William Ackman, the CEO of Pershing Square Capital, discusses the nuts and bolts of finance and investing in this lecture titled Everything You Need to Know About Finance and Investing…
So let’s begin. We’re going to go into business together. We’re going to start a company and we’re going to start a lemonade stand and now I don’t have any money today, so I’m going to have to raise money from investors to launch the business.
So how am I going to do that? Well I’m going to form a corporation. That is a little filing that you make with the State and you come up with a name for a business. We’ll call it Bill’s Lemonade Stand and we’re going to raise money from outside investors. We need a little money to get started, so we’re going to start our business with 1,000 shares of stock. We just made up that number and we’re going to sell 500 shares more for a $1 each to an investor. The investor is going to put up $500. We’re going to put up the name and the idea. We’re going to have 1,000 shares.
He is going to have 500 shares. He is going to own a third of the business for his $500? So what is our business worth at the start? Well it’s worth $1,500. We have $500 in the bank plus $1,000 because I came up with the idea for the company.
Now I’m going to need a little more than $500, so what am I going to do? I’m going to borrow some money. I’m going to borrow from a friend and he’s going to lend me $250 and we’re going to pay him 10% interest a year for that loan.
Now why do we borrow money instead of just selling more stock? Well by borrowing money we keep more of the stock for ourselves, so if the business is successful we’re going to end up with a bigger percentage of the profits. So now we’re going to take a look at what the business looks like on a piece of paper. We’re going to look at something called a balance sheet and a balance sheet tells you where the company stands, what your assets are, what your liabilities are and what your net worth or shareholder equity is.
If you take your assets, in this case we’ve raised $500. We also have what is called goodwill because we’ve said the business—in exchange for the $500 the person who put up the money only got a third of the business. The other two-thirds is owned by us for starting the company. That is $1,000 of goodwill for the business. We borrowed $250. We’re going to owe $250. That is a liability. So we have $500 in cash from selling stock, $250 from raising debt and we owe a $250 loan and we have a corporation that has, and you’ll see on the chart, shareholders’ equity of $1,500, so that’s our starting point.
Now let’s keep moving. What do we need to do to start our company? We need a lemonade stand. That’s going to cost us about $300. That is called a fixed asset. Unlike lemon or sugar or water this is something like a building that you buy and you build it. It wears out over time, but it’s a fixed asset. And then you need some inventory. What do you need to make lemonade? You need sugar. You need water. You need lemons. You need cups. You need little containers and perhaps some napkins and you need enough supplies to let’s say have 50 gallons of lemonade in our start of our business. Now 50 gallons gets us about 800 cups of lemonade and we’re ready to begin.
Let’s take a new look at the balance sheet. So now we’ve spent $500 on supplies. We only have $250 left in the bank, but our fixed assets are now $300. That is our lemonade stand. Our inventory is $200. Those are the supplies and things, the lemons that we need to make the lemonade. Goodwill hasn’t changed at 1,000, so our total assets are $1,750 and we still owe $250 to the person who lent us the money. Shareholder equity hasn’t changed, so we haven’t made any money. All we’ve done is we’ve taken cash and we’ve turned it into other assets that we’re going to need to succeed in our lemon stand business.
So let’s make some assumptions about how our business is going to do over time. We’re going to assume we’re going to sell 800 cups of lemonade a year. That’s not a particularly ambitious assumption, but we should assume the lemonade business is fairly seasonal. Most of the lemonade sales will happen over the summer. We’re going to assume that each cup we can sell for $1 and it’s going to cost us about $530 per year to staff our lemonade stand.
So now let’s take a look at the income statement, so the income statement talks about the profitability, about the revenues that the business generated, what the expenses are and what is left over for the owner of the company. So we’ve got one lemonade stand. We’re selling 800 cups of lemonade at our stand. We’re charging $1, so we’re generating about $800 a year in revenue and we’re spending $200 on inventory. There is a line item here called COGS. That stands for cost of goods sold. We have depreciation because our lemonade stand gets a bit beat up over time and it wears out over five years, so it depreciates over 5 years. We’ve got our labor expense for people to actually pour the lemonade and collect cash from customers and we have a profit. We have EBIT and that is earnings before interest and taxes, of $10. That is kind of our pretax profit for the business. We didn’t make very much money because you take that pretax profit of $10 and you compare it to our revenues. It’s about a 1.3% margin. That is not a particularly high profit.
Now we’ve got to pay interest on our debts and we have a loss of $15 and then we don’t have any taxes, but at the end of the day we still lose money. So the question is, is this a particularly good business? Well we’re losing money and our cash is basically going down over time.
Is this a business we want to stay in? Now the cash flow statement takes the income statement and figures out what happens to the cash in the company’s till, so when you put up $750, some money goes to pay for a lemonade stand. Some money is lost selling the product and at the end of the day we started with $750 and now we only have $500.
Let’s look at the balance sheet. What has happened? Our cash has gone down from 750 to 500. Our fixed assets have gone from 300 to 240. That means our lemonade stand is starting to wear out. Goodwill hasn’t changed. We still owe $250 and our shareholder’s equity is now down to $1,490, so it was 1,500 we started with minus the $10 we lost over the course of the year.
So should we continue to invest in the business? We’ve lost money in the first year. Is it time to give up? Well let’s think about it. Let’s make some projections about what the company is going to look like over the next several years. Let’s assume that we take all the cash the business generates and we’re going to use it to buy more lemonade stands so we can grow. Let’s assume we’re not going to take any money out of the company and we’re not going to pay a dividend. We’re going to keep all the money in the company and reinvest it. Let’s assume that we’re going to—as we build our brand we can charge a little more each year, so we’re going to raise our prices about a nickel, five cents more for each cup of lemonade each year and then we’re going to assume we can sell 5% more cups per stand per year. So we’ve got built in growth assumptions.
Now let’s take a look at the company. So if you take a look at this chart you’ll see in year one we started out with one lemonade stand. We add one a year and then by year five we’re up to seven because we’ve got a big expansion plan. Our price per cup goes up a nickel a year and our revenue goes from $800 and starts to grow fairly quickly and the growth comes from increased prices for cups of lemonade and it also comes from opening more stands. So by year five we have almost $8,000 in revenue. Our costs are relatively constant, which is the lemonade and the sugar. That’s about $1,702. We have depreciation as more and more stands start to wear out over time. We’ve got labor expense, but by year five the business is actually doing pretty well. We went from a 1.3% margin to over a 28% margin. The business is now up to scale. We’re starting to cover some of our costs. We’re growing.
We’re still paying $25 a year in interest for our loan and we have earnings before taxes, after interest of $2,300 by the end of year 5. So we put $500 into the business. We borrowed 250 and by year five we’re making a profit of $2,300. That sounds pretty good.
Now we have to pay taxes to the government. That is about 35% and we generate net income or another word for profits of $1,500 by the fifth year and about a dollar a share. So if you think about this our friend put up $500 to buy 500 shares of stock. He paid a dollar and after five years if our business goes as we expect he is actually making a dollar a share in profit. That sounds like a pretty good deal.
So what has been the growth? The growth has been fairly dramatic over the period and that is what has enabled us to become a successful business. Now these are just projections, but if they’re reasonable projections this might be a business that we want to start or invest in.
Now let’s look at the cash flow statement. So as the business becomes more and more profitable we generate more and more cash and the cash builds up in the company. We go from $500 of cash in the company to over $2,000 of cash over the period. The balance sheet, again, the starting balance sheet had shareholder’s equity of $1,490, but as the business becomes more profitable the profits add to the cash. They add to the assets of the company. Our liabilities have not changed and the business continues to build value over time. So again by the end of year five we’ve got $4,000 of shareholder equity and that’s almost three times what it was when we started.
Now is this a good business or a bad business? How do we think about whether it’s good or bad? One thing to think about is what kind of earnings are we achieving compared to how much money went into the company. Now this is a business that we valued at $1,500 when we started. Someone put up $500 for a third of the company. We gave it a $1,500 value. By the end of year five it’s earning over $1,500 in earnings, so that’s over a 100% return on the money that we put into the company. That’s actually quite a high number. We spent—let’s talk about return on capital. We’ve spent $2,100 in capital building lemonade stands and we earned $2,336 in year five on the capital we invested. That’s over 100% return on capital. That is a very attractive return.
Earnings have grown at a very rapid rate, 155% per annum. This is really a growth company and our profitability has gone from 1.3% to 28.6% by year five and that sounds pretty attractive and it is.
So let’s look at the person who put up the loan. Well that person put up $250 and the business has been profitable. We’ve been able to pay them their interest of 10% a year, $25 a year and they’re happy because they put up $250. They’re getting a 10% return on their loan and the business is worth well 3more than $250. We’ve got more than that in cash. As a result, they’re in a safe position, but they’ve only made 10% on their money.
Now let’s compare that with the equity investor, the person who bought the stock in the company. That person earned a dollar a share in year five versus an investment of a dollar a share, so he is earning over 100% or about 100% return on his investment versus only 10% for the lender. So who got the better deal? Well obviously the equity investor.
Now why did the equity investor, why do they have the right to earn so much more than the lender? The answer is they took more risk. If the business failed the lender is entitled to the first $250 of value that comes from liquidating the company, so if you sell off the lemonade stands and you only get $250 the lender gets back all their money. They’re safe. They got their 10% return while the business was going. They got back their $250, but the equity investor, the person who bought the stock is wiped out because they come after the lender.
So what is the difference between debt and equity? Debt tends to be a safer investment because you have a senior claim on the assets of a company and it comes in lots of different forms. You’ve heard of mortgage debt on a home. That’s a secured loan secured by a house, but you could have mortgage debt on a building for a company. There is senior debt. There is junior debt. There is mezzanine debt. There is convertible debt, but the bottom line, it’s all debt. It comes in different orders of priority in a company and the rate your charge is inversely related to your security, so the better the security and the less risk the lower the interest rate you’re entitled to receive. The more junior the loan the higher the interest rate you’re entitled to receive, but you can avoid the complexity. All you need to think about is debt comes first. It’s a safer loan, but your profit opportunity is limited.
Now the equity also has their varying forms. There is something called preferred equity or preferred stock. There is common equity or common stock and again stock and equity are basically synonyms. They’re options, but really not worth talking about today. The important point is that equity gets everything that is left over after the debt is paid off, so it’s called a residual claim.
Now the good thing about the residual claim is that business grows in value if you don’t owe your lender anymore, but all that value goes to the stockholder. So the question is why was the lender willing to take only a 10% return when the equity earned a much higher rate of return and the answer is when the business started there was no way of knowing whether it would be successful or not and the lender made a bet that if the business failed they could sell off the lemonade stand. It cost $300 to make it. They would have some lemons, some lemonade. Even if they sold it at a much lower price than the dollar they originally projected the lender felt pretty comfortable that they would get their money back, whereas the stockholder is really taking a risk. They were betting on the profitability of the company and they were taking a risk that if it failed they would lose their entire investment, so they were entitled to get a higher return or have the potential to have a higher return in the event the business we successful.
So let’s talk about risk. Lots of different ways people think about risk, but the one that we think is the most important—you know a lot of people talk about risk in the stock market as the risk of stock prices moving up and down every day. We don’t think that’s the risk that you should be focused on. The risk you should be focused on is if you invest in a business what are the chances that you’re going to lose your money, that there is going to be a permanent loss. When you’re thinking about investing your own money, when you’re thinking about one investment versus another don’t worry so much about whether the price moves up and down a lot in the short term. What matters is ultimately when you get your money back will you earn a return on your investment.
How do you think about risk? Well one way to think about risk is to compare your risk to other alternatives, so you could buy government bonds and government bonds are considered today the lowest risk form of investment and the US Treasury issues 10 year, 3 year, 5 year debt. There is a stated interest rate and today a 10 year Treasury you earn about a 3% return. So you give your government $1,000 and you get $30 a year in interest. At the end of 10 years you get your $1,000 back, so that’s very, very safe and that sort of provides a floor.
Now obviously if you’re going to make a loan you can lend money to the government and earn 3%. Well if you can lend money to a lemonade stand you want to earn meaningfully more, so in this case the lender is charging a 10% rate of interest. Why 10%? Because they want to earn a nice fat spread over what they can make lending to the government because a startup lemonade stand business is a higher risk business. Equity investors sort of think about things similarly, so the higher the valuation—the more risky the business, the higher the rate of return the equity investor is going to expect and the lower the risk business the lower the return the equity investor is going to expect and equity investors don’t get interest the same way a lender does. What equity investors get is they get the potential to receive dividends over the life of a company.
Let’s talk about raising capital. You started this lemonade business. Now the point of this was to make money in the first place. The business is doing very well yet I, having started the business coming up with a name and the concept, hired all the people, I’ve made nothing, right. So the business has grown in value, but where is my money? I need money to buy a car for example, so I want to buy a car for $4,000. What are my choices? What can I do? Well we’ve taken all the cash the business has generated. We’ve reinvested it in the business. Now the good news is we’ve taken all that money. We’ve been able to use it to buy more lemonade stands and these lemonade stands are more and more productive and it’s grown the value of the business faster and faster. Now my alternatives could include instead of growing the business so quickly, instead of investing in more lemonade stands I could simply have paid dividends to myself.
Now the good news about that is I get money along the way, but the bad news about that is the business wouldn’t grow as quickly and if you have a business as profitable as this lemonade stand company and you just open a new lemonade stand and people earn—we can earn hundreds of dollars in each new stand it makes sense to keep investing.