I'm calling this bonds and stocks still, because I want when there's a connection across two weeks, I like to carry both issues. For now, though, just for the sake of, so that you are thinking that we have talked about this, we're going to focus on this. The reason I am carrying both is that both are forms of fundamental financing. Now we are going to go to stocks and bare with me, I am going to get excited and I am going to get really into it, hopefully. Not that I am not usually. What is a stock? What is equity? What are shares? What an animal is or a thing is is extremely important to understand before getting caught up in numbers. So let's look at it. Boiling pot, what is it? Another form of financing. If you gave me that answer, I'd be, I would have to say you're right, but it's not very uplifting. I mean, I already know that. How is it different from a bond? So think about the word. Equity, stock, share. It doesn't necessarily show a contract or a relationship that's as specific. So we know what a bond is. A bond is a contract, if I don't know how much you're going to pay me back in the future, I'm not going to sign up and give you money today. Is it an IOU, really? So now let's think about a stock. What is a stock? Is stock an IOU, really? Answer is maybe. So let me show you what a bond does and this is so fascinating. Here's a bond, and let's stick with our long term bond. It says ten years and in your head, what are you thinking? 20 periods. It says face value, 1,000, and says coupon rate of what 6%. So you know that actually ten years is 20 periods. You know 1,000 will come at the end. And you know that every six months, you'll be paid 3%, which is 30. This to me is an IOU. So, suppose this is issued by say, IBM. You know the entity that's issuing it. And you know that the rating companies will tell you whether it's a good bond, Triple A, whatever. I want you to recognize, though, the relationship between the yield to maturity of the bond, and the risk of the bond, is a very intimate funds, intimate one. And I want you to remember this, I'll say this many times, there's no such thing as a good risk, or a good return. Risk and return match each other. And this is one of the things that you really, really performed about finance. You get what you paid for, typically. So this is an IOU, what does a say of IBM, same. You got a piece of paper, sure it says, you own one share of IBM. Now tell me is that an IOU? The beauty about this is [LAUGH] you're willing to give money without a promise. And that's so awesome. Think about it. I know this Wall Street and financial markets and financial institutions are getting beat up by the public. And I think, in my view, you have to remember this very clearly. One of the most awesome things created by people, by us, is a stock. The willingness to give money without a contract in return, right? Is the most fascinating thing created, but it's like the ring in Lord of the Rings. It's a good ring not a bad one like that one however, everything great created has been abused by humanity. And that, to me, is not the problem of the stock, it's the problem of humanity. Okay, let's keep going. Who gets paid first? So you are a company who's going to borrow, you issuing a bond, or directly from a bank and you also issue stock, but who gets paid first? The contract, the bond. So what does the stock get? Whatever's left over. How are you paid back and this is the definition. You get paid back in two ways. For a bond, what is the periodic one, coupon, here it's called dividend. What is the other way you get paid in a bond? You get the face value. But what's the difference between a bond and a stock? A bond as a contract has an end. A stock doesn't have an end. So if you want to end the stock what do you have to do? Remember one thing very simply. You always control things. Don't let others control you. You could always sell the stock. So selling Price. And this could be a capital gain or loss. Let me just share a couple of things about this and really get into detail. Companies do not have to pay dividend. It's not a contract. Similarly, companies don't know their own stock price in the future. So they're not promising you anything yet you are investing and the reason is very simple. This is how most value is created but taking on new ideas, new risk. Does equity have a life? Answer's what? No, fundamentally. Of course, do companies disappear over time? Yes, they do. In fact, that's the beauty of competition. Competition if let loose means that you will not survive forever. However, you have to recognize that when stocks are issued, they are not a contract. So unlike a bond, they don't promise you anything and unlike a bond, there's no finite life. Now tell me, what else in life except love is similar to this? Where you give in the expectation of getting, but you don't have a contract signed. Right? That's what I really like about stocks, is stocks is our ultimate belief in the future. And clearly you want something in return, right? But it's not, you don't want to tie down and make it a contract. So just so that I get into this little bit better and get your feeling of what's going on and believe this is far more important than understanding the mechanics of things. Both will be covered in this class but not so let me repeat some things to show you the beauty of bonds and stocks. Okay, so equity also is called stocks. We have also started off with, we know what bonds are. So here's the thing. Where is value created quickly? Here. This is where value creation happens. And the thing that is, your idea does is it generates cash flow. Cash flow. Right? Do you know what it's going to be in the future? Answer is no. And that's the beauty of it. Because things are not known, the cash flow bonds has arrived. But the cash flow is generated by your real asset, your ideas. Then what happens? You have to finance it. But when you go financing it, you start with equity always because why would anybody give you a loan If you don't have your skin in the game. So typically when things start, entrepreneurs start, they put in their own money, their family money and so on, I'm doing a fascinating venture fund at the Ross School of Business, as part of a bigger structure. And what we do is we try to invest in companies that are creating value and also having social impact. And the reason I'm bringing it up is, equity investment is the first thing any entrepreneur does, and gets from other people to participate in. Okay, so equity happens, and what is happening, you're giving up your resources or money In creation of value over here. But then, many companies also have debt. But this is what? This is as explicit contract. So just recognize one thing. If I make $10 million tomorrow, who gets paid first? First of all, very obviously, this guy. Because it's an explicit contract. Then, what do we do? We pay the stockholders. But we may not necessarily pay the stock holders. In fact let me give you an example. If you think of Microsoft in 1980s, 90s, the one thing you'll see is it never paid dividends. Never paid out anything, yet the price kept going up. And we'll talk about these issues in a second as we go deeper down this week. But I want you to recognize that just because it's paying out money doesn't mean it's good news. In fact, companies with great ideas do what with that 10 million, after they've paid the bond holders? They reinvest in better ideas for the future. Okay, so we'll talk about that in a second. But the point I'm trying to make here is the key difference is you generate 10million from your idea, existing ideas. You first pay off your bondholders. Last point, very important. Engine rating your real asset value, your cash flows. Remember, how did we go from cash flows? How did we get cash flows? Revenue, minus costs, minus capital expenditures, and so on, right. Each one of those is also a contract. Why? Because if you are working in a fair, competitive market every supplier should have a contract, and revenues generated through contracts. In fact, if you walk into a store, the price should be on the commodity. That's contract already. So why I'm raising all this important issues is everything on that snap shot is a contract except what? Stocks and that's why it's one of the most fascinating things to understand and to see climbing marketing and I wish almost all of us had the ability to own the future of what we collectively are trying to create. And I repeatedly come back to the issue. Stock markets have done great, but the day they are the greatest is when almost all people in the world have the opportunity to participate. So it's like it will be better than elections, okay? So what I want you to do now is, just before we get into the pricing, I want you to take a little break. Think about what I've just said, because what I've said is not simple, is not widely understood. And is extremely important to jumping into the pricing of the stock. Because we are going into la-la-land now. We are going to a dimension where things are not written on a piece of paper. We have to use our imagination. See you soon, bye.
