So let’s see where
we left off. We were studying the balance
sheet of this Bank A, I think that’s what I called it. And we said, OK on the assets
side, had some government bonds, had some AAA
corporate bonds, some commercial mortgages. And then this is the thing
that I really wanted to highlight, that it also had
$4 billion of residential collateralized debt
obligations. And I explained little bit
about what those are. And I have several videos
where I explain that in more detail. And how they probably led, or
most definitely led, to the housing bubble. And then we have a little bit
of cash on top of that. On the liability side,
the bank just owes a lot of money to people. If this were a commercial bank,
kind of your Bank of Americas, or your Chases of
the world, then one of the liabilities here would have also
been the deposits of the people who keep their
money at the bank. But we’re not going
to assume that. This could be just
kind of any bank. Actually, this could be any type
of financial institution. Frankly, it doesn’t
have to be a bank. This could be the balance sheet
of a hedge fund, or a private equity firm, or pretty
much any type of financial institution. But anyway, back to where
we were in the example. We said, and we learned it in
the first video, and we learned it in the balance sheet
video, that if you take your assets and you subtract
out your liability– so you take what you have, you subtract
out what you owe, you’re left with what
you’re really worth. And that’s called your equity. And if you’re a publicly traded
company, actually you don’t have to be publicly
traded, but if you’re a corporation, that’s called your
shareholders’ equity. And what does that mean? Well that means the people who
own a stake in the company, or the shareholders, they
share this piece. And just to hit the point home,
and I think this is an important one because I
feel like people kind of talk past this. There’s two notions, there’s
your book value of equity, and that’s the value of the equity
that comes out of your balance sheet. So if you assume that
everything, all of these numbers, are accurate– and
we’re going to think a lot about what it means to have an
accurate number here– and you assume that all of these
numbers are accurate. Then the number that pops out on
the equity side, that is a book value of your equity. And just as an example, I said
well let’s say that Bank A is a public company. It has 500 million shares. And so that means that if you
take its $3 billion of equity, divide by 500 million shares,
that means that there is $6.00 of book equity per share. So that means if all of these
numbers are correct, then the stock of that company is
worth $6.00 per share. Exactly $6.00 per share. And you’re saying, wait Sal,
that doesn’t make sense, we all know that the stock market
is a wild ride, especially banking stocks. They swing left and right
and up and down. And how can you tell me that you
know just by looking at a balance sheet, you can give an
exact amount for what its equity value is? And that is an important
distinction. Let me scroll down
a little bit. Maybe I’ll erase this. Actually, let me
clear this out. I think it’s a distraction. You might just want to watch the
video on mortgage-backed securities and collateralized
debt obligations if you need a refresher there. So what does it mean when, I’m
telling you right now that you can look at it company’s balance
sheet, and if you believe what they say, you can
actually calculate a book value per share. So why do stocks fluctuate
wildly left and right? Well, it’s interesting. It actually tells you a lot
about what the market thinks about a company’s
balance sheet. Let me fill this in. This was $26 billion
of assets. And then I had $23 billion
of liabilities. And that’s how we got equity
of $3 billion. And book equity per share,
or the book value per share of $6.00. Now let’s say we go on to Yahoo
Finance and we type in the ticker symbol for this
bank– Bank A, whatever we want to call it. And let’s say that its market
price is I don’t know, it is $12.00 per share. So what is happening here? The book value is $6.00, but the
market saying no, no, no, we are willing to pay
$12.00 per share for one of those shares. And just to make a point here,
when you look up a share price in the stock market, or even
better, when you buy a stock on the stock market,
that money is not going to the company. The company initially raises
money by selling shares. And that’s often done with an
initial public offering. They will sell some shares
directly to the market. And that money goes directly
to the company. Or they might do it in an
offering, and we’ll talk more about that later. But 99% of the time, when you
buy a share, it is not going to the company. It is going to the previous
person who held that share. That’s why it’s called
a secondary market. It’s not going to the company. So it’s just a bunch of people
trading the share price. And the only reason why that
share price really fundamentally matters to the
company is if the company were to raise money at
a future date. So let’s say the share price
today is $12.00. Let’s say I bought a share for
$12.00 dollars a share today, that means maybe I bought
it from you. I didn’t buy from the company. But that at least tells the
company that if it needed money, if it needed to raise
money, it could sell shares probably at something close
to $12.00 a share. It also tells someone who wanted
to buy out the whole company, so if they wanted to
take over the company, that maybe if they offered some type
of a premium to $12.00 a share, they could buy out
all of the stock. But that’s not the
topic for this. And actually, the more I think
about it, I really should do videos on all of
these concepts. But anyway, so the market is
giving a $12.00 per share value, what does that mean? The person who’s paying $12.00
a share is assuming that this is understated, the book
value is understated. And so if the book value is
understated, that means that either the assets are
understated, or the liabilities are overstated. Most times the liabilities
are pretty easy to get a handle on. Sometimes pension liabilities
or some type of litigation liabilities, that’s hard
to get a grasp on. But most times, you can look
at a balance sheet and you say, OK this is the
money they owe. That’s not too hard to value. What is often very interesting
to value are the assets on a balance sheet. So, with this balance sheet, you
would say $6.00 per share, but the market is willing
to say $12.00. Then you say, either these
assets or somehow being undervalued or the company might
have some assets that somehow are not captured on
the balance sheet, right? Maybe they’re intangible
assets. Or there’s some type of earning
power that in some way is not captured here. I think when I originally did
the videos on balance sheets, I actually talked about you
can’t quantify charisma and good looks. And so that’s maybe why I have
more assets than might balance sheet might predict. Well, this notion is
the same thing, but on the company level. Maybe, if this were Goldman
Sachs’ balance sheet, maybe its book value per
share is $6.00. But the market is willing to pay
$12.00 for it because it’s Goldman Sachs. That’s the corporate equivalent
of charisma and good looks. They say, just by their brand
they’re able to make more money than everyone else. They’re able to do more with
whatever assets we give them. So I’m willing to pay a premium
to their book value. And whether or not that’s true,
that’s a tough case. I think that argument can very
easily be made with a company like Coca-Cola, where it does
have a very powerful brand. Where that brand and that
formula, that secret formula, really are the value of the
firm, and they probably aren’t captured on their
balance sheet. With a bank, I’d be a little
more skeptical of paying a significant multiple
of this, right? Here, what multiple
are we paying? If this is the market value– so
let’s say this is the stock price, or the market stock
price– I’d be skeptical of paying two times
the book value. But it’s actually not hard to
find a lot of companies that are trading at far more than
two times the book value. So that’s what it means. That’s what the market is
essentially saying if they’re paying $12.00 a share for
something that essentially has a book value of $6.00
per share. Or maybe one of these assets
are worth more. Maybe they had, on the books,
there’s a property here in Manhattan that they bought 50
years ago that they have it on the books for $0.50. But maybe the shareholders say,
oh no that’s really worth a million dollars or something,
I don’t know. Another way to think about it
is, if the market is paying $12 million per share, what’s
the market cap of the company? And the market cap of the
company is really what’s the market’s guess of what the
shareholders’ equity is? So the market cap, you take $12
per share, multiply it by 500 million shares. So 12 times 500 million, or
let’s say 0.5 billion. And you get a $6 billion
market cap. So if the equity is trading,
or if the stock is trading, that day at $12.00 dollars per
share, that says that the market, or at least the people
on the margin trading that stock that day– and I’ll do
not another whole set of videos on what that means
and how prices are set. But that means that they think
that this equity isn’t $3 billion, that it’s actually
worth $6 billion. I told you for all the reasons,
maybe the brand is worth a lot, or they have some
secret formula, or one of these assets somehow
is understated. So that’s fine. That’s the situation where
the market price is above the book value. But what’s the situation where,
let’s say that on that day of trading, the share price
is that $3.00 per share. Well if we say 3 times 0.5
billion, that means that the market says that this company’s market cap is 1.5 billion. Or another way of viewing it,
is that this is the market’s guess, or you could
call it the market value of the equity. This is the market’s guess
of the value of this company’s equity. So the market says, OK I don’t
care that Bank A says that they have $3 billion, that their
assets minus liabilities are $3 billion. We don’t buy it. We actually think this is
only worth $1.5 billion. And it’s probably because they
think that one of these things on the left-hand side of the
balance sheet, one of these assets, are worth less
than what the bank says they’re worth. It could be that one of these
liabilities is worth more. Maybe there’s some type of
environmental liability that the company is somehow
understating. But let’s not get too
complicated right now, I’ll do a bunch of videos on that. But when the market value, or
the market cap, is below the book equity, that’s the market
just saying, hey we’re calling your bluff. Something here doesn’t
smell right. Something here isn’t worth
what you say it’s worth. And I just realized that
I’m out of time. And I will continue this
in the next video.