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  • In the price to earnings conundrum video we encountered

  • a situation where two different entrepreneurs bought

  • an identical asset, in this case it was a pizza parlor or

  • a pizzeria, but they each financed it

  • in a different way.

  • This guy was a little bit more conservative.

  • He paid for it outright.

  • The entire asset was his equity.

  • He had no debt.

  • While this guy, he borrowed some money and he even had

  • some non-operating assets.

  • So he levered up.

  • For every $1 he put in he borrowed $10 from the bank in

  • order to buy more assets that he actually

  • brought to the table.

  • And we saw when you did their financial statements-- their

  • revenue, cost of goods-- everything up to the operating

  • profit line was the same.

  • And that makes sense because, if you remember the first

  • introduction to income statement video, operating

  • profit is really indicative of what the operating assets are

  • generating.

  • So in this case it's what this purple area right here is

  • generating.

  • You could also consider that the enterprise.

  • What the enterprise is generating.

  • And everything below the operating line, everything

  • below the operating profit line, is either coming from

  • non-operating assets, that would the case of

  • non-operating income.

  • And the entrepreneur on the right had some of that.

  • He had some of this non-operating income, $2,000

  • per year in that case.

  • While this guy didn't have any.

  • And then you have expenses associated

  • with interest. Right?

  • In this case this entrepreneur had 5% of

  • $100,000, so $5,000 a year.

  • And then when you have these differences in capital

  • structure it changes what your net income is.

  • And they have slightly different net income numbers.

  • But what we saw is when we applied the same price to

  • earnings ratio, and they had the same share counts-- I

  • didn't change too many variables here I just really

  • changed how they paid for the asset.

  • But when you apply the same price to earnings ratio to

  • both earning streams, to both companies, you got something

  • that was reasonably unintuitive.

  • And there's no trick here really.

  • Because it's not crazy to assign the same price to

  • earnings ratio.

  • And if you try it out, if you grow this guy's revenue a

  • little bit, if you actually grow both of their revenues by

  • the same amount or both of their gross profits by the

  • same amount or if you grow both of their operating

  • profits by the same amount, you're actually going to see

  • that this guy's earnings per share is growing faster.

  • So given that someone might say, oh, because of the

  • leverage maybe I'm willing to pay even a higher multiple.

  • So it's not crazy to pay the same multiple for both of

  • these guys.

  • But we saw at the end of the last video, when you apply,

  • let's say, a 10 multiple, or really any multiple to both of

  • these earning streams, you get a situation that at first

  • doesn't look crazy.

  • OK, the market cap of this guy is $210,000 if you apply a 10

  • multiple to their earnings stream, while the market cap

  • of this guy is $189,000 if you apply a 10 multiple to their

  • earning stream.

  • Right?

  • 10 times 18.9 thousand is 189,000.

  • 10 times 21 thousand is 210,000.

  • But what was the conundrum, what really got us thinking,

  • was how can this whole equity stream right here, or this

  • equity, or this earnings stream be, worth 210 and this

  • one be worth 189 when this guy only put $10,000 in initially

  • and this guy put $100,000?

  • He put in 10 times as much.

  • And so when you're paying $210,000 for this asset, for

  • this equity, you are essentially saying that this

  • asset is worth $210,000.

  • But if you're saying that this equity is worth $189,000,

  • right, that's what the market cap is.

  • It's the value of the equity.

  • Then you're implicitly saying that this asset, that all of

  • these assets are worth the value of this market

  • capitalization plus this debt, right?

  • So that's $289,000.

  • And then if you wanted the value of this operating asset

  • you would subtract out this much right here, the cash.

  • So you got something like $279,000.

  • So when you apply the same price to earnings to to these

  • similar businesses you've actually got a situation where

  • you're overpaying for this asset relative to this one,

  • even though they're identical.

  • So that left us with a question: what do we do?

  • What can we use other than a price to earnings ratio?

  • And that's what this video is for.

  • So the short answer is, one, you do have to

  • use something different.

  • Price to earnings ratio is a good a quick way of comparing

  • two companies relative to their growth or

  • relative to an industry.

  • But it does lose a lot of information relative to how

  • the companies are capitalized.

  • You saw in the last video that how you're capitalized, and

  • when I say capitalized I mean how do you

  • pay for your assets.

  • If you have a lot of debt versus a lot of equity, what

  • actually happens on the earnings line

  • is very, very different.

  • And so you lose all of that information.

  • And so if you want to capture that information, when you

  • look at the price of a stock you have to figure out what

  • you're actually paying for the enterprise of the company, the

  • enterprise value of the company.

  • So when I talk about the enterprise, or the enterprise

  • value, I'm talking about the operating assets.

  • It gets a little bit more complicated if you're talking

  • about a financial company like a bank or

  • an insurance company.

  • But if we're talking about a widget factory, the enterprise

  • is essentially the assets.

  • The enterprise value is the asset value of the assets that

  • allow the company to do business.

  • So whatever factories-- well, in this case it's a pizzeria,

  • so the ovens, the building, the places, where people

  • actually eat their food, and even the cash that's necessary

  • to operate the business.

  • The enterprise value shouldn't incorporate the cash that's

  • surplus, that's not necessary to operate the business.

  • So that begs the question, how do you calculate the

  • enterprise value?

  • So you could go backwards and you say, OK, for a given price

  • how much am I paying for an enterprise value?

  • So let's say that this stock-- let's say that Company A or

  • this one, let's say the stock right now is trading at $20.

  • So this is the current price that you could buy it at.

  • So it's the asking price in the market is at $20.

  • While this one is at, let's say it's at $10.

  • It's at $10.

  • So at first glance you might just do a quick price to

  • earnings ratio.

  • And you'll say, OK, for $20 I'm getting $2.10 earnings per

  • year, assuming it's not growing or something.

  • So my price to earnings is approximately, I don't know

  • have my calculator in front of me, but $20 divided by $2.10

  • is going to be 9 point something, something.

  • Right?

  • While this guy, for $10, I am getting $1.89 of

  • earnings per year.

  • So what's 100 divided by 18?

  • It's 5 or 6 times.

  • It's going to be 5 point something.

  • 6 times 18 is 60 plus -- Yeah it's going to be 5 point

  • something, something.

  • So when you superficially just look at this you're going to

  • say, wow, this is a cheaper price to earnings ratio, maybe

  • I should buy that.

  • But what we saw in the last video is that price to

  • earnings isn't a good relative valuation metric when two

  • different companies are capitalized very differently.

  • So what you want to do is instead back out what these

  • prices imply about the enterprise value.

  • So what does $20 imply about the enterprise value and what

  • does $10 imply.

  • And how do you do that?

  • Well first you say what is the market cap?

  • Market cap.

  • So you take the price times the number of shares.

  • If you remember, we had 10,000 shares.

  • So in this case $20 times 10,000 shares implies a