WEBVTT

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In the last couple of videos
we saw that looking just

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purely at market capitalization
can be a little

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bit misleading, when you look at
companies that have a good

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bit of leverage or companies
that have a good bit of debt.

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For example, if that's the
assets of the company, and

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let's say that they have
this much debt.

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And this is their equity.

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And then let's say they
have some excess cash.

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Cash that's not necessary to
actually operate the business.

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I'll draw that up here.

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So this is excess cash.

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Some cash is necessary, and
oftentimes people don't make

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the distinction.

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And they'll just view this
as all the cash.

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But we really want to separate
the value of the enterprise

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out of the market value
of the equity or the

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value of the debt.

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So let me just write
all this down.

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So this right here, this is
the value of the business.

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The enterprise value.

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Here is the debt.

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There's the debt.

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And this is the equity.

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And this is a little bit of
a slight, I would say,

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technicality.

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And you don't have to worry
about this if it

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confuses you at all.

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When I write the enterprise
here, this is the value of the

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business itself.

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So it's kind of the operational
assets net of the

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operational liabilities.

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It's literally-- if you had
to go out in the past two

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examples and buy the pizzeria--
how much net would

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you have to pay for
that pizzeria?

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And that's what we're trying to
figure out right here when

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we're talking about the
enterprise value.

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And we saw in the last couple
of videos how you calculate

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it, but it never hurts
to review it.

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This is actually one of those
less intuitive calculations

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the first few times you
see it, so it doesn't

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hurt to do it again.

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So the first thing to figure out
is, how do you figure out

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the market value
of the equity?

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The book value of the
equity is very easy.

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You could go into a company's
balance sheet and they'll

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write down a number.

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They'll say, this is what our
accountants say that the book

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value of our equity is worth.

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But the market value, figure it
out from what the market's

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willing to pay for a share.

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So the market value of equity or
the market cap is equal to

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price per share times the
number of shares.

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And that's the market value
of this equity.

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And you can see, just even from
this diagram, that the

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enterprise value plus the
non-operating cash or

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investments or liquid
investments, whatever you want

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to call them.

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Enterprise value plus the cash
is equal to the debt plus,

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let's just say the market cap.

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Because we want to know, when we
look at a price, we want to

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be able to figure out what
is the market saying the

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enterprise value of
the company is?

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What is the market value
of the enterprise?

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So debt plus-- instead of
equity-- I'll write market

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capitalization, because
it's the same thing.

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Market capitalization is the
market's value of the equity

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plus market cap.

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So we know market cap.

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We can look up the debt on a
company's balance sheet.

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We can look up the cash.

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So we just subtract cash from
both sides, and we get

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enterprise value is equal
to market cap

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plus debt minus cash.

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We're just taking cash
onto the right-hand

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side of this equation.

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So for example, if I have a
stock that is trading at-

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let's say the price is $10.

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And let's say that there
are 1 million shares.

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And let's say that the company
has $50 million of debt.

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And let's say it has $5 million
of excess cash, what's

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its enterprise value?

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Well, you first figure
out its market cap.

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Its market cap is $10 per share
times a million shares.

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So that's 10 million shares.

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That's the market cap.

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You add the debt.

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So, plus $50 million.

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And once again, I said this in
the last video, it's very

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unintuitive when you figure
out the value of the

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enterprise to add the debt.

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And the intuition is that if
someone were to want to buy

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this company from the
stakeholders and be debt free,

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they would have to pay these
people the total amount of

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debt, and they'd have to pay
these people the total amount

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of the market value.

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So they'd have to pay the
debt plus the equity.

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And they get a refund
of the cash.

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This would be extra stuff that
they would be buying that they

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could get money back for.

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So you have to pay the equity
holders, you have to pay the

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debt holders, and then you
get a refund of the cash.

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And so the enterprise value's
what? $60 million minus 5.

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That's $55 million.

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Fair enough.

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This is all just review of the
enterprise value video.

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But the question is, now that
you've figured out enterprise

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value, how do you figure
out if that's a

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fair enterprise value?

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When you looked at market
capitalization you compared

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that to earnings.

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The price to earnings ratio.

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You were doing this
on a per share.

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This is price per share divided
by earnings per share.

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This ratio's equivalent to
market cap divided by the

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actual net income
of the company.

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Where if you just multiply the
numerator and the denominator

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by the number of shares, you get
market cap and net income.

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This is EPS.

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P/E is actually price
per share divided by

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earnings per share.

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And that was one way
to look at it.

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You could compare
two companies.

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And we saw it breaks down if
they have different types of

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capital structure.

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So what do you compare
enterprise value to?

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Here we did market cap
to net income.

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Enterprise value should
be compared to what?

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Now I made an argument in the
last video that, well if we're

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looking at the enterprise, we
should look at essentially the

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earnings that are popping
out of the enterprise.

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We should look at the earnings
that are coming out of this

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asset right here.

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And on the very first video
on the income statement, I

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implied that-- let's do
a balance sheet--

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you have your revenue.

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Your revenue could be 100.

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You have your cost
of goods sold.

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Cost of goods sold could be,
let's say it's minus 50.

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And I'll show you another
convention.

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One of the commenters suggested
that I do this

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convention.

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Which is actually the most
typical convention for a lot

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of accountants and financial
analysts.

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Instead of writing a negative,
they'll write it in

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parentheses.

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That means negative.

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Minus 50.

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And then the gross profit
would be 50.

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And then, actually I want to
do something a little bit

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interesting.

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Let's say that this cost of
goods sold, it involves no

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depreciation or amortization.

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And watch those videos if
those words confuse you.

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And all of the appreciation and
amortization is actually

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occurring at the corporate
level.

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So let's say that there
is some SG&A.

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But this is without the
depreciation and amortization.

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So let's say that this
is an expense of 10.

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Let's say there's some
depreciation and

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amortization as well.

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D&A.

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In the last couple of videos
I kind of grouped.

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And that tends to be the case.

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On a lot of income statements
they won't separate out the

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depreciation and amortization.

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And you'll actually have to
look at the cash flow

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statement to figure
out what this is.

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And I'm going to do that
in a future video.

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But let's say that we actually
do break it out.

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Sometimes that does happen.

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And let's say that
that's another 5.

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Maybe these are in thousands.

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And then you're left with
the operating profit.

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In this case, which is 50
minus 15, so it's 35.

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And then you have things
below that.

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You have interest. And I'll do
those just for-- you have the

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non-operating income and
interest and all that.

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Let me just do that.

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Interest. Let's say that that is
also 5,000, if that's what

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we care about.

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And then you have pre-tax.

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I didn't put the non-operating
income.

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Let's say this cash isn't
generating anything.

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So pre-tax income is 30,000,
if that's what

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we're dealing with.

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It's getting a little messy.

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So then you have taxes.

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Let's say it's 1/3.

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It's 10,000 of taxes.

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And then you have earnings.

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30 minus 10 is 20,000.

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So I suggested, what part of
this income statement is

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dependent purely on this
piece right here?

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Well all this stuff with
interest, that's

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dependent on the debt.

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And essentially taxes is also
dependent on the debt.

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Because the more interest
you have, the more

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you can deduct it.

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And so all of this down
here is dependent on

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your capital structure.

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So if you wanted to look just
what the enterprise value is

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generating, it's generating
the operating profit.

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So I suggested that a pretty
good ratio, although this is

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very non traditional.

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It's not very not traditional,
but you don't

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hear it said a lot.

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I'd argue that you could look at
EV to operating profit as a

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good metric.

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Which in a lot of cases is the
inverse of the return on

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assets, as I defined it
in the first video.

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There's a lot of different
return on asset definitions.

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But it's essentially saying, for
every dollar of operating

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profit, how much are you paying
for the enterprise.

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Which I think is a pretty
good metric.

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Now, the more conventional
metric that you'll see when

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you see people talk about
enterprise values, enterprise

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value to EBITDA.

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And if you go and get a job as
a research analyst at some

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firm, this is going to be
something that you're going to

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be expected to calculate
for a company.

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And hopefully talk reasonably
intelligently about it.

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So the first question, to talk
reasonably intelligently about

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anything is, what is EBITDA?

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So EBITDA is Earnings Before
Interest, Taxes, Depreciation

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and Amortization.

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So let's see what that
would be here.

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So it's earnings before
interest, taxes, depreciation

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and amortization.

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So it's before all
of this stuff.

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Actually, let's compare that to

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something we covered before.

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So you have EBITDA.

00:10:36.370 --> 00:10:39.280


00:10:39.280 --> 00:10:41.660
And you have EBIT.

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EBIT is Earnings Before
Interest and Taxes.

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So EBIT is earnings.

00:10:47.520 --> 00:10:49.240
You add back taxes and
interest. You're

00:10:49.240 --> 00:10:51.350
at operating profit.

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And I've gone over this in the
past, but the distinction

00:10:53.530 --> 00:10:57.220
between operating profit and
EBIT is that EBIT might

00:10:57.220 --> 00:10:59.080
include some non-operating
income, which

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I haven't put here.

00:10:59.890 --> 00:11:03.790
But if this cash was generating
some profit

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unrelated to the operations
of the business, it'd

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be included in EBIT.

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It wouldn't be an operating
profit.

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But they're usually pretty close
if we're talking about,

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let's say, a non-financial
type of business.

00:11:13.310 --> 00:11:14.370
So this is EBIT.

00:11:14.370 --> 00:11:16.440
And if you want to get EBITDA,
you just add back the

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depreciation and amortization.

00:11:18.670 --> 00:11:20.310
So EBITDA would be here.

00:11:20.310 --> 00:11:23.510


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So the EBIT is 35,000.

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If you add that back,
it would be 40,000.

00:11:30.380 --> 00:11:32.510
So the EBITDA in this
case is 40.

00:11:32.510 --> 00:11:36.360
And if my units are in
thousands, it's 40,000.

00:11:36.360 --> 00:11:39.450
Now the question is, why do
people care about EBITDA?

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Why is EBITDA used instead
of operating profit?

00:11:42.710 --> 00:11:45.610
And the logic is that
depreciation and amortization,

00:11:45.610 --> 00:11:48.040
and we did this in the
depreciation and amortization

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videos, these are just
spread-out costs that

00:11:50.860 --> 00:11:54.240
necessarily aren't cash going
out the door in this period.

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We saw that this depreciation
and amortization.

00:11:56.390 --> 00:12:01.120
Maybe this is, I bought
a $100 or $100,000

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object 10 years ago.

00:12:03.020 --> 00:12:09.250
And every year I depreciate
1/20 of it.

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But the cash went out the
door 20 years ago.

00:12:11.180 --> 00:12:14.220
And so this depreciation and
amortization in this period,

00:12:14.220 --> 00:12:16.040
it isn't necessarily cash
out of the door.

00:12:16.040 --> 00:12:17.350
In fact, it isn't cash
out the door.

00:12:17.350 --> 00:12:20.190
We'll talk in future videos
about how do you find out what

00:12:20.190 --> 00:12:22.390
the cash out the door
is in a period.

00:12:22.390 --> 00:12:24.175
So it's considered a
non-cash expense.

00:12:24.175 --> 00:12:27.210


00:12:27.210 --> 00:12:30.580
So when you figure out EBITDA,
when you add back taxes, you

00:12:30.580 --> 00:12:33.290
add back interest, and you
add back depreciation and

00:12:33.290 --> 00:12:34.360
amortization.

00:12:34.360 --> 00:12:37.820
What you're left with is
essentially, how much raw cash

00:12:37.820 --> 00:12:39.925
is the enterprise
spitting out?

00:12:39.925 --> 00:12:43.720


00:12:43.720 --> 00:12:45.950
And a lot of people care about
this because this is an

00:12:45.950 --> 00:12:47.510
indication of, one,
the company's

00:12:47.510 --> 00:12:50.150
ability to do things.

00:12:50.150 --> 00:12:54.010
To do things like pay its
interest, pay its taxes, or

00:12:54.010 --> 00:12:55.630
invest in the business itself.

00:12:55.630 --> 00:13:03.010
Or another way to view it is,
if you look at EV to EBITDA,

00:13:03.010 --> 00:13:06.030
you're saying for every dollar
of raw cash that this

00:13:06.030 --> 00:13:07.360
business spits out.

00:13:07.360 --> 00:13:10.490
And let's say I were not to
reinvest in the business or

00:13:10.490 --> 00:13:11.590
buy new equipment.

00:13:11.590 --> 00:13:13.850
If it's just raw dollars, how
much am I paying for the

00:13:13.850 --> 00:13:14.760
enterprise?

00:13:14.760 --> 00:13:16.860
And a general rule of thumb, and
we'll do more on this in

00:13:16.860 --> 00:13:17.290
the future.

00:13:17.290 --> 00:13:21.210
I think I'm already well over my
regular time limit, is that

00:13:21.210 --> 00:13:26.090
for a very, stable, simple,
non-declining non-growing

00:13:26.090 --> 00:13:30.330
business, five times EBITDA is
considered a good valuation.

00:13:30.330 --> 00:13:34.340
But what matters more is what
other companies in that

00:13:34.340 --> 00:13:35.490
industry are trading at.

00:13:35.490 --> 00:13:38.270
So all of these ratios
are better as

00:13:38.270 --> 00:13:40.160
relative valuation metrics.

00:13:40.160 --> 00:13:42.240
In the future I'll show you how
to do maybe a discounted

00:13:42.240 --> 00:13:46.160
cash flow or a discounted free
cash flow type of analysis.

00:13:46.160 --> 00:13:48.410
Or a dividend discount model or
something, so you can kind

00:13:48.410 --> 00:13:49.890
of figure out an
absolute value.

00:13:49.890 --> 00:13:52.830
But when you're looking in
public markets, when you're

00:13:52.830 --> 00:13:55.330
picking to decide something,
you're also implicitly picking

00:13:55.330 --> 00:13:56.650
not to buy other things.

00:13:56.650 --> 00:13:58.690
When you're choosing to sell
something, you're also

00:13:58.690 --> 00:14:00.800
implicitly choosing not
to sell other things.

00:14:00.800 --> 00:14:04.110
So relative value starts to
matter a little bit more.

00:14:04.110 --> 00:14:06.910
Anyway, hopefully you
found that helpful.