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Speaker 1

00:00

Thank you. Thank you. Thank you very much. I just posted a couple of days ago on where I actually am very lucky to the intersection of 3 different businesses.

Speaker 1

00:16

I'm a teacher first, I love to write, and I'm in finance. And the way I described it, I'm in 3 businesses that are all begging to be disrupted. 3 really big, badly run businesses, all of which need to be taken to the cleaners. So I've made it my objective at this point in my life to disrupt the businesses I'm in.

Speaker 1

00:38

And this is 1 of those acts of disruption, because I think for too long we've thought about teaching as being classrooms in universities, but I don't see that restriction anymore. So what I'd like to talk about is actually what I've been teaching for 30 years. To give you some background, I came to NYU in 1986. And when I first came to NYU, they gave me a class to teach.

Speaker 1

01:00

It was called Security Analysis. And for those of you who know the history of that class, it was a class that Ben Graham taught at Columbia in the 1950s that you know who, he who shall not be named, took. And it's a class with a long and hoary tradition. So they handed it to me and said, you've got to teach this class.

Speaker 1

01:18

I took 1 look at the class and said, no way. This is the most boring piece of collection of topics I can think of. Because by the 1980s, it was showing its age. So I went to the head of the department and said, I'd like to teach a valuation class.

Speaker 1

01:31

And he said, don't do it. There isn't enough stuff in valuation to actually teach a class. And you know what? In 1986, there wasn't enough stuff in valuation.

Speaker 1

01:40

There were no books in valuation. In fact, when I did my MBA, which was way, way, way back in time, 1979 through 81, 2 years of the program, we spent about an hour and a half collectively on valuation. So I thought about it, and I said, I'd really like to teach the class. And I considered 2 options.

Speaker 1

01:57

1 is to go the official route in the university, which is to ask officially for the class to be okayed. And if you've ever been in an academic setting, as most of you have, you know how difficult it is to get things done officially at a university. A committee would be formed to report another subcommittee, and by the time they get back to you, you'd be ready to retire. So I discovered early on in my academic life that if you want to get something done, it's best to do it subversively.

Speaker 1

02:24

So here's what I did. I said, OK, I'll teach a security analysis class. And I went into the classroom, and I taught evaluation class. They have absolutely no idea what I do in the classroom.

Speaker 1

02:34

I mean, I could be teaching cooking for all they know, right? So you know how long it took them to find out? In 2008, I got a call from the dean's office. This is 22 years after I've been teaching this class saying, we've heard you're teaching evaluation class.

Speaker 1

02:47

And I said, yes, I've been doing it for 22 years. They said, we should call it valuation. I said, welcome to reality. So if you look at the NYU schedule, you won't see valuation until 2008.

Speaker 1

02:58

But that's because I've hijacked like 6 other classes in previous iterations and made them all valuation classes. I'm fascinated by valuation, but I'll tell you up front what I think about valuation. I think valuation is simple. Fundamentally, anybody can do valuation.

Speaker 1

03:16

I think we choose to make it complex. Who's we, the people who practice valuation? Why? Because that's how you make a living.

Speaker 1

03:23

You've got to cover things up with layers of complexity, keep people away. So I want to get back to basics. Obviously in 40 minutes, I'm not going to cover the details of valuation, but I want to kind of hit some points that I think sometimes get missed, especially when people look at valuation from the outside. So here's the first message I want to deliver.

Speaker 1

03:42

Valuation is not accounting. And the reason I say that is most people, if you say, valuation, think numbers, think accounting statements, think income balance sheets. Valuation is not accounting. And it's actually a task I face every year I teach this class.

Speaker 1

03:57

In fact, many of the MBAs that I teach come into my class in the first year in the spring semester. When they come in the spring semester, they've taken 1 class in accounting. And if you've looked at how MBA programs have evolved, MBA programs are very diverse now. I get museum directors.

Speaker 1

04:18

I get basketball players. So to them, the only sense of finance they've had is the accounting class. And part of my job is to get them out of the accounting mindset. So let me start off by explaining the way I see the difference between how accountants look at the world and how finance looks at the world.

Speaker 1

04:37

Accounting is backward looking. Nothing bad about that. So nothing I say should be viewed as bad. It's their job to record what's happened.

Speaker 1

04:46

So if you look at a balance sheet, and most of you, if you open up a 10K or an annual report, you'll see a balance sheet. This is a classic accounting balance sheet. So let me look at the breakdown of how accountants break down a company. On the asset side, they break assets down into current assets, basically inventory, accounts receivable, cash.

Speaker 1

05:06

Fixed assets, land, building, equipment, accountants are big on tangible fixed assets. For some reason, if they can see it, they're much more comfortable with it. Then you have financial assets, investments in other companies. And then you have what accountants euphemistically like to call intangible assets.

Speaker 1

05:24

Now, if I went around this room and asked people to name intangible assets, you'd see lots of things come to the surface, brand name, technology. But if you look at an accounting balance sheet, you know what the most common intangible asset is? Goodwill. And let's be completely clear about this.

Speaker 1

05:39

Goodwill is the most useless asset known to man. And here's why. For goodwill to manifest itself on an accounting balance sheet, you know what a company has to do? It has to acquire another company.

Speaker 1

05:54

So if you're the greatest company on the face of the earth, and you've grown entirely with internal investments, there will be no goodwill on your balance sheet, period. The minute you do an acquisition, goodwill pops up. And here's why it pops up. You acquire a company.

Speaker 1

06:09

It has a book value of $4 billion. So what did the accountant say until just before you acquired it? It's worth $4 billion. It's worth $4 billion.

Speaker 1

06:16

You offer $10 billion. The accountant has a $6 billion problem to explain away, right? So you know what he does? He calls it Goodwill.

Speaker 1

06:24

He puts it on the balance sheet. And he has to do it because the balance sheet has this very unpleasant requirement. It has to balance. Goodwill is a plug variable.

Speaker 1

06:35

The problem with Goodwill is it sounds good. And when something sounds good, people feel the urge to pay for it. So every week I get emails from people saying, I'm valuing this company, it has 5000000000 in goodwill, how much should I pay for it? And my response is, it's a plug variable.

Speaker 1

06:50

What the heck are you doing paying for a plug variable? On the other side of the balance sheet, again, accountants get carried away. You have current liabilities, accounts payable, supplier credit, Deferred taxes, so all kinds of stuff. Then you've got long-term liabilities, bank loans, corporate bonds, and then you have an item that's called shareholder's equity.

Speaker 1

07:11

If you get a chance, take Google, look at the balance sheet. There will be a shareholder's equity number. Take any company, there's a shareholder's equity number. You know what goes into it?

Speaker 1

07:20

Everything that's happened to this company over its lifetime. Think about it. When you look at the shareholder's equity for Coca-Cola, in that number is the original public offering that Coca-Cola made, which was about 100 years ago, and everything that has happened since. The shareholders' equity is a reflection of the past.

Speaker 1

07:40

So here's what I'm going to do first. I'm going to replace it with what I prefer to look at a company as, a financial balance sheet. And at some level, a financial balance sheet is far simpler than an accounting balance sheet. At another level, it's far more complex.

Speaker 1

07:56

Look at the assets out of the balance sheet. There are only 2 items, Assets in place and growth assets. Let's take the easier half of that. Assets in place are investments you've already made as a company.

Speaker 1

08:11

That's pretty straightforward. It's a value of investments you've already made. Pick any company you want. Think about the investments they've already made.

Speaker 1

08:19

Growth assets is a little messier. It's a value I'm attaching to investments I expect you to make next year, 2 years out, 5 years out, 10 years out, forever. I'm giving you credit for investments you haven't even thought about yet. It's pretty scary, right?

Speaker 1

08:33

An accountant can never do that, but I play by no rules. So if I feel that you have great investments in the future, I can give you a large value. Let's look at a contrast. You look at Procter & Gamble.

Speaker 1

08:47

Where's most of the value for the company coming from? Investments they've already made or growth assets. Most of the stuff they've done is already in the ground. What else are they going to do?

Speaker 1

08:58

But if you look at a LinkedIn and you can pick any young growth company, and I'm not going to pick them in terms of quality. Just think of any young growth company. On a good day, maybe LinkedIn's assets in place are worth a billion, because they made about $10 million in operating income last year. You're paying $40 billion for the company.

Speaker 1

09:18

The extra $39 billion is for what? Expectations, perceptions, hopes. Nothing wrong with it. But that's a first stop when you're an investor.

Speaker 1

09:27

You've got to stop and do a reality check. What are you buying when you buy this company? Because the way you assess the company is going to be very different if it's Procter & Gamble as opposed to LinkedIn. If you're Procter & Gamble, you should be very focused on earnings reports and say, how much did they make last year?

Speaker 1

09:42

If you're LinkedIn, who cares what they made last year? That's why when I see investors freak out over earnings reports from young companies, and there are lots of them, right? Take any social media company. Look at how they freak out.

Speaker 1

09:57

Earnings per share were $0.02 below expectations. I don't care, because the value of your company is not coming from what you did last year. It's coming from what I think you can do in the future. So when I look at an earnings report for Twitter, I'm not looking at what did they do last year.

Speaker 1

10:13

I'm looking for clues as to, Is their growth potential increasing or not? Are they doing the right things to create value from their growth assets? Most of the tools we have in finance were developed for mature companies. PE ratios, return on invested capital, things you're taught in business school.

Speaker 1

10:32

But if you have a growth company, you try to assess them using those tools. It's like using a hammer to do surgery. Think about it. That's going to be bloody, and it's going to come to a bad end.

Speaker 1

10:45

It doesn't work. So 1 interesting thing you can do when you sit with a business is take the accounting balance sheet and contrast with the financial balance sheet. The younger a company, the less you will learn by looking at the accounting balance sheet, for a simple reason. If you haven't been around long, the accountant has nothing to record.

Speaker 1

11:04

So you look at a Twitter's balance sheet or LinkedIn's balance sheet, there isn't much there yet. Doesn't make them bad companies. It just makes them different. And on the other side of the balance sheet, You've got only 2 items, debt and equity.

Speaker 1

11:18

There are only 2 ways you can fund a business. You can borrow the money or use your own money. You can slice this and dice this as much as you want. You can call them bonds and stocks.

Speaker 1

11:27

But every business has to have that choice. And guess what? You tell me where the bulk of your value comes from. I'll tell you whether you should be funding your business with debt or equity.

Speaker 1

11:37

And think of what? Let's say you're a young growth business. How young? You're an idea business.

Speaker 1

11:42

You're Snapchat. No revenues yet, no earnings yet, plenty of potential. How should you fund your business? What's the problem with borrowing money to fund an idea business?

Speaker 1

11:54

Have you tried paying interest with ideas? Go to the banker and say, you know what, I have a lot of ideas. You can't make interest payments with ideas. If you're an idea business, this is corporate finance 101.

Speaker 1

12:06

Don't go looking for trouble. You have to raise equity. So that's the first message I want to deliver. Here's the second 1.

Speaker 1

12:20

I often see valuation classes structured around spreadsheets. In fact, some of you might have sat in 1 of these classes by training the stream. I like those guys. They come in with spreadsheets.

Speaker 1

12:31

They teach you how to be an Excel ninja. You can write macros on top of macros. You can do those shortcuts and turn columns into yellow, green, blue, et cetera. And at the end of 2 days, you are a master at Excel.

Speaker 1

12:46

And you think this is what valuation is about at the end of the process. In fact, the way I like to describe this is to step back and think about what drives the value of a company. If I'm asked to value a company, there are 4 basic questions to which I need answers. Here's the first 1.

Speaker 1

13:02

You've already made those investments in the ground. What are the cash flows you're getting from those existing investments? Could be very small if you're a young growth company, but that's my starting point. That's why I look at the last financial statements, to get a measure of what your existing cash flows are.

Speaker 1

13:17

The second question I'm going to ask you is, what is the value that I see you creating with future growth? Notice how I phrase the question. I'm going to ask you, what's your future growth? Growth by itself can be worth a lot, can be worth nothing, or can destroy value.

Speaker 1

13:32

Growth can be good, bad, or neutral, because you've got to pay for growth. So I'm going to ask, what's the value you create from future growth? Much more difficult to answer than, what are your cash flows from existing assets? But I need that answer.

Speaker 1

13:45

Third, I'm going to ask, how risky are these cash flows? Notice I didn't throw in any terms, the kind of buzzwords you throw in there. What's a beta? Those are tools.

Speaker 1

13:54

Don't mistake tools for end games. I need a measure of risk, and I need to bring it into the value. And finally, I'm going to ask, when will your business be a mature business? Because I've got to put some closure on this process.

Speaker 1

14:08

I cannot keep estimating cash flows forever. So those are the 4 questions around which the valuation swivels, Which then brings me to the way I think about valuation. When I start my valuation class, which doesn't start on Monday, there'll be 200 people who walk into the class. And the first question I ask them is, are you numbers people?

Speaker 1

14:29

Are you storing people? But think about it for a moment. I'd bet, given where I am, that there are more numbers people in this room than story people, right? And the reason I say that is when I look at investing, you have 2 camps.

Speaker 1

14:44

You have the numbers people who love to grind through numbers. It's all about the numbers. And if the story people like to be creative, they like storytelling. The VC business is a storytelling business.

Speaker 1

14:55

I know they throw numbers in like that target rate of return, but it's an afterthought. It's a negotiating tool. It's a story game. And the problem right now is the story people think that the numbers people are all geeks.

Speaker 1

15:09

And the numbers people think that the story people are all crazy. And they can't talk to each other. In fact, it's almost funny to sometimes watch 2 story people and 2 numbers people trying to talk about things, and they're talking right past each other. And here's the challenge I see myself having.

Speaker 1

15:29

When I come into that class, and there are how many story people and how many numbers people? I asked them actually in a very simple way to see which 1 you are, if you're not sure. I asked them, how many of you enjoyed history in high school? And he left 20 people, but I love that class.

Speaker 1

15:45

Those are the story people. So how many of you preferred algebra to history? That's the numbers people right there. And my end game for my evaluation class is to have numbers people with imagination and story people with discipline.

Speaker 1

15:59

That's a way to think about valuation. If you're a story person, I'm not going to stop you from telling stories. Stories are actually much more effective at selling businesses than numbers are. And it's been true for as long as human beings have been on the earth.

Speaker 1

16:12

So if you tell a story, what I want you to also bring in is enough numbers to discipline yourself. Because if you don't have the numbers, it's very easy to veer away into fantasy land. If you're a numbers person and you have no imagination, you're not going to be able to do valuation, because it's all about the numbers. If you do a good valuation, it should sing a tune.

Speaker 1

16:34

It should tell me a story. That's what I'm looking for. Behind the numbers, what is the story you're telling about a company? So when you look at the 2 groups, each believes they're the chosen people.

Speaker 1

16:45

The numbers people say, we're the chosen people. We have spreadsheets. We have numbers. We're on the right side of history.

Speaker 1

16:51

And the story people think, oh, you should listen to us. We have the great. We are the creative people. And I think They're both right, and they're both wrong.

Speaker 1

17:03

There's something to be gained from the other side. And to me, that is the key in doing valuation right. You've got to work with both sides of your brain. I don't even know whether this is mythology or not, that there's a left brain and a right brain.

Speaker 1

17:16

But let's face it. Some of us prefer to work with numbers, and we have to force ourselves to think about stories. And some of us prefer to tell stories, and we have to force ourselves to think about numbers. Think about your weaker side and work on it, because that's what's going to give you power and valuation.

Speaker 1

17:32

So when I do a valuation and I use a discounted cash flow valuation, it's a 2. So when you're DCF being used as a curse word, and venture capitalists have used this on me. You're doing a DCF. The way they say the contempt oozes out of it.

Speaker 1

17:49

You can't value this company using a DCF. I think they're completely misunderstanding what a discounted cash flow valuation is. Because ultimately what am I saying the value of your business is the present value of your expected cash flows from running this business. That's been true for as long as business has been around.

Speaker 1

18:08

We can debate as to whether we can estimate these cash flows. But don't tell me cash flows don't matter, that it doesn't matter whether your company ever makes money. We heard that in the dot-com era, and look at how well that ended. It does matter how much you make.

Speaker 1

18:23

So when I think about a discounted cash flow valuation, a discounted cash flow valuation to me is just a tool to bring in answers to those 4 questions. My cash flows from existing assets feed in my base year. My value from growth gets fed in through the growth rate I use and how much I'm setting aside to get that growth. My risk is built in through the discount rate.

Speaker 1

18:43

And I bring it to closure by assuming that some point in time, things settle down, and I can estimate the value of everything that happens after that with this big number at the end. But the DCF is not the end game. It's just a tool to convert your story into a number. So let me use a very simple example to illustrate this.

Speaker 1

19:02

I want to pick somebody who's never done a valuation before, and we're going to do some valuation 101. Anybody who's never done a valuation before? OK, you can be my guinea pig. I can't move too far away, because I have to be on the camera.

Speaker 1

19:14

But This is an empty envelope. I'm not David Copperfield, no magic tricks. So here's what I'm going to do. I'm going to put a $20 bill.

Speaker 1

19:22

It's a little crumpled, but it's legal tender still. How much should you pay for this envelope? Don't think too long. That's what gets us in trouble.

Speaker 1

19:31

First rule in valuation, if you pay $20 for an envelope of $20, you get nothing. So let's try again. How much did you pay for this envelope? 10 dollars.

Speaker 1

19:40

Go 1. You never know what disease I have. I might not be able to read numbers. First rule in valuation is we know the value of something.

Speaker 1

19:49

Don't throw it on the table. You know the value of a company. Don't offer that value up front, because then what do you have left for yourself? Put it in your back pocket.

Speaker 1

19:57

Start really low and then build up. But this is such a transparent asset to value that if I put it up for a bidding war, my guess is by the end of the bidding, you'd probably get pretty close to 20. Now I'm going to make it interesting. What does this card say?

Speaker 1

20:16

Control. I'm going to put control into this envelope. How much did he pay for this envelope now? It's got control in it.

Speaker 1

20:27

You know what? I tried this in investment bank last week. In investment banks, you're trained. If you put a control into a company, there's a 20% premium.

Speaker 1

20:36

I know where that came from. The guy offered me 24. I sold it. He thought it was a game.

Speaker 1

20:42

I said, no, no, no, no. This is a real transaction. Pay me the 24. So, guess what he done?

Speaker 1

20:47

He paid $4 for a 3x5 card that I stole from NYU that cost me absolutely nothing. This is a money machine. Now that I know you like to pay for 3x5 cards with nice sounding words, I can say, try more. What does it say?

Speaker 1

21:03

Synergy, that's a big 1. I'll throw that in there. That'll probably go to 26. What does it say?

Speaker 1

21:11

Brand name. Oh, big. That's a big 1. That's $32 right now.

Speaker 1

21:16

And if that doesn't work, I have my 2 trump cards. What does this say? Strategic consideration. Strategic.

Speaker 1

21:22

That is the most dangerous word. When I hear the word strategic, I'm running out of the door. Because you know what it means? The numbers don't fly, but I really, really, really want to do this.

Speaker 1

21:32

A strategic deal is a really stupid deal.

Speaker 2

21:34

But you really want to do this.

Speaker 1

21:35

A strategic deal is a really stupid deal. But you really want to do this. A strategic buyer is a synonym for a stupid buyer.

Speaker 1

21:40

A buyer who makes up his mind to buy something and then shows up at the table. And here, nothing else works. Here is the trump card that always works. What does it say?

Speaker 1

21:52

China. China. Just mentioned the word. It's amazing how common sense will lead through the other door.

Speaker 1

22:00

Take a look at earnings reports. Every company that reports it, even the most horrible, at the end they will say, but there's China. Nothing about China, but there's China. That alone does it.

Speaker 1

22:11

China, okay, that, you know, we'll forget all the fact. The fact that you've lost billions doesn't matter. You have China. I call these weapons of mass distraction.

Speaker 1

22:22

You know they come out because the numbers don't fly. In fact, I have a very simple test. When I read an analyst report, I count the number of times these words show up of a list of a dozen. And the more times these words show up, the less substance there is to that report.

Speaker 1

22:38

Because this is what you use when you can't come up with a real reason for doing something. So here's my first proposition. It's called the it proposition. If it does not affect the cash flows, and it does not affect risk, it cannot affect value.

Speaker 1

22:53

You think, what's it? Whatever it is, control, synergy. I'm not saying control doesn't have value. But if you tell me control is value, tell me what it's going to change.

Speaker 1

23:02

Maybe by controlling this company, you're going to run it differently, generating different cash flows. Maybe by synergy, saying my revenues will grow faster. Let's talk about specifics. You can't let buzzwords drive decisions.

Speaker 1

23:16

Because if you let buzzwords drive decisions, you're going to make bad decisions. And worse, you're not going to plan to deliver those, because there's nothing behind them. The second proposition I call the duh proposition. I've named it after a subset of emails I get every week.

Speaker 1

23:34

Usually this is how the emails will go. I'm valuing a money losing company. I expect it to lose money forever. Which valuation model will work best in valuing this company?

Speaker 1

23:46

I feel like walking up to the person, slapping them around the face, and say, wake up. You're valuing money, losing company, expect to lose money forever. You're thinking about paying for this company. What's wrong with you?

Speaker 1

23:57

Which brings me to my third and final proposition. Next week when my class starts, I let people pick companies. In fact, I insist that they pick companies. They have to value those companies over the next 14 or 15 weeks over the semester.

Speaker 1

24:08

They can pick whatever company they want. They can pick Lukoil. They can pick Google. They can pick Amazon.

Speaker 1

24:15

And sometime in the first or the second week, a subset of people, not everybody in the class, thank God, but 10 of them will show up saying, I have to change my company. He says, it's a little early, why are you panicking? So well, I worked out the cash flows for my company, And they're negative. And you said in the DERP proposition that cash flows are negative, you can't value a company.

Speaker 1

24:36

I said, that's not what I said. I said, the cash flows are negative forever. You can't value the company. But if your cash flows are negative in year 1, year 2, year 3, it's not the end of the world.

Speaker 1

24:45

In fact, there are a subset of companies, when you value the company, you should get negative cash flows up front. What types of companies will you get negative cash flows up front? Young growth companies, and here's why. To grow, what do you have to do?

Speaker 1

24:59

You got to put money back into the business. There is no magic bullet that you can use to grow at 80% a year. So if I'm valuing a Tesla, I should expect to see negative cash flows up front. Why?

Speaker 1

25:11

Because you've got to build those assembly plants to deliver those 10 times more cars I expect you to sell 5 years from now. But if you have negative cash flows up front, you've got to have disproportionately large positive cash flows in the future. You see why they have to be disproportionately large? You lose a billion in year 1.

Speaker 1

25:30

You've got to make up for it with $10 billion in year 10. So with young growth companies, that's exactly what you should expect to see. You should see negative cash flows up front, because that's what you need to grow the company. And as the company matures, nirvana shows up.

Speaker 1

25:45

Cash flows turn positive. You get the big values. But that's OK. So here's 1 way to think about the search for valuation.

Speaker 1

25:53

You sit down to value a company. You pull up the financials, right? Annual report, 10K, 10Q. That'll give you a sense of what this company did last year.

Speaker 1

26:03

And if you have a mature company, that might be all you need, because they're so set in their path that you can pretty much value the company using last year's financials. But if you have a company that's in transition and a market that's changing, you have to collect information about how the market is evolving, who the competitors are. When you think about risk, you're going to look at the past. You're going to look at the future.

Speaker 1

26:25

You're going to be looking at every piece of information. And my only suggestion is we value businesses. Don't do a blind Google search. You know what I mean?

Speaker 1

26:36

If you say, for instance, I have to value Uber. If I type in Uber and Google, you know what I get? Everything ever said about Google on the face of the earth. When you search, you want focused searches.

Speaker 1

26:47

In other words, you first figure out what you're looking for, and then you go looking for it. In fact, what I do is I open up an Excel spreadsheet with the inputs I need. And with each 1, I say, this is the number I'm looking for right now. I'm not going to get distracted, even if I find something interesting about something else for the moment, I'm going to stay focused on it.

Speaker 1

27:05

So if I'm looking at the risk in a company, that's all I'm looking for. Are there any clues I can get by looking at the company, the market, and the competitors about that risk? And at the end of the process, I'm keeping my eyes on the price. This is not about getting more information.

Speaker 1

27:21

It's about taking data and converting it to information. We live in a world where we have too much data. That's the reality we face. Our job is to take that data and compress it into information that actually shows up in evaluations.

Speaker 1

27:35

So here's a simple example of evaluation of a very boring company. We all know what 3M does, right? Incredibly sophisticated stuff like the Post-it note. But don't laugh.

Speaker 1

27:47

It's an incredibly profitable product. It's a company with a long history. And this is a valuation I did at 3M in what I call the days of innocence. So the days when there were developed markets on 1 side and emerging markets on the other, and never the twain shall meet pre-2008.

Speaker 1

28:05

So it was a mature company in what I thought was a mature market. In hindsight, I was hopelessly wrong. But my point is, in valuing 3M, I had to make estimates. But those estimates were easy to make.

Speaker 1

28:17

Why? Because there was a lot of history I could use. I knew what their business model was. I didn't have to figure out what they would do in the future.

Speaker 1

28:24

So it's a valuation that was centered. There was uncertainty, but the uncertainty was much smaller. The way to think about it, if you think about narrative and numbers, in the case of 3M, the story's almost done. You're in chapter 33.

Speaker 1

28:39

There's not much room for you to change the story. You can't go back and rewrite the story. So this is a valuation that you can do almost in autopilot. And this is the kind of company that you're taught to value in a valuation class in school.

Speaker 1

28:55

And I have some really bad news for you. If this is the kind of company you can value, Anybody can value these companies. In fact, I'm not even sure you need a body. I have, in fact, how many of you have Apple devices or is that not allowed in Google?

Speaker 1

29:09

If you have an Apple device, go to the iTunes store and type in U-Value. It's an app that I co-developed with a friend of mine, Anand Sundaram at Dartmouth, that does valuation. So you download it, you plug in the numbers for it. Your flight is 30 minutes delayed, you have nothing to do, you're 1 of those freakish people who likes to work with numbers.

Speaker 1

29:27

You put in 9 numbers, you value a company, you move on. And I wrote it because I wanted to disrupt this valuation business because so much of what you pay for in valuation is a banker feeding numbers into something like that and then spending 25 days making it look like he did a lot of other stuff and then charging you millions of dollars. It's something he has no business charging you millions for. So if you're valuing 3M or companies like that, you don't need an appraiser.

Speaker 1

29:53

You don't need a banker. Anybody should be able to value those companies. But let's talk about more interesting companies. It's a valuation I did of Apple in March of 2013.

Speaker 1

30:06

I've actually valued Apple every 3 months forever. But since 2010, I've been public about my valuations. What I mean by that is on my blog, which is a Google blog, so it's a good thing about it, I guess. I post my valuation of Apple because I don't believe in high, I mean, the way I describe it is I'd rather be transparently wrong than opaquely right.

Speaker 1

30:31

And in this business, people want to be opaquely right. What I mean by that is that they would say things that are so difficult for you to construe that no matter what happens, they could say, I told you so. And it drives me crazy. So What I do is I say, this is what I think the value of Apple is.

Speaker 1

30:49

And of course, I'm going to be wrong, but at least you can see where I went wrong. So this is an evaluation I did of Apple in March of 2013, because every time a new earnings report comes out, I revalue the company. So I'm due for 1 very soon, because Apple's earnings report just came out last week. What I'm trying to illustrate here, though, is in valuation, traditional valuation, here's how you value a company.

Speaker 1

31:12

You make best case, basically, not even best case. You make your expected value estimates for things like cash flows and growth and risk. Point estimates. So I ask you what the growth is, you give me a number.

Speaker 1

31:25

You ask me what the risk is, you give me a number. But the reality is, if you think about it, is you face uncertainty. You have a distribution in your head, and I'm forcing you to give me a number. Part of you is saying, it's 8%, but it could be 3%, it could be 11%.

Speaker 1

31:39

And 25 years ago, I can see why you were stuck. You had to do that, because we did not have the tools to actually bring in uncertainty. I actually have Crystal Ball attached to my Excel. If any of you use Crystal Ball, it's a simulation add-on to Excel.

Speaker 1

31:54

And what it allows you to do is enter a distribution for your assumptions rather than a single number. So If I'm running a company like Apple, rather than give 1 number, I can give you a distribution. So rather than say revenue growth is 6%, I can say it's uniformly distributed between 3 and 9. And the more uncertainty you feel, the wider the distribution is going to be.

Speaker 1

32:14

And if any of you have done a simulation, here's what happens. A computer picks 1 outcome out of each simulation and does a valuation. Crystal Ball's default is 100, 000 simulations. This is what my simulated value for Apple was in March of 2013.

Speaker 1

32:32

How does that help me? The stock price was $450. In my base case valuation, I got about $580. So I could give you the base case values.

Speaker 1

32:39

I think Apple is undervalued, but your defense would be, but you could be wrong. Of course I could be wrong. But what the distribution shows you is how wrong I can be. And if I'm a decision maker, I'd much rather base it on a richer set of information, because here's what I can tell you about Apple.

Speaker 1

32:55

I can give you an expected value like I did before. I can also tell you if you pay $450, what the chance you are wrong up front is. I can give you an x-anti probability. There's a 21% chance you could be wrong.

Speaker 1

33:08

All I have to do is count the number of values below 450. And I put up a distribution. And In March of 2013, based on my valuation, I said, I know I can be hopelessly wrong on my inputs. But based on the outcomes, it looks like there's a 90% chance.

Speaker 1

33:28

You see where the 90% comes from? The 10th percentile is about $450. The stock is trading at $450. Investing is a game of odds.

Speaker 1

33:36

And it looks to me, based on my assessments, that the odds are in my favor. And of course, this is an investment that's worked out hopelessly well in some cases. Hopelessly well because the stock is now, what, 840 with the 7 to 1 split. Not everything works out that well.

Speaker 1

33:51

But what I'm trying to say is don't let uncertainty stop you. And especially in the technology business, I find this defense to be very troubling. You ask people, why are you not valuing this company? Because there's too much uncertainty.

Speaker 1

34:07

What does that mean? Your estimates could be wrong, but that doesn't mean you can't make an estimate. Saying that there's too much uncertainty to do evaluation And then investing in the company, to me, is the height of insanity. And lots of venture capitalists go through that cycle over and over again.

Speaker 1

34:27

They say, I don't want to value the company, but I'll invest in the company. You can't tell me 1 thing and do the other. So if you cannot value the company, at least do the logical thing and never invest in those companies. But if you want to invest in young growth companies, you have to get your hands around those numbers and make your best estimates.

Speaker 1

34:46

Now, of course, with a young startup, all these questions become more difficult to answer. If you're the founder of a young startup, let me ask you the 4 questions to which I need answers, and you're going to see why life is so much more difficult. First question, what are your cash flows from existing assets? You have a young startup.

Speaker 1

35:02

What's the answer to the question? What assets? I have nothing. I'm sitting on a chair.

Speaker 1

35:06

I don't even own it. OK, that was easy. Then I ask you, how much value do you think future growth will bring in? You say, a lot.

Speaker 1

35:14

So can you be a little more specific? Not really. I don't even have a business model yet. They say, how risky are you?

Speaker 1

35:20

Very. But you can't give me past prices and earnings because you haven't been around. I say, when will you be a mature company and you fall on the ground laughing? You might not even make it through tomorrow.