We found that we diversify. And we diversify because we're risk averse. And diversification in turn leads to a concept of risk and that risk we call beta. So we spent a lot of time on how do you go from diversification to the concept of risk. And I think you will acknowledge that the beauty of finance is that we don't stick to just the concept. First of all, The more important the concepts, the simpler they are. So diversification is not something profound or new but what's really profound is taking a complex thing like that, defining a measure of risk based on that and then being able to measure beta. We saw how beta's measured, in fact if you remember at the back of your mind, remember we were trying to value orange. Which kind of looks like Apple, and was coming up with products very similar to Apple's. So we were looking at a comparable and we went ahead and looked at the risk of Apple to be able to evaluate the value of Orange. But how do you go from risk to return, which is the key aspect. We said that the return is equal to Rf plus Rm minus Rf times beta. And this we call, this is one of the most famous models of finance. It's called capital asset pricing model. So, we are going to talk about this again but I just wanted you to know that what we covered last time is take a simple concept of diversification. Go to the math of it a little bit, come up with the concept of beta, know how to measure it. You can actually go on Yahoo Finance or Google Finance and look up beta. I would encourage you not to do that, if you're doing a serious analysis and do the estimation yourself. We did some regression also but, in the end of the day, we kind of came up with where does the beta go in order to determine return and this return became the cost of capital. All right, so that's what we did in week eight. What I'm going to do in week nine, the good news is, it's pretty much building on this. But the bad news is that it's subtle. So, you know, the things about life that you have to remember is if you have a lot of detail, a lot of spreadsheets, it could be because of the complexity of the job, that you're trying to handle. But I think it usually is not understanding what's going on. If you really understand what's going on the problem can be quote unquote addressed, or understood in very simple ways. And I hope this class kind of pushes you in that direction rather than encourages you to just do Excel. We gravitated to the concept of NPV and all of you know what that is, net present value and if you stare at that equation for a little while it's something that should be in the system by now. If I asked you how to do end theory right the concept or do it in excel you should be able to do both without taxing your memory. That's what I say it's nice. So you've cash flows, the only cash flow that has an I instead of a C is the time zero investment, but otherwise hopefully the cash flows in the future are positive and not negative that like the I knot but not necessarily so. A lot of great long term projects took a lot of cash outflow to create huge value in the future. Okay?:So this is what our book harsh valuation model is. One simple point which I may or may not have made earlier is this NPV call also be called PV if you're rallying an existing firm. Remember you could value existing things or value new things you're going to do. So existing things are ongoing that don't require any investment today. So you'll drop the minus I knot and look at the future cash flow that fulfill. So for example, if I were valuing the Let's go back to Apple. What you would have is, Apple is probably not going to make a huge investment today, but has cash flows from previous investments. So if you wanted to figure out what should be the value of Apple, or these days, Facebook, which is extremely controversial, is you try to predict what the cash flows would be and then you bring the value today and don't have a minus I knot. So that's the only difference between valuing ongoing things and valuing when you new in the ship, okay. So what are the main ingredients? There are two basic ingredients. Cash flows and I said I would be very painful about things that are repetitive and critical to a valuation. Cash flows are true for every project or idea and who do they belong to? Now remember that belong is in quotations because they don't belong to anybody. They belong to all of us; we, together, customers. Determine the value of anything in a competitive market. So the cash flows here belong to, the belong here refers to who's responsible for showing me these cash flows. It is the entity, it is the idea generator. It is the firm whatever you may call it, entrepreneur. The second element is the cost of capital, over which we have spent a lot of time, and by the way, that's critical. Cost of capital, if you screw up by even a little bit, conceptually especially, you're off-base completely. Whereas cash flows are every period, the discounting enters through r. So it's very important to understand and try to get as close to what it should be like. So r, who does this belong to? Turns out, most people think r also belongs to the idea. No, r belongs to the next best alternative. I can't emphasize how important it is to recognize that value is always relative, right? So if you do not know what the next best alternative is making. It'll be very tough for you to figure out value of your idea. So that's why markets are so important, right? I keep coming back to that. If not anything, markets help us do good valuation. So if you saw the dot com boom what happened? It was a boom and a bust, you can explain that by a simple phenomenon. That we really don't know what it was all about, so we were trying to sort it out and in the process of sorting it out, you make mistakes. And you can make big mistakes, because you don't know what the alternative is. We have spent some time on cash flows. Now, here again, I remind you we spend a lot of time on cash flows, but on the fundamentals. And cash flows has a necessary language ingredient which I emphasis is called accounting. And we'll talk about it on the last day again, as to how could you learn more about accounting to improve the cash flows estimation. The second piece, we talked about risk and return, and there was cost of capital. The return here is also called cost of capital but we made a very important assumption. For simplicity we made the word such that the firm had only equity. Or the idea the comparable that you're thinking about in this case Apple to value orange Apple has only equity. Why is that straightforward? Let me spend some time with you to re-emphasize the importance of that and how more difficult practically it becomes, if you also have debt. So look at this picture, let me ask you the following question and let's spend at least five to ten minutes on it. Because I think this will give you a sense of where ever you're headed and this will also kind of as I said catch up with what we have been doing in the past. What are the two things that are generated by your assets? And the only two things you really need to know, cash flows and we need to know return on asset. I can not emphasize enough that these are the only two things you need to know to figure out your value. Cash flow you figure out from your idea and return on assets you have to go and look at whom? Remember, you're orange so whose balance sheet are you looking at? Apple, so just as a reminder in order to value Orange you are looking at Apple's balance sheet. What was the good news? The good news was you know exactly what kind of assets you are producing exactly than exaggeration. And that's why you went to Apple right? Orange was producing uPad, uPhone. So you're assuming that the marketplace assuming that you can create that quality of Apple, it's similar to Apple. So that's why you're going to Apple. That's the good news. But here's the bad news, and the fundamental, practical problem. This cannot be observed in the market place, because return is like a change in value over time, right. So in order to observe or measure it, what would we have to need? You need the real assets to be trading and which assets are these? Not the iPhones, not the iPods, not the iPad but the assets that generate those. Now I'm sure of an Apple doesn't know the right of it's own assets. The good news is that Apple is publicly traded, why publicly traded? Because publicly traded means everybody who has money of course, can trade and that trading leads to value. Now here comes the real good news. You want this, you can't see it. So you go to this side and this is where markets come in, right? So there's a marketplace for trading debt and equity and the good news is actually there's no debt. So imagine I can straight go here and if I could figure out RE, which is return on equity on Apple, what's the good news? RA has to be equal to RE because the balance sheet should balance, of a crook, I mean, I'm obviously having fun right now, but balance sheet, the beauty of a balance sheet is it balances, by definition. So, the value of equity, if there's no other obligation, has to equal the value of the assets or another way of saying it in this context is return on equity has to be equal to return on asset. One little twist, how do you figure this out? For doing this you need two things, you need to know how to measure the risk of equity which we saw. We just went to Google or Finance Yahoo and you can see Beta equity. But the other pieces you have to put it in CAPM. So you can use CAPM to figure out the return on equity and you know return on equity is equal to return on assets. But there's another last piece I want you to think about. What determines the return on assets, is beta of asset? And how would if you knew Beta of asset how could you get return on asset? Again, CAPM, so CAPM doesn't care whether you're giving equity or assets. It gives you the corresponding return, okay. But in this context what's so cool is that the return on assets has to be equal to return on equity. Which you can measure by knowing the beta of equity because equity is traded. But then this has to be true which is that the risk of equity has to be equal to the risk of assets so beta equity and beta assets have to be the same, therefore return on equity and return on assets has to be the same. So what we did last time was kind of make the world a little simple but the quick question I want to ask you is did we force this? Like if you know about economics the biggest problem about economics is it's just a bunch of assumptions right? So in the end your thinking is as good as your assumptions because if most of your assumptions are not true in the real world which usually is the case in economics. You cannot predict anything, in fact economic's biggest downfall is, we largely do not know what's going on. So anyway but in finance, I've made this assumption. Now, when we went to look at Apple's balance sheet, what did you see? In fact, that assumption of no debt in the balance sheet was true for Apple and we don't have time in this class to figure out why does Apple choose to have no debt or why do some firms don't? Turns out technology, growth firms tend to have very little debt or no debt. We don't have the time or luxury to study finance because as I said, we are doing financing only to figure out evaluation. So what I'm going to do now is I'm going to encourage you to take a break and think about What we just did and I hope you're taking notes. I really hope you've been taking notes because that's the way you're internalizing what otherwise could be just words.
