The Floating University


I. Starting a Business – a lemonade stand

A. Raising money from investors

1. Incorporate: file a business with the state

2. Sell shares of stock in the company

a. Example: issue 1,000 shares of stock and sell 500 of them for $1 each to an investor

b. The business is worth $1,5000: $500 in the bank + $1,000 because we came up with the idea

B. Raising money from a loan

1. Example: borrow $250 with 10% interest every year

2. Borrowing vs. selling more stock

a. by borrowing you keep more of the stock for yourself

b. therefore if you’re successful you’ll have a bigger percentage of the profits

C. The Balance Sheet: A snapshot of the company

1. Includes assets, liabilities and net worth of a company

a. Assets – equity: $500 + $250 debt = $700 cash + $1,000 goodwill equity = $1,750

b. Liability - $250 loan

c. Shareholder’s equity - 1500 shares x $1 per share = $1,500

D. Fixed Assets and Inventory

1. Fixed asset: an investment in physical property used to generate income

a. Example: lemonade stand that costs $300

b. It wears out over time

2. Inventory: sugar, water, lemons, cups, napkins

a. Example: 50 gallons of lemonade to start, about 800 cups

3. We’ve now taken cash and turned it into other assets we need to succeed

E. Income Statement: How well has the business performed over time?

1. Revenue

a. Assume it takes one year to sell 800 cups

b. Assume each cup can be sold for $1

2. Costs

a. Assume it costs $530 per year to staff a lemonade stand

3. Income statement: includes the profitability, revenues, expenses, and net worth of the company

4. COGS: costs of goods sold

5. Where our example stands

a. 800 cups x $1 each = $800 a year in revenue

b. Spending $200 on inventory

c. The lemonade stand itself is depreciating over 5 years, 1/5 of $300 = $60 how much it depreciates per year

d. $530 labor expense to staff it

e. EBIT: earnings before interest and taxes = $10

f. After paying interest on our debt we’ve lost $15

II. Growing the Business

A. Growth Assumptions

1. We take all the cash we generate and reinvest it in new lemonade stands

2. We do not pay out dividends

3. As our brand grows we can charge $0.05 more per cup each year

4. We will sell 5% more cups per stand per year

B. Bringing the Business Up to Scale

1. After revenue increase from more stands and more cups sold at a greater price, costs stay constant, depreciation of more stands, bigger labor expenses, $25 a year in interest on the loan, and paying taxes our net income / profits = $1,500 by year 5, or about $1 a share, which is quite good

C. Cash Flow Statement

1. All incoming cash from operations and external investments

2. All outgoing cash for business activities and investments

3. As the business is more profitable cash starts to accumulate in the company (from $500 to $2,000 in 5 years), and that is added to our assets

III. Good vs Bad Businesses

A. Evaluating Growth

1. In our business we’ve got over 100% return on capital, earnings have grown 155% per annum, profitability increased from 1.3% to 28.6% which is very good

2. How are the investors doing?

a. The lender

(1) is still making $25 a year on the loan, but the business is worth way more than that

(2) is in a safe position but has only made 10% on the investment

b. Equity investor/shareholder

(1) is now getting over 100% return on his investment

(2) is getting much more return than the 10% the lender is getting, but also took on much more risk

c. Risk differential: The lender recoups investment, while the equity investor loses everything

B. Debt and Equity: risk and reward

1. Debt

a. comes in many forms: mortgage, senior debt, junior debt, mezzanine debt, convertible debt

b. is structurally senior to equity

c. is a safer loan

2. Equity (stock)

a. comes in many forms: preferred equity, common, options

b. only has a residual claim

c. riskier, but holds greater profit opportunities

3. Higher risk = higher return

C. Assessing Risk

1. Investment risk: the probability of the permanent loss of an investment

2. If you invest in a business you should worry about the long term, not short term

3. Compare your risk to other alternatives

a. Example: government bonds earn about 3% a year but are very safe vs. lending money to a lemonade stand which might have a 10% rate of interest but is a riskier lend

4. The riskier the business, the higher the rate of return

5. Equity investors do not earn interest like debt-holders do

6. Equity investors potentially receive dividends over the life of the company

a. Dividend: company profits paid out to stock holders

IV. Profiting as an Entrepreneur/Taking cash out of the business for your personal use

A. Reinvest less cash and grow slower

1. Example: instead of buying more lemonade stands you pay yourself a dividend

2. Pros: cash in your pocket

3. Cons: slower growth and less profits

B. Sell the company

1. Pros: cash in your pocket

2. Cons: you give up control and future profits

C. Sell part of the company

1. Find a private investor and share the profits

2. Take the business public

a. IPO = initial public offering, the first time (initial) a company is going public (selling stock to the broad general public); you are offering people the opportunity to participate

b.An IPO just takes a business someone owns and sells a piece of it to the public on the stock exchange, it doesn’t make someone rich

c. You have to disclose all the risks and attributes of the company to the Securities and Exchange Commission (SEC)

d. Pros

(1) usually yields the optimally high price for the company

(2) lets you retain part or most of the company

(3) puts cash in your pocket from the initial stock offering

V. Valuation: Determining a Company’s Worth

A. Comparing companies to determine value

1. Compare the stock price of your company to other similar companies

a. Resources: New York Times, Wall Street Journal, Yahoo Finance, Google Finance

B. Capitalizing on a valuation: what happens when you sell shares

1. You lose part of our ownership of the company

2. Being owned by public shareholders means you have to set up a Board of Directors

a. The board looks after the shareholders first

b. This gives you, the owner, less flexibility than if you owned more of the company

3. Pros: market liquidity

a. It is easier to sell your shares for cash on the public market

b. It is easier to find new investors

c. Exiting the business is easier

d. Lets you raise money easily by selling stock in the public market

VI. Investing - The Power of Compound Interest

A. Compound interest: interest is added to the principal, and then that total earns interest, and on and on . . .

B. Start early

1. If you invest $10,000 at 22 years old at a 10% rate of return per year, when you’re 43 it will be worth $600,000

2. If you start that investment at age 33 you’ll only have $232,000 when you’re 43

C. Earn a high return

1. In the same scenario if you earn 20% a year, if you start at age 22 you’ll have $25 million

D. Avoid losing money

1. Albert Einstein: “The most powerful force in the universe is compound interest.”

2. Warren Buffet: The Two Rules of Investing 1. Never lose money 2. Never forget rule #1

VII. Keys to successful investing

A. Invest in public companies

1. Avoid investing in start-ups (like lemonade stands)

2. Avoid investing where prospects are not very well known; you don’t need to earn 100% return a year to have a fortune, you just need 10-15% over a long period of time

3. Consider public securities to reduce risk and increase flexibility

4. Choose companies that trade on the stock market

a. they are usually more established

b. they have to meet certain criteria in order to go public

c. the stocks are liquid so it’s easy to change your mind

B. Understand how the companies make money

1. Just because a product seems good doesn’t mean the business isn’t overly complicated

2. Example: Enron appeared to have a good track record but few people understood how they made money

C. Invest at a reasonable price to get a good return

D. Invest in a business that “lasts forever”

1. You want a business you can own forever; since you plan to invest for 40+ years you don’t want to be shifting around all the time

2. Examples of businesses the “last forever”

a. Coca-Cola – it’s easy to understand how they make money by selling a formula to bottlers and retail establishments; people drink it for a long period of time, the world’s population is growing, and it’s sold all over the world; it’s unlikely to be competed away through a new technology or other product; it’s been around for a long time

b. McDonald’s – they build small stores, rent them as franchises, charge royalties in exchange for the name, they sell a low cost, have pretty good quality food, people have to eat, the business grows every year

3. Find a business that

a. you understand

b. has a record of success

c. makes an attractive profit over time

4. Characteristics of a business that “lasts forever”

a. sells a product people need

b. sells a unique product

c. has brand loyalty from consumers

d. example: people tend to buy brand name candy over generic brands

E. Find a company with limited debt

1. Its profits should far outweigh its interest payments

F. Look for a business with high barriers to entry

1. Barriers to entry: obstacles that make it hard to enter a market

2. Example: Coca-Cola

a. has strong market presence – people expect when they go somewhere they can ask for a Coke and get it

b. it has been around for a very long time

c. people are loyal to it and are accustomed to the taste

G. Invest in a company immune to extrinsic factors

1. The business shouldn’t be sensitive to outside factors you can’t control

2. Examples: interest rate change, wars, tragedies, natural disasters

3. Coca-Cola has continued to make profits for 120 years through world wars, depressions, nuclear weapon development, government collapses, tragedies, etc.

H. Invest in a company with low re-investment costs

1. The best businesses

a. generate lots of cash that they can use to pay dividends to shareholders

b. or can invest the cash in new high-return, attractive projects instead of having to reinvest in the company

2. Example: lemonade stands only cost $300 each, whereas a business that requires a whole factory has to invest a lot of money every time they want to expand

I. Avoid businesses with controlling shareholders

1. Controlled company: a business in which one shareholder owns the majority of the stock

2. Even if you really trust the controlling shareholder you can’t guarantee you will trust them in the future or that they won’t sell control to someone else that you don’t trust

VIII. When to Invest

A. When you have money you don’t need for 5-10 years

B. After paying off credit card debt

C. After paying off student loans

D. After you have 6-12 months of money set aside to live on in case of unemployment

IX. The Psychology of Investing

A. How to withstand market volatility

1. Be financially secure – make sure the money you invest you don’t need for many years

2. Don’t get spooked by short-term fluctuations

a. The stock market in the short term is a voting machine – it represents the whims of people in the short term

3. Do your own work

a. Understand the business you invest in

4. Invest at a reasonable price - make sure the price you invest at is reasonable relative to the earnings of the company

X. Other Ways to Invest

A. Mutual funds

1. Mutual fund: a manager pools together capital from a large group of investors and invests the money in a diversified collection of securities

2. Pros

a. portfolio diversity, even for small investments

b. managed by a professional investor

3. Cons

a. there are 10,000+ mutual funds to choose form

b. significant research is required to pick a good fund and manager

B. How to pick a good mutual fund - a good mutual fund manager

1. can easily explain his investment strategy

2. has a good reputation

3. has a successful track record of at least 5 years with a consistent approach

4. invests his own money in the fund

XI. Finance in Our Lives

A. Books can teach you a lot about the topic

B. It’s worth spending time on because money can make a big difference in the quality of life you and perhaps your children have

C. Building a career in finance

1. At 22, Ackman read the book The Intelligent Investor by Benjamin Graham, a famous value investor, and it was an epiphany to him

2. The skills you use to determine a good investment portfolio are also applicable to other big decisions like buying a house, growing your own business, etc.