Hi. Hope you had some chance to think through why are we thinking about risk and return, because without doing a concept of risk we cannot figure out our concept and cost of capital. Which is the second ingredient in evaluation, the first being cash flows. So we have done the cash flows of orange, which is doing your pads and your phones now you want to figure out the 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. So the real world will come in our way. There's always the case that the compiables 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. So 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 so remember the real assets here. 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 are produced, the uform, the upad, ucloud, if you may. Okay, so they generate cash flows. It's my job as the owner of the company or idea, right, or creator to sell what I'm producing. And if I don't know what cash flow it'll generate and I'm unable to convince you what they are there's a problem. So I have to generate the cash flows. Quick question, the cash flows are not known for sure, they're bouncing around. They are risky, right? In order to discount, I need to know the real assets of a comparable firm. And this is where this picture comes in, so I go to 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 is a stand for? Assets. Why I'm I saying that? Because the return are not generated by equity and debts, the return is generated by my assets and to be Completely consistent as always. Let me just put it in a lowercase r. If I'm using the uppercase R, that's just, I'm going back and forth. I sometimes use capital R, sometimes lower, okay? View it as my hangup. You're looking at this return on asset of what assets? Assets similar to oranges. But I don't know oranges' return on assets, right? And even if I knew them, it would be very, very good for me to go assess them relative to the marketplace. What is my return on assets of Orange is like an IRR, right? This is how do I evaluate myself. What's in my hurdle is my return on assets. So, I want to go outside. Now, where do I go. Turns out, lets 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 the company that is producing something similar, right. So what is good is I can go to the marketplace and hope, what, that first, Apple exists. Number two. It is publicly traded. By that I mean, not the assets, and that's the catch 22. The fundamental problem is, the assets of the company don't trade. You see, the machines making the iPads and iPhones are not trading every day. And because they're not trading everyday I don't know the return on assets of Apple. But if it's publicly traded it's equity had debt will be trading. Right? So 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, right? So think about this. I want my return on assets and let's assume apple has no debt. What does apple have only? Equity. So 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 right. I cannot the real assets trading, but luckily I can see the equity trading. So 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. The value is completely financed by equity. So you see what the fundamental problems, how markets help. Markets help because I know the value of equity is publicly traded. What's fascinating is I know its value every second people are trading it. So if there's no debt I can go start thinking about figuring out the risk of equity. Figuring out the risk and therefore it's return and trying to make sure if there's no debt, the two are the same as RA and it's risk. Okay so that's what the beauty of market is. So let me show you one more thing and you'll understand what I'm talking about. And you'll just be blown away. Here's going to Yahoo again. So what do I want? Suppose I have done my research already and I have figured out yeah, you know what, another Based company not for based, but, the fruit in its name is probably the company have done this research in 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 is the market value, market 552 billion dollars. By the way, it's the most valuable company out there. Price time number of shares. I think in terms of just value creations through stock evaluation, this is the biggest company. By the way, that doesn't mean that's the value of the company today, that's very different from does it take future action for the value creating right? So if it takes positive NPV projects the value will go up. Okay, let's go and remember I told you look for key statistics, and you'll see in a second I keep coming back to this page. So 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 enterprise value of, existing value of its company is about 513 and then it has some for future business opportunities hopefully. Okay, so let's go down, and let me show you something. Look at total debt. What do you see? 0. What did we assume for the purposes of this part of the Class and this week we'll assume no debt. And 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, and 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. And if I can go from risk of equity to return on equity, which 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. So 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 it's risk, I would be in trouble. That's why I told you, the fundamental problem has been resolved by the existence of financial markets. 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 and I'm teasing, obviously, about balances. Let's take a break. We'll come back and move in small pieces today because I said today is a class. And this week in fact, where I'll be doing things either conceptually, or with statistics, and you've got to start practicing. See you in a minute.
