Hi. Welcome back. I'm going to end this video with a fair amount of time, but it's so straightforward that I don't want to spend hours on it. But on the other hand, I want you to recognize that this example captures everything we need to know, barring one thing. That is putting more kinds of financing in place to see how to evaluate a company. But for time being, we have made only one assumption; no debt, which by the way, is not a bad assumption at all, especially for Mr. Orange. Let's start valuing Orange. Back to the beginning. How would we measure the risk of Orange? Let's just go through whatever we have talked about today one more time in our head. Would it be the standard deviation or variance of Orange? Answer is no. We need to find a way of measuring the relationship between the business called Orange and the rest of the marketplace. Where do you need to go? We need to go to Apple. Why? Because we have made a conceptual artistic prediction that iPhone and Ufone are going to be similar and so on, are similar in terms of choices for the investor. How would we make this estimate whatever we get of risk more robust? We will try to estimate relationships. How will we make that more robust? Instead of just going to Apple, one simple way of making our risk estimate more robust is, I will just do Apple today with you in the analysis. We'll go on the website and we'll talk about it. I want you to recognize that your goal is to minimize measurement error. I'm not talking about the measurement error in the S&P 500 versus Russell 2,000 because those two are market choices. I'm talking about the inherent comparable data you're picking. I'm assuming I'll stop to the Apple, but in real life, you want as many comparables as possible to cut out the noise because Apple's data is not perfect, it's just data. What will you go for? Probably Samsung. But if you run into Samsung, Samsung may be producing other stuff other than the competitors of Ufone, and Upad, and so on. What you have to then try to figure out, how much of their business is in your competition and how much is not. That's an important issue. How would we measure the cost of capital of Orange? The first thing is we want to measure risk, then we want to measure the cost of capital. Remember, there are two steps. Risk determines return and return on assets is my cost of capital, me being Orange. Let's get started. I'm going to go to Yahoo Finance, and I am going to have some fun if it's okay with you. I hope it is. Notice the one thing on the top again. Let's go right across. Let me ask you. We'll just walk through and I will just keep notes, you keep notes. Do you see the S&P 500 there? Yes, I do. Is it measured? Yes, it is. Could I get data on it for the last 60 months? Sure. But what is the data I want? Returns. How do you calculate returns? Very simple. It's change in S&P index plus adding the dividends. I have that. I have the market. Remember, the first ingredient I have to have to measure the risk is the market. Let's assume our S&P 500 is a good reflection of the market. What else do I need? Remember, for risk it's okay to have the market and then I need Apple's return. But let's pause for a second and look forward. When I take the measure of risk that I'll capture by running a regression between Apple's return and market, what will I also need? The historic risk premium, which I've already given you; five percent, seven percent. Read up on it and get to your comfort level. Then I have to calculate the Beta, which I'm going to do if I have returns on Apple with one more ingredient, which is what? Just the risk-free rate by itself. Ideally in CAPM, I should use forward-looking measures of everything. But unfortunately, I'm left with only one forward-looking measure, which is the 10-year treasury bond return. Is it there? Answer is yes. What's the rate of return? What will be your substitute for RF today? Don't look at past averages. We use averages from the past simply because we have no choice. But when we have a choice, we know the risk-free rate for the next 10 years, use it. Use the beauty of data. It is 1.4 or 1.46. Do you see that? It's up here. I already know my RF. I already have told you that I know the market, so I have to figure out two things, and I already have the risk premium, so I'll just have to figure out how the heck do I get a measure of beta for Apple? Let me do this. Let me look for Apple, and what I'll show you is that you may be a little bit surprised, but hopefully pleasantly. Let's go to the first thing that jumps out at you. I think that Apple is right there. Its price is 577, and if you go down, there's bid and ask which are different slightly because there's a person willing to buy and sell, and look at what's right after the first year target estimate, and that's the price estimate of somebody who seems to know much more than I do, but beta is what? 0.94. Yes? What have I done? I have just directly taken you to a website which calculates the beta for you right there and what is the beta over here? I would recommend very strongly to you to do some research and press "Key Statistics". If you go to Key Statistics, you will get various measures of market cap that confirm for yourself something that we assumed throughout this that the total debt of Apple is zero. Why I'm I confirming this? Because if it's not true, then my return on equity will not be equal to my return on asset that I get out of it. Do you understand what I just said? If your debt is not zero, your balance sheet has assets on the left-hand side, debt and equity on the right-hand side, only if there's no debt will my equity and my assets be the same. Therefore the risk I measure of equity and the risk of assets is the same, and the return on equity is equal to the return on assets as well. Is this clear? I've confirmed that. Now you will see I'll come back to similar balance sheet later, but I would encourage you to pick another company you like to do the same analysis over and above all your assessment work for the past week. Let me put it this way. The past two weeks, the examples and the execution are very simple. I'm not asking you to create brand new portfolios and do portfolio management. That's a class on its own, that's not easy to do. What I'm asking is very simple. Think about what beta is, think about what RF is, think about the risk premium, and then try to get comparables, and try to figure out the cost of capital of Orange. Remember Orange is doing what? Investing a new phone, an iPhone. Apple is the one example I took. Try to find others and if there is positive debt, ignore it for the time being, and we'll capture next week the effects of debt on valuation, and there'll be some fascinating mind-boggling things you'll see, but for now, let's assume that I am evaluating just using Apple. Do the same exercise without just using Apple. So I've confirmed what? I have the beta, and I have the level of debt is zero, so I'm going to take all the data and go back to the beginning to the slide we were on: valuing Orange. How do you measure the risk of Orange, the beta of Apple we want to comparable. How do you make it more robust? I hope you do so going to the website and picking up companies that are similar to Apple, because I'm looking at Apple because I'm valuing Orange. How would we measure the cost of capital of Orange? We need beta, we need the risk-free rate, we need the risk premium, and we need for the time being not worry about debt, so debt is zero. We went to this page, we got hold of some data, and the main data we got hold of was we saw that there's lot of data out there, but already published as beta, and I know my risk-free rate is right the 10-year bond. Let's put it all together, and I'm going to just write out this stuff. First recognize in my balance sheet on top that I had equity, but I had debt equal zero, and I'm looking at Apple because Apple is a comparable of Orange. I had equity. The good news is, I could figure out Beta of equity. I have real assets sitting here. The awesome news is this, I cannot see the real assets producing, I can see the product. I can't see the real asset but the good news is, Beta asset is now by definition equal to Beta equity. Did I get that number? Yes. It was 0.94. This is from Yahoo! Quick comment. Is this something that if I were doing a very detailed analysis where the money was on the line and investing, would I stop at Yahoo! No. Please go to Morningstar and browse. You won't have access to all their data but this is one of the most reliable set of datas for Beta estimates. You can always do estimates yourself. When you go to the key statistics, look for how Yahoo! calculated Beta. I think it requires 20 years of data on S&P 500 and 20 years of data on Apple's equity. But let's, for the time being, presume with 0.94 is right. You can refine this as I said. Now, take CAPM, what does capital asset pricing model say? The return in this case on equity and expected for Apple is what? The first number going in there is the risk-free rate. How much did we find on a 10-year bond? 1.45 approximately. We just went on the website and found it to be 1.45. What's the good news? It's forward-looking. What's the bad news? It's forward-looking. You have to take it at the point in time that you're executing your analysis. It'll go into change for sure in the future. Next component, the average risk premium. Remember, you cannot predict the market in the future. If you could, you wouldn't be here, I wouldn't be here. What do you have to do? You have to rely on historic data. What did I tell you? US historic data maybe output-biased if you believe in some steady-state risk premium. You could use seven percent but, let's for the time being, just stick with the textbooks that say use market data from America. I would use five percent but let's stick with this. What's left? Beta, of what? Equity. Equity return, equity Beta. Of what? Apple. Do we have it? Yes, 0.94. Now, tell me how easy is this to figure out? Let's do it. I'm going to make a big shortcut. Let me assume that the Beta is approximately one. Why am I doing that? Because that 0.94 is measured with a lot of error. This real world has lot of noise, don't think 0.94 is exactly right. That's why I said, how will you reduce the error? By taking similar companies as Apple to bring them closer and closer. Suppose it's approximately one. What do I have? 1 times 7 is about seven percent plus 1.45 is how much? 8.5 percent approximately. Now, do you see how simple this is? This is a piece of cake and this is about a complicated situation. Final question, is this your cost of capital? Answer's yes, this is also return on asset on Apple. How did I go from here to here? I know for a fact that debt is zero right here. This tells you how simple a very complicated thing can be. This got a Nobel Prize, effectively, multiple ones, because to get here and make it look so simple, it was lot of work done. But remember one thing, what was the bottom line in all of this? Don't put all your eggs in one basket, which we knew centuries ago. In fact, when we were born, we probably felt that way. See you next time. I warn you with one caution again, please do all the problems. This is a conceptual piece. I have used numbers, I've gone to Yahoo! Finance and I have done a lot of numbers. But basically, I have stuck with the why, why, why? Because the more simple something is, the more abused it is if you don't understand why.
