Hi. Hope you had some chance to think through why are we thinking about risk and return. Because without knowing the concept of risk, we cannot figure out our concept, cost of capital, which is the second ingredient in evaluation, the first being cash flows. We've done the cash flows of Orange, which is doing uPads and uPhones. Now, we want to figure out cost of capital. Remember, where do you have to go? It doesn't belong to you. You have to go to the competition and hope there is something comparable. The real world will come in our way. There's always the case the comparables are not perfect, but life ain't perfect. Finance can't be perfect. The answers we get are all wrong. But the way of thinking is what's really almost perfect. Let's go. What is this? If you look at this, stare at this, this is a simple balance sheet, an idea of where value is generated. This is important, so please stay focused. The real assets are what? I'll call that Orange real assets. What are the assets? Things that will produce the uPhone, uPad whatever, uCloud, if you may. They generate cash flows. It's my job as the owner of the company or idea, or the creator, to sell what I'm producing. If I don't know what cash flows it'll generate and unable to convince you what they are, there's a problem. I have to generate the cash flows. Quick question. The cash flows are not known for sure. They're bouncing around. They are risky. In order to discount, I need to know the real assets of a comparable firm and this is where this picture comes in. I go looking for a comparable firm. What should the comparable firm look like? I know Orange's cash flows, but now I go look at this picture for a comparable firm. Similar business, similar risk, because remember risk and return, you agreed with me, hopefully move together. But I'm looking for this. What does a stand for? Assets. Why am I saying that? Because the returns are not generated by equity and debt, the return is generated by my assets, and to be completely consistent as always, let me just put it in a lower case r. If I am using the upper case r, just that I'm going back and forth. I sometimes use capital r, sometimes lower. View it as my hang up. You're looking at this return on asset. Of what assets? Assets similar to Orange's, but I don't know Orange's return on assets, and even if I knew them, it would be very good for me to go assess them relative to the market place. Return on assets of Orange is like an IRR. Whereas how do I evaluate myself? What is my hurdle? It's my return on asset. I want to go outside. Now, where do I go? Turns out, let's assume there's a company with a name, also, like a fruit, and let's call it Apple. Let's agree that Apple could be a company that is producing something similar. What is cool is, I can go to the market place and hope what? That first Apple exists. Number 2, it is publicly traded. By that I mean, that not the assets and that's the catch-22. The fundamental problem is, the assets of a company don't trade. You see the machines making the iPads and iPhones are not trading every day, and because they're not trading every day, I don't know the return on assets of Apple. But if it's publicly traded, it's equity and debt will be trading. What do I know? Let's assume for a little bit and you'll see in a second, again, sticking with our fundamental problem, which is, let's make our life simple and make debt zero. Think about this, I want my return on assets. Let's assume Apple has no debt. What does Apple have only? Equity. What will be true? The risk of equity and the return of equity. If I can figure out the risk of the equity and know the relationship of the return of equity, I've solved my problems. Why? Even though I'm not interested fundamentally in the equity risk and return, if there is no debt, what's the relationship between the risk return of equity and the risk return of the real assets creating the cash flow? This is important. I cannot see the real assets trading, but luckily I can see the equity trading. What is the relationship? The risk return of assets have to be identical to the risk return of equity under one very strong assumption, which is what? That there's no debt. Why? Because the balance sheet balances, value is completely financed by equity. You see what the fundamental problem is, how markets help? Markets help because I know the value of equity, it's publicly traded. What's fascinating is, I know its value every second people are trading it. If there's no debt, I can go start thinking about figuring out the risk of equity and therefore its return, and trying to make sure if there's no debt, the two are the same as RA and its risk. That's what the beauty of markets is. Let me just show you one more thing and you'll understand what I'm talking about and you will just be blown away. Here, going to Yahoo again. What do I want? Suppose I have done my research already and I've figured out, you know what, there's another fruit based company. Not fruit-based, but with fruit in its name. Here's probably the company, I've done this research on Google, and now I arrive here. By the way, look at the price of that company, $579 per share. But look at the market value, where's the market value, market cap, $552 billion. By the way it's the most valuable company out there. Price times number of shares, I think in terms of just value creation through stock evaluation, this is the biggest company. But either way, that doesn't mean that's the value of the company today. That's very different from, does it take future actions that are value-creating? If it takes positive NPV projects, the value will go up. Remember I told you, look for key statistics, and you'll see in a second, I'll keep coming back to this page. My comparable is, let's assume Apple, and I want to show you something. The market cap is 542. That's the value of all the stocks, and the excess cash is about 30. That means the existing value of its company is about 513 and then it has some capacity for future business opportunities hopefully. Let's go down and let me show you something. Look at total debt. What do you see? Zero. What did we assume for the purposes of this part of the class in this week? We'll assume no debt. Now you know, I'm being a little naughty, and I'm picking a company called Orange, knowing that Apple didn't have any debt. But by the way, what did I show you about Microsoft last time? Microsoft too has $13 billion of debt out of about $250 billion of value, so effectively no debt. Unfortunately, we don't have time in this class to do financing in depth. How come Apple and Microsoft don't have debt? There are multiple reasons for that, but right now I just wanted to show you that you can go and figure out risk and return of the equity of Apple. Assuming Apple is similar to Orange, and assuming Apple has no debt, which is not even assuming, it's clear. As soon as I figure out the risk of equity of Apple, I've figured out the risk of the assets of Apple. If I can go from risk of equity to return on equity, which really that's the goal, I can go the same relationship will hold. In other words, the return on assets and the return on equity without any debt have to be the same. You see how cool this is? But you have to recognize the value of all this information. If Apple wasn't a traded company and I couldn't figure out its risk, I would be in trouble. Look at the title of this page, a way around trying to figure out return on assets is the best way is, because we have financial markets and by hook or by crook, and I am teasing, obviously our balance sheet balances. Let's take a break. We'll come back and move in small pieces today because I said today is a class where I'll be doing things either conceptually or with statistics and you got to start practicing. See you in a minute.
