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.