0:02:18.800,0:02:25.230 enterprise value plus the[br]non-operating cash or 0:02:25.230,0:02:28.590 investments or liquid[br]investments, whatever you want 0:02:28.590,0:02:29.280 to call them. 0:02:29.280,0:02:37.580 Enterprise value plus the cash[br]is equal to the debt plus, 0:02:37.580,0:02:39.420 let's just say the market cap. 0:02:39.420,0:02:42.970 Because we want to know, when we[br]look at a price, we want to 0:02:42.970,0:02:45.230 be able to figure out what[br]is the market saying the 0:02:45.230,0:02:46.970 enterprise value of[br]the company is? 0:02:46.970,0:02:49.500 What is the market value[br]of the enterprise? 0:02:49.500,0:02:51.820 So debt plus-- instead of[br]equity-- I'll write market 0:02:51.820,0:02:54.020 capitalization, because[br]it's the same thing. 0:02:54.020,0:02:58.150 Market capitalization is the[br]market's value of the equity 0:02:58.150,0:02:59.840 plus market cap. 0:02:59.840,0:03:01.690 So we know market cap. 0:03:01.690,0:03:04.240 We can look up the debt on a[br]company's balance sheet. 0:03:04.240,0:03:05.820 We can look up the cash. 0:03:05.820,0:03:09.470 So we just subtract cash from[br]both sides, and we get 0:03:09.470,0:03:20.480 enterprise value is equal[br]to market cap 0:03:20.480,0:03:25.120 plus debt minus cash. 0:03:25.120,0:03:27.500 We're just taking cash[br]onto the right-hand 0:03:27.500,0:03:30.730 side of this equation. 0:03:30.730,0:03:35.070 So for example, if I have a[br]stock that is trading at- 0:03:35.070,0:03:38.650 let's say the price is $10. 0:03:38.650,0:03:45.290 And let's say that there[br]are 1 million shares. 0:03:45.290,0:03:52.450 And let's say that the company[br]has $50 million of debt. 0:03:52.450,0:03:59.400 And let's say it has $5 million[br]of excess cash, what's 0:03:59.400,0:04:00.880 its enterprise value? 0:04:00.880,0:04:02.510 Well, you first figure[br]out its market cap. 0:04:02.510,0:04:06.750 Its market cap is $10 per share[br]times a million shares. 0:04:06.750,0:04:08.670 So that's 10 million shares. 0:04:08.670,0:04:10.510 That's the market cap. 0:04:10.510,0:04:11.410 You add the debt. 0:04:11.410,0:04:13.560 So, plus $50 million. 0:04:13.560,0:04:15.760 And once again, I said this in[br]the last video, it's very 0:04:15.760,0:04:17.390 unintuitive when you figure[br]out the value of the 0:04:17.390,0:04:19.459 enterprise to add the debt. 0:04:19.459,0:04:23.480 And the intuition is that if[br]someone were to want to buy 0:04:23.480,0:04:27.040 this company from the[br]stakeholders and be debt free, 0:04:27.040,0:04:29.750 they would have to pay these[br]people the total amount of 0:04:29.750,0:04:32.270 debt, and they'd have to pay[br]these people the total amount 0:04:32.270,0:04:33.060 of the market value. 0:04:33.060,0:04:35.610 So they'd have to pay the[br]debt plus the equity. 0:04:35.610,0:04:37.830 And they get a refund[br]of the cash. 0:04:37.830,0:04:40.100 This would be extra stuff that[br]they would be buying that they 0:04:40.100,0:04:41.970 could get money back for. 0:04:41.970,0:04:44.260 So you have to pay the equity[br]holders, you have to pay the 0:04:44.260,0:04:46.720 debt holders, and then you[br]get a refund of the cash. 0:04:46.720,0:04:51.630 And so the enterprise value's[br]what? $60 million minus 5. 0:04:51.630,0:04:54.200 That's $55 million. 0:04:54.200,0:04:54.780 Fair enough. 0:04:54.780,0:04:58.170 This is all just review of the[br]enterprise value video. 0:04:58.170,0:05:00.980 But the question is, now that[br]you've figured out enterprise 0:05:00.980,0:05:02.490 value, how do you figure[br]out if that's a 0:05:02.490,0:05:04.130 fair enterprise value? 0:05:04.130,0:05:06.290 When you looked at market[br]capitalization you compared 0:05:06.290,0:05:09.440 that to earnings. 0:05:09.440,0:05:11.560 The price to earnings ratio. 0:05:11.560,0:05:12.880 You were doing this[br]on a per share. 0:05:12.880,0:05:16.320 This is price per share divided[br]by earnings per share. 0:05:16.320,0:05:22.350 This ratio's equivalent to[br]market cap divided by the 0:05:22.350,0:05:23.810 actual net income[br]of the company. 0:05:23.810,0:05:27.570 0:05:27.570,0:05:29.520 Where if you just multiply the[br]numerator and the denominator 0:05:29.520,0:05:32.370 by the number of shares, you get[br]market cap and net income. 0:05:32.370,0:05:33.490 This is EPS. 0:05:33.490,0:05:36.210 P/E is actually price[br]per share divided by 0:05:36.210,0:05:37.240 earnings per share. 0:05:37.240,0:05:38.880 And that was one way[br]to look at it. 0:05:38.880,0:05:40.210 You could compare[br]two companies. 0:05:40.210,0:05:42.570 And we saw it breaks down if[br]they have different types of 0:05:42.570,0:05:43.310 capital structure. 0:05:43.310,0:05:45.880 So what do you compare[br]enterprise value to? 0:05:45.880,0:05:48.670 Here we did market cap[br]to net income. 0:05:48.670,0:05:52.450 Enterprise value should[br]be compared to what? 0:05:52.450,0:05:55.460 Now I made an argument in the[br]last video that, well if we're 0:05:55.460,0:05:58.340 looking at the enterprise, we[br]should look at essentially the 0:05:58.340,0:06:00.850 earnings that are popping[br]out of the enterprise. 0:06:00.850,0:06:03.640 We should look at the earnings[br]that are coming out of this 0:06:03.640,0:06:05.100 asset right here. 0:06:05.100,0:06:08.280 And on the very first video[br]on the income statement, I 0:06:08.280,0:06:10.180 implied that-- let's do[br]a balance sheet-- 0:06:10.180,0:06:12.370 you have your revenue. 0:06:12.370,0:06:14.740 Your revenue could be 100. 0:06:14.740,0:06:18.730 You have your cost[br]of goods sold. 0:06:18.730,0:06:23.130 Cost of goods sold could be,[br]let's say it's minus 50. 0:06:23.130,0:06:24.520 And I'll show you another[br]convention. 0:06:24.520,0:06:27.720 One of the commenters suggested[br]that I do this 0:06:27.720,0:06:28.100 convention. 0:06:28.100,0:06:30.380 Which is actually the most[br]typical convention for a lot 0:06:30.380,0:06:32.260 of accountants and financial[br]analysts. 0:06:32.260,0:06:34.050 Instead of writing a negative,[br]they'll write it in 0:06:34.050,0:06:34.720 parentheses. 0:06:34.720,0:06:36.000 That means negative. 0:06:36.000,0:06:38.270 Minus 50. 0:06:38.270,0:06:45.060 And then the gross profit[br]would be 50. 0:06:45.060,0:06:47.350 And then, actually I want to[br]do something a little bit 0:06:47.350,0:06:47.750 interesting. 0:06:47.750,0:06:50.830 Let's say that this cost of[br]goods sold, it involves no 0:06:50.830,0:06:52.170 depreciation or amortization. 0:06:52.170,0:06:55.360 And watch those videos if[br]those words confuse you. 0:06:55.360,0:06:57.720 And all of the appreciation and[br]amortization is actually 0:06:57.720,0:06:58.850 occurring at the corporate[br]level. 0:06:58.850,0:07:04.760 So let's say that there[br]is some SG&A. 0:07:04.760,0:07:07.240 But this is without the[br]depreciation and amortization. 0:07:07.240,0:07:14.630 So let's say that this[br]is an expense of 10. 0:07:14.630,0:07:16.110 Let's say there's some[br]depreciation and 0:07:16.110,0:07:18.505 amortization as well. 0:07:18.505,0:07:20.990 D&A. 0:07:20.990,0:07:23.250 In the last couple of videos[br]I kind of grouped. 0:07:23.250,0:07:24.490 And that tends to be the case. 0:07:24.490,0:07:26.540 On a lot of income statements[br]they won't separate out the 0:07:26.540,0:07:28.060 depreciation and amortization. 0:07:28.060,0:07:29.470 And you'll actually have to[br]look at the cash flow 0:07:29.470,0:07:30.890 statement to figure[br]out what this is. 0:07:30.890,0:07:32.920 And I'm going to do that[br]in a future video. 0:07:32.920,0:07:34.560 But let's say that we actually[br]do break it out. 0:07:34.560,0:07:35.700 Sometimes that does happen. 0:07:35.700,0:07:39.200 And let's say that[br]that's another 5. 0:07:39.200,0:07:41.620 Maybe these are in thousands. 0:07:41.620,0:07:45.160 And then you're left with[br]the operating profit. 0:07:45.160,0:07:49.410 0:07:49.410,0:07:53.740 In this case, which is 50[br]minus 15, so it's 35. 0:07:53.740,0:07:55.010 And then you have things[br]below that. 0:07:55.010,0:07:58.360 You have interest. And I'll do[br]those just for-- you have the 0:07:58.360,0:08:00.420 non-operating income and[br]interest and all that. 0:08:00.420,0:08:01.150 Let me just do that. 0:08:01.150,0:08:08.160 Interest. Let's say that that is[br]also 5,000, if that's what 0:08:08.160,0:08:09.430 we care about. 0:08:09.430,0:08:11.750 And then you have pre-tax. 0:08:11.750,0:08:13.500 I didn't put the non-operating[br]income. 0:08:13.500,0:08:15.820 Let's say this cash isn't[br]generating anything. 0:08:15.820,0:08:19.570 So pre-tax income is 30,000,[br]if that's what 0:08:19.570,0:08:20.710 we're dealing with. 0:08:20.710,0:08:21.920 It's getting a little messy. 0:08:21.920,0:08:23.480 So then you have taxes. 0:08:23.480,0:08:25.390 Let's say it's 1/3. 0:08:25.390,0:08:27.380 It's 10,000 of taxes. 0:08:27.380,0:08:28.630 And then you have earnings. 0:08:28.630,0:08:31.090 0:08:31.090,0:08:33.409 30 minus 10 is 20,000. 0:08:33.409,0:08:37.250 So I suggested, what part of[br]this income statement is 0:08:37.250,0:08:40.059 dependent purely on this[br]piece right here? 0:08:40.059,0:08:45.450 0:08:45.450,0:08:47.180 Well all this stuff with[br]interest, that's 0:08:47.180,0:08:48.570 dependent on the debt. 0:08:48.570,0:08:50.810 And essentially taxes is also[br]dependent on the debt. 0:08:50.810,0:08:52.630 Because the more interest[br]you have, the more 0:08:52.630,0:08:53.500 you can deduct it. 0:08:53.500,0:08:58.980 And so all of this down[br]here is dependent on 0:08:58.980,0:09:01.300 your capital structure. 0:09:01.300,0:09:03.620 So if you wanted to look just[br]what the enterprise value is 0:09:03.620,0:09:05.810 generating, it's generating[br]the operating profit. 0:09:05.810,0:09:10.220 0:09:10.220,0:09:13.220 So I suggested that a pretty[br]good ratio, although this is 0:09:13.220,0:09:14.200 very non traditional. 0:09:14.200,0:09:16.050 It's not very not traditional,[br]but you don't 0:09:16.050,0:09:17.970 hear it said a lot. 0:09:17.970,0:09:21.730 I'd argue that you could look at[br]EV to operating profit as a 0:09:21.730,0:09:22.980 good metric. 0:09:22.980,0:09:29.300 0:09:29.300,0:09:36.550 Which in a lot of cases is the[br]inverse of the return on 0:09:36.550,0:09:39.200 assets, as I defined it[br]in the first video. 0:09:39.200,0:09:41.770 There's a lot of different[br]return on asset definitions. 0:09:41.770,0:09:44.350 But it's essentially saying, for[br]every dollar of operating 0:09:44.350,0:09:46.940 profit, how much are you paying[br]for the enterprise. 0:09:46.940,0:09:49.010 Which I think is a pretty[br]good metric. 0:09:49.010,0:09:52.340 Now, the more conventional[br]metric that you'll see when 0:09:52.340,0:09:55.100 you see people talk about[br]enterprise values, enterprise 0:09:55.100,0:09:56.370 value to EBITDA. 0:09:56.370,0:09:59.340 And if you go and get a job as[br]a research analyst at some 0:09:59.340,0:10:01.550 firm, this is going to be[br]something that you're going to 0:10:01.550,0:10:03.620 be expected to calculate[br]for a company. 0:10:03.620,0:10:06.410 And hopefully talk reasonably[br]intelligently about it. 0:10:06.410,0:10:10.080 So the first question, to talk[br]reasonably intelligently about 0:10:10.080,0:10:11.720 anything is, what is EBITDA? 0:10:11.720,0:10:18.460 So EBITDA is Earnings Before[br]Interest, Taxes, Depreciation 0:10:18.460,0:10:20.300 and Amortization. 0:10:20.300,0:10:22.560 So let's see what that[br]would be here. 0:10:22.560,0:10:28.890 So it's earnings before[br]interest, taxes, depreciation 0:10:28.890,0:10:29.900 and amortization. 0:10:29.900,0:10:32.280 So it's before all[br]of this stuff. 0:10:32.280,0:10:33.920 Actually, let's compare that to 0:10:33.920,0:10:35.120 something we covered before. 0:10:35.120,0:10:36.370 So you have EBITDA. 0:10:36.370,0:10:39.280 0:10:39.280,0:10:41.660 And you have EBIT. 0:10:41.660,0:10:45.660 EBIT is Earnings Before[br]Interest and Taxes. 0:10:45.660,0:10:47.520 So EBIT is earnings. 0:10:47.520,0:10:49.240 You add back taxes and[br]interest. You're 0:10:49.240,0:10:51.350 at operating profit. 0:10:51.350,0:10:53.530 And I've gone over this in the[br]past, but the distinction 0:10:53.530,0:10:57.220 between operating profit and[br]EBIT is that EBIT might 0:10:57.220,0:10:59.080 include some non-operating[br]income, which 0:10:59.080,0:10:59.890 I haven't put here. 0:10:59.890,0:11:03.790 But if this cash was generating[br]some profit 0:11:03.790,0:11:05.740 unrelated to the operations[br]of the business, it'd 0:11:05.740,0:11:06.620 be included in EBIT. 0:11:06.620,0:11:07.810 It wouldn't be an operating[br]profit. 0:11:07.810,0:11:10.900 But they're usually pretty close[br]if we're talking about, 0:11:10.900,0:11:13.310 let's say, a non-financial[br]type of business. 0:11:13.310,0:11:14.370 So this is EBIT. 0:11:14.370,0:11:16.440 And if you want to get EBITDA,[br]you just add back the 0:11:16.440,0:11:18.670 depreciation and amortization. 0:11:18.670,0:11:20.310 So EBITDA would be here. 0:11:20.310,0:11:23.510 0:11:23.510,0:11:27.440 So the EBIT is 35,000. 0:11:27.440,0:11:30.380 If you add that back,[br]it would be 40,000. 0:11:30.380,0:11:32.510 So the EBITDA in this[br]case is 40. 0:11:32.510,0:11:36.360 And if my units are in[br]thousands, it's 40,000. 0:11:36.360,0:11:39.450 Now the question is, why do[br]people care about EBITDA? 0:11:39.450,0:11:42.710 Why is EBITDA used instead[br]of operating profit? 0:11:42.710,0:11:45.610 And the logic is that[br]depreciation and amortization, 0:11:45.610,0:11:48.040 and we did this in the[br]depreciation and amortization 0:11:48.040,0:11:50.860 videos, these are just[br]spread-out costs that 0:11:50.860,0:11:54.240 necessarily aren't cash going[br]out the door in this period. 0:11:54.240,0:11:56.390 We saw that this depreciation[br]and amortization. 0:11:56.390,0:12:01.120 Maybe this is, I bought[br]a $100 or $100,000 0:12:01.120,0:12:03.020 object 10 years ago. 0:12:03.020,0:12:09.250 And every year I depreciate[br]1/20 of it. 0:12:09.250,0:12:11.180 But the cash went out the[br]door 20 years ago. 0:12:11.180,0:12:14.220 And so this depreciation and[br]amortization in this period, 0:12:14.220,0:12:16.040 it isn't necessarily cash[br]out of the door. 0:12:16.040,0:12:17.350 In fact, it isn't cash[br]out the door. 0:12:17.350,0:12:20.190 We'll talk in future videos[br]about how do you find out what 0:12:20.190,0:12:22.390 the cash out the door[br]is in a period. 0:12:22.390,0:12:24.175 So it's considered a[br]non-cash expense. 0:12:24.175,0:12:27.210 0:12:27.210,0:12:30.580 So when you figure out EBITDA,[br]when you add back taxes, you 0:12:30.580,0:12:33.290 add back interest, and you[br]add back depreciation and 0:12:33.290,0:12:34.360 amortization. 0:12:34.360,0:12:37.820 What you're left with is[br]essentially, how much raw cash 0:12:37.820,0:12:39.925 is the enterprise[br]spitting out? 0:12:39.925,0:12:43.720 0:12:43.720,0:12:45.950 And a lot of people care about[br]this because this is an 0:12:45.950,0:12:47.510 indication of, one,[br]the company's 0:12:47.510,0:12:50.150 ability to do things. 0:12:50.150,0:12:54.010 To do things like pay its[br]interest, pay its taxes, or 0:12:54.010,0:12:55.630 invest in the business itself. 0:12:55.630,0:13:03.010 Or another way to view it is,[br]if you look at EV to EBITDA, 0:13:03.010,0:13:06.030 you're saying for every dollar[br]of raw cash that this 0:13:06.030,0:13:07.360 business spits out. 0:13:07.360,0:13:10.490 And let's say I were not to[br]reinvest in the business or 0:13:10.490,0:13:11.590 buy new equipment. 0:13:11.590,0:13:13.850 If it's just raw dollars, how[br]much am I paying for the 0:13:13.850,0:13:14.760 enterprise? 0:13:14.760,0:13:16.860 And a general rule of thumb, and[br]we'll do more on this in 0:13:16.860,0:13:17.290 the future. 0:13:17.290,0:13:21.210 I think I'm already well over my[br]regular time limit, is that 0:13:21.210,0:13:26.090 for a very, stable, simple,[br]non-declining non-growing 0:13:26.090,0:13:30.330 business, five times EBITDA is[br]considered a good valuation. 0:13:30.330,0:13:34.340 But what matters more is what[br]other companies in that 0:13:34.340,0:13:35.490 industry are trading at. 0:13:35.490,0:13:38.270 So all of these ratios[br]are better as 0:13:38.270,0:13:40.160 relative valuation metrics. 0:13:40.160,0:13:42.240 In the future I'll show you how[br]to do maybe a discounted 0:13:42.240,0:13:46.160 cash flow or a discounted free[br]cash flow type of analysis. 0:13:46.160,0:13:48.410 Or a dividend discount model or[br]something, so you can kind 0:13:48.410,0:13:49.890 of figure out an[br]absolute value. 0:13:49.890,0:13:52.830 But when you're looking in[br]public markets, when you're 0:13:52.830,0:13:55.330 picking to decide something,[br]you're also implicitly picking 0:13:55.330,0:13:56.650 not to buy other things. 0:13:56.650,0:13:58.690 When you're choosing to sell[br]something, you're also 0:13:58.690,0:14:00.800 implicitly choosing not[br]to sell other things. 0:14:00.800,0:14:04.110 So relative value starts to[br]matter a little bit more. 0:14:04.110,0:14:06.910 Anyway, hopefully you[br]found that helpful.