Hi. Today's class is all about decision criteria in a deeper way. And we talked about NPV last time, payback, and IRR. I spent a lot of time on IRR but I hope you realize that in the process I'm trying to show you why NPV makes sense. One last comment about IRR. And that is that the thing that concerns me is that companies' value creation is happening very differently these days than used to happen a long time ago. In other words capital is coming from all over the world. Globalization is happening which is great. But at the same time the people running companies like us are not the same as the people who own companies. So our horizons are shorter than what companies' horizons are. And what that may create is a little bit of bias in favor of using short term myopic measures. And that's why I'm so concerned about percentages. I hope you think about it and move forward, this I was very deliberately slow. Because it's a very complicated issue and a very important one. I think it's deep inside of us and so I just wanted to raise some issues about it. Now I'm going to move onto the one ingredient common to everything we do. Regardless of it's measure we use for picking projects or valuing things. Cash flows are the basics to all. I want to warn you about one thing as we move forward which I'll do repeatedly again. I told you promised you that we'll stretch whatever we need during this class, we'll stretch ourselves to learn it as we go along, but this is one topic on which I was actually talking to Ryan during the break. Is that this is one topic where we could go on forever or we could just give you the fundamentals. And I'm going to just give you the fundamentals because you need to take class on accounting or learn it on your own. Because a lot of the issues we talk about are in tutor but many of the issues here require a knowledge of accounting. How do we keep our books. So let's get started. We are going to use NPV as the basic value creating paradigm or procedure and it has two ingredients, right? So the first ingredient, sorry, is the cash flows on the top and the discount rate on the bottom. But remember, we need cash flows to even do our IRR payback. Before we go onto that, let me just emphasize something about a snapshot of a project firm or you. You could have a balance sheet, a firm could have a balance sheet, and a project could have a balance sheet. And I don't mean it in the accounting sense really. I mean it about how to think about an idea, how to think about value. I think of it in the following way as do most people who understand finance really deeply. Is on the balance sheet on the asset side, are real assets. You could have a financial firm which has financial assets on both sides. But we are largely talking about real assets here. And what are real assets? Things that generate your value for you. I.e., cash flows is the first step. So think of your idea as being a real asset. Think of machines being needed to execute your idea, right? So those are all sitting on the assets side of the balance sheet. I want you to remember that on the assets side of the balance sheet is where the action of value creation is happening. So, your real assets are doing two things, generating cash flows and then you're to go figure out what your r is to evaluate them. For the time being, we're going to focus on these. I want you to be very careful in understanding one simple thing. And this is a profound result we'll talk about later as well. Value creation is happening on your assets side. On your liabilities side, you finance your idea. So once you have an idea you go say do I use my own equity, my money. Or do I borrow from the bank or even in equity, you don't have to just use your own. After you become big and successful, you may need more money. And we'll talk about equity and debt in detail. But the point right now I'm trying to emphasize is this, don't worry about this aspect right now. Keep this out of your mind. And the reason is, to judge an idea and to value an idea you shouldn't have to worry about how you finance it. You should have to worry about what's the value of your idea and the first ingredient important to judging value for idea is the cash flow. This picture, I'll bring up over and over again because it emphasizes where your focus has to be. Okay, so let's get started. Timeline, important as always, and I know I'm going to be very painful about this because the one thing if you can put on your timeline, your word problem, your firm, your idea, whatever. You're in business. So, let's draw a timeline. So, first thing you have to decide is when you're doing your analysis, you're doing your cash flows, you're to decide what is the length that you're comfortable with for your project analysis? And for the sake of convenience I'm just picking 10 years, 1, 2, and so on. The first thing to remember is which point are you standing at? Here, and your job is to do what? Figure out cash flows C1, C2, C10. And maybe they aren't. And also what? C naught. Negative. So remember unless you have an idea of how far you can do valuation, or what the life of your project analysis is, you can't start. So please remember we are going to come up with some notion of project life. Which depends on your comfort level in how far you want to go. So if ideas are brand new there's no point going for ten years. In fact, when you're in a very early stage of investment if you go for ten years you're kind of fooling yourself that you know what's going to happen. So shorter horizons are used in your analysis. But under steady state business you're going to start to compete with say, Walmart, which I won't necessarily encourage you to do because it's tough. But if you start dealing with things that are known, you've known about them for a while, it's easier to have a longer interval. But the point, I'm not, I'm not trying to say go ten of five. I'm saying the nature of the beast, the idea, determines how long you can do project analysis. And we are going to assume that's the first thing you do, and what is this in an Excel spreadsheet? Just different columns. So that's why I like Excel. It's a natural time line. And now Excel becomes very important for another reason, and that is, how do I get all these numbers? And you'll see it's not easy. So Excel is extremely important in terms of laying out all the data. But as I said very early in this class, I'm not into teaching Excel because it'll take away from understanding what's going on. Excel is just a machine, is just a number calculating and data gathering machine. Let's just move on to valuing an idea or project. All value is relative. When you do cash flow estimation, and when you do valuation, remember what we love in finance as the only thing we probably have to offer is the law of one price. That's way throughout this class, what have I said? Try to figure out your competition is. Because value is always relative. If I don't know what the price of a bottle of Coca Cola is, and I want to produce something very similar, I'll have a tough time. Right? So that's why markets are so cool. That's why I love markets. Markets allow you to figure out value. But value's always relative. So what my value should be depends on the closest parable. It's not perfect, but in the real world a very simple rule to follow, one which we don't. There are two basic ingredients. Cash flows, who do they belong to? The project. The other is cost of capital. Who does it belong to? The marketplace, other opportunities. This session will be very brief introduction to estimation of cash flows. And to understand cash flows deeply, I really encourage you, especially because you're right now all over the world. Some of you are having breakfast, others are getting ready to go to bed. And some of you are just bored in the middle of the night and found this class so exciting. And I hope that's true, actually. Anyway, bless you. Let's see one thing about this which I really want to emphasize. Whenever I know I'll need your help in boning up or kind of gaining knowledge in another area I'll warn you and this is one warning point. Do not expect this class to equip you with al the accounting principles, but at the same time, I'm pretty okay with it, because I teach you fundamentals for which you go looking for accounting. So you already know what you're looking for. The second reason why I don't mind not doing accounting is for a lot of the stuff we do in this class, it's personally oriented. Should you invest in a stock, should you invest in a bond, should you take a loan? Lot of those examples, you don't need to know accounting. So, accounting is particularly useful if you're trying to evaluate your own idea, which I hope you become an entrepreneur, I hope you create value, or I hope when you're working for someone you're constantly asking yourself what is value and cash flow is an important step. Okay, all about future cash flows for the life of the project, this is not about the past remember in finance the first principle always look forward. Now the problem is the future is not known so this is not going to be easy. Sources of cash flows come from what are called Pro forma Income and Balance Sheet statements. This is where accounting comes in. And I'm not going to spend a lot of time on accounting, but I'll talk about these two as we go along. Fundamentally, what's an income statement? Income statement shows you the flow of things during the year. So you obviously going to ask yourself, why the heck don't I use the income statement directly? Why am I doing cash flows? And the reason is, accounting is a language. Even when it wants to express something, it's stuck by the language. And the language is very specific to a country too, many times. So like I speak English right now and you are probably thinking in Japanese. Your accounting systems in the two countries are likely to be different too. So yes, income statement ideally should be exactly what I should go to, it's not the case. The second reason is, I have to go to balance sheets. And the simple thing about a balance sheet, which I showed you conceptually a little while ago, assets and liabilities. What a balance sheet is, a snapshot of how your value looks like, all the assets that you have. Right? So know there are bunch of things that are ongoing. What is the value of Google? You look at the assets. What is the value of Microsoft? What is the value of a shop next to you? You look at the balance sheet and assets. But the difference between a balance sheet and income statement is one is a flow similar to cash flow, the other is a snapshot at a point in time. So the question is you ask yourself, why the heck do I need the balance sheet to do cash flows? And you'll see the balance sheet is needed for a couple of reasons and we'll get to that in a second. Okay so remember, you do need flows for the most part, but sometimes you also need balance sheet items to calculate specific things. Quick question. Suppose I have a snapshot and I want a flow. How do you get that? I have a snapshot and I want to measure the change over a period of time. So suppose you want to see, using Google, how your city has changed over the last ten years. What do you need to do? You need to take a snapshot ten years ago and take another snapshot ten years later. So, what do you need to do to be able to get a flow from balance sheets you need to have two snapshots, beginning of the year, end of the year. And how do you get a flow? Just the change. This is a very simple thing. The reason I am emphasizing all of this is because it is easy to understand without knowing a specific language, which is accounting. Okay, but I re-emphasize over and over. If there's one class you need to do, is the language class which is accounting. Specific to your country and then read about other countries too because business is all over. So, now specifics. Let's get started. I would encourage you if at this point you want to just go run around the block, do yoga, smile, talk to your relatives. Have breakfast with your family or dinner whatever. Nice time to take a break. But because it's not heavy right now I would encourage you if you feel inclined to just move on to the next part of the video. And try to get an understanding okay? I'll take a break here, but we will start in a second.
