Okay great in terms of expenses from the first line item we put down under revenue is the cost of goods
sold.
So remember we made the banana watches and it costs us 200 bucks to make one but we sold them for three
bucks apiece.
So for this company we have the costs of goods sold bottled out there as 10 percent gross margins.
And so it makes sense early on in the lifecycle of a company that it costs them much more money to produce
one unit of their product than it does later on.
And so revenue minus the cost of goods sold member it's equal gross profit and so gross profit divided
by revenue is called gross margin and it's expressed in the Presenter.
And so the gross margin for our company here that we're modeling is 10 percent in 2015 and it goes down
to 60 percent in or goes up to 60 percent in 2018.
Higher is better because you're making more gross margin profit on that item.
Now we have to come up with the operating expenses as well which is below gross profit.
Okay so we add to our three generic titles or line items for operating expenses.
And this is applicable to most companies can you ad sales and marketing that's S&M general administrative
unit and then R&D which is research and development and almost all companies have these three line is
pretty simple.
Okay great.
So when you look at operating profit now so we're going to model it.
And as you can see I put in these numbers and you may ask yourself Chris how the heck did you come up
with these numbers.
Well you can actually go to publicly traded companies that are similar to this company and you can look
at what percent of revenue as cinemas or GNN or R&D and all this stuff is out there on the Internets.
The Securities and Exchange Commission mandates all companies put this stuff out there.
If they're publicly traded it will cover that more later on when we analyze a publicly traded company
and model.
JACOB.
OK so as you can see we look at everything as a percentage of revenue and operating expenses here are
just sales and marketing plus G'day plus R&D.
Okay great.
So we did that all the way across.
And so we make our assumptions.
We assume that the company becomes more efficient over time.
So as you can see by this graphic here this Excel snapshot I had sales and marketing at $500000 in the
first year spikes to 4 million in the next year.
And that's actually less as a percent of revenue.
Okay.
So you'll see that sales marketing is 25 percent sales in year 1 then it goes down to 20 percent of
sales but it jumps to 4 million still 20 percent then it goes to 19 then 17 yada yada yada.
Okay gets less and less and less until eventually the company breaks even starts making money.
So this hypothetical model here we have our company breaking even from an operating profit perspective
in 2017.
Okay.
And again keep adding comments.
Now we're into below the line items which is an accounting nerd term for the low operating profit numbers
like interest and taximeter we talked about how we're comparing our banana watch company in the past
to the less successful swish Swiss watch companies and how they have different tax rates and different
interest rates which is why we look at below the line numbers.
OK so we threw in that number there.
And again just comment your code your Excel spreadsheet so that later on you can understand what you
were thinking.
OK.
So we don't really put in tax until year three because we were profitable until year three.
In fact what you could do and I'm not going to go into too much detail of tax accounting but you get
a massive loss.
You lost 20 million bucks in year one year two.
You can carry that forward and you'll never pay taxes until you make up for that $20 billion in losses.
OK.
So that means that the first 20 million dollars going forward.
For example in taxes you're supposed to pay.
You're not paying.
They're carried forward.
Those are called and oh wells are net operating losses.
OK back to our model.
So everything you've seen here is just a percent of sales.
And again what we do when we analyze a publicly traded company we're going to look at this in much more
detail.
I want to make this a very quick study for you.
So I asked now is the $350 billion valuation that we paid from venture capital perspective to invest
in this company attractive or not.
We invest we we invest in this company and evaluation 3 or 15 bucks.
So in order to answer that we have to analyze the market and what competitors are are trading at.
And so right now the stock market is paying 10 times revenue for Growth investors.
Okay 10 times revenue that's a little bit high will come down on see stock market for example is paying
10 times for value investors and I don't think value investors are good at tech but that's OK.
They're just a different breed of investor.
OK so let's assume an IPO now in five years.
OK.
So our value investors who I wrote here suck at Tech.
No disrespect to them.
They pay 10 times earnings.
OK so in five years our earnings times 10 equals a valuation of five billion dollars.
Not bad.
Making 500 million bucks in earnings five years.
Now our growth investors in five years or so our growth investors are going to pay 10 times revenue
our revenues eventually will be.
It'll be like $1.3 billion.
So 10 times that is about 13 or 14 billion dollars which is pretty good so we're assuming IPO 2020.
And when I say that value investors Succot tech I don't mean that they're bad investors when it comes
to attack but you can never buy a tech stock because the stock is cheap.
When a tech stock is cheap it's because no one wants to buy it.
Right.
Remember the best investors in tech value companies based on earnings five years now.
And it reminds me of something Warren Buffett came in guest lectured at one of my classes at Columbia
years ago and it was a real treat for us.
And one of my colleagues.
Now this was back in 1989 one of my classmates was pitching a text to him in front of hundred fifty
states in Warren Buffett listened politely for 30 seconds and then he very politely interrupted my classmate
and said Son I'm going to sock you right.
Stop right there because I'm not going to invest in a technology company because I don't understand
where these companies are going to be product cycle wise.
Three five seven years from now when I invest in a company like Coca-Cola I know the cool beverage is
not going to change that much.
And so I can understand it longer term.
And so you never invest in something you can't really understand longer term.
And he was brilliant because a couple of months after that you came in November of 19 percent at school.
By March of 2008 the market crashed.
Tech stocks went down.
And so he was quite brilliant so value investors just they just don't like to invest in tech companies
because that's not cool man.
I'm a growth investor.
I don't know what you are yet you might not know for quite some time.
But people are usually growth or value on that spectrum.
And if you're stuck in the middle then that's called Garp growth at a reasonable price.
And so venture capital investors and tech investors are growth investors and people that like to buy
stuff that's cheap meaning outside of tech value investors and all great companies in technology go
from growth.
And then when they mature member the last stage mirror that the red bar with the shark when large companies
or tech companies when growth slows and they mature they transition from growth slowly the value in
that transition.
When these companies are big and mature takes at least 10 years and that's purgatory for divestitures.
Why.
Because growth investors will touch the stock because it's not growing fast and that investors won't
touch the stock because it's not cheap enough.
And so I remember when I worked at Citadelle I pitched Microsoft as a long idea a decade ago and my
boss at the time told me he was right.
He said Chris in all my years of investing I've learned don't ever invest in the company that haven't
hasn't moved in like five years or so or that's not growth is not valued stuck in the middle because
who's incremental buyer.
There are so many markets for quite a while.
OK I digress back to our model.
OK so our growth investors believe that this company we just create a model for is going to be valued
at close to $14 billion in five years.
When we go public.
OK.
And our value investors who value based on earnings are painted Hampshirites in five years.
So 2020 roughly at that point in time the company will be valued at at 5 billion dollars or 10 times
500 million dollars.
Okay great.
So that's awesome.
That's awesome.
So that means that our 350 million dollar valuation on the company.
This company we invested in is is a ferkin home run.
Right.
So even if you take the valuation target that you had the price target and you discounted it by 25 percent
to be conservative you're still making a ton of money.
It's it's more than it's had back so far 350 million valuation on this hypothetical investment was great
and we're going to do well in this investment because we invested in a great management team.
The job is more important than the horse.
This person has been successful in that in the past selling companies he started.
So the probability of you being successful back in this jockey is much higher Okay.
Great.
So how do we value this company.
And so this company is a little bit like sales force there's a software cloud component to it.
Sales force those you don't know it is the largest employer in San Francisco.
It's a big cloud software company.
OK so we can see if you look at the bottom here or the second line from the bottom on the sales force
valuation analysis sales force is trading at nine times nine times revenue.
We valued our company it 10 times revenue and then took a 25 percent haircut in our company is growing
much faster in sales forces.
Okay.
So again our valuation net 350 million bucks in this company is a darn It's a steel it's a steel case
so it's a it's a great investment and again it all came down to backing the right jockey.
Notice how I'm not really talking about what the company does that's on purpose.
Okay.
Invest in the right management team first business model is always secondary.
Anyway you'll see I learned the hard way early in my career when I was a public market investor.
I remember I bought this company that it was a software company not going tell you which one it was
very embarrassing but it was dirt cheap and they had the worst management team on the planet.
And I lost money on it and I learned my lesson that I'll never invest in the company I don't care how
cheap it is.
I don't care how awesome the business model is I'll never invest in a company that doesn't have a kick
ass management.
Okay great.
So look at that.
We've got 40 percent growth there their revenue growth in 2020.
Right so 20 We've got 1.3 9 9 billion dollars in revenue forecast right.
It's you know if we throw a ball not that's a 14 million dollar value company.
So growth investors will value based on revenue multiple so 10 times revenue in this hypothetical example
is 14 billion dollars.
Okay.
And if you haircut that a lot it's still a bargain compared to our 350 million dollar investment valuation.
And the bottom line there is net income you can cut off the titles there I'm sorry.
So in 2020 we're going to have net income that is very very right.
So anyway actually I digress I'm sorry about that the bottom line there is gross profit net income was
closer to 5 million dollars which is way way below that.
OK so what is a sustainable growth rate in 2020 when this company goes public and we'll talk about the
whole IPO process first.
It's best.
So how fast can this company physically grow before hitting a wall.
We can quantify that.
So the sustainable growth is basically what is the maximum growth rate a company can achieve without
getting additional financing from equity firms or debt firms.
And the form is pretty simple.
It's ending equity minus beginning equity divided by beginning equity.
That's a sustainable growth and so retained Erde retained earnings is part of equity which is how much
profits we've derived over the years.
So let's check out our sustainable growth rate in 2020 which is the year of our IPO.
We're not going to assume we have dividends.
It's a tech stock.
Tech companies that go public donation dividends usually within the first decade to be public.
OK.
Are they getting equity value we had for our company was 350 million bucks the equity value of that
year is a hundred sixty million bucks.
The difference there is Culver's haner is and what you do is you take net income and you add it to your
beginning equity value and that becomes your thing any equity value.
OK.
So here we've got the most we can grow in 2020 is 145 percent.
Let's make sure we're blowing as much.
So let's take a look.
So if we look at our spreadsheet our 2020 growth rate is actually Ninety eight percent.
So we're growing at a rate below our sustainable growth rate.
All good.
Now if we were growing above the sustainable growth rate we would need to raise money in order to feed
our growth.
Okay.
So again our sustainable growth rate the maximum we can grow before raising more money is a hundred
forty five percent and we're currently at 98 percent.
But if an activist investor like Carl Icahn for example pressures us to issue a dividend of say 40 percent
then we simply multiply the sustainable growth rate by 1 minus the dividend rate.
So that would mean 87 percent.
Right.
So the max we could grow if we had a 40 percent dividend is 87 percent.
Okay.
So a sustainable growth rate equals net income become divided by beginning equity times the retention
rate the retention rate is why it didn't get
so Lisk manipulate that last formula a little bit and so have some fun with math so we can better kind
of understand how to manipulate our financials to meet our sustainable growth targets.
Okay.
So here we go.
And if this is a little bit over your head right now and you're not Passhe about math to worry about
just skip over his actions but I'll try to go through net income divided by equity equals return on
equity member whenever you have a return on something.
It basically means net income or profits divided by whatever that return on thing was.
So return Akwe is net income over equity.
Okay.
And so net income we're just moving that for around net income divided by equity is equal to return
on equity return equity equals net income over earnings return on equity equals earnings or net income
over over I'm sorry net income over equity times one times one.
Well on second can I put that times one times one there because it's equal to net income over equity
times sales and sales times asset over assets and you manipulate those.
It's just math.
Okay.
And then what you can do is find out that growth is a function of those three formulas.
Okay.
And so therefore you know growth is equal to net profit margin which is net income or sales times the
asset turnover rate which is sales of our assets times the equity multiplier which is assets over equity
a lot of my.
But I only mention this because I can increase my sustainable growth rate using one of those three equations.
Right.
So let's increase our net income or our profit margin which is net income over sales.
So right now we see that our net income is growing 98 percent year over year.
How do you make that look better.
And this is important.
This is called leverage.
Okay.
So we can see that sales and marketing as a percentage of revenue in 2020 is 14 percent.
Right.
If we tweak that it 15 percent now it's 14 percent.
If we brought it from 15 percent down to 14 percent then you'll you'll see that our year over year growth
rates in earnings increases from 98 percent to 15 percent.
That's called leverage and it's a beautiful thing.
It's a beautiful thing.
Okay.
We cover a of that.
Okay.
And I know some of it might sound a bit confusing but it's going to get much easier because we're get
to a much easier example later with a publicly traded company.
I'm getting excited because soon our company is going public.
I'm excited.
OK.
So here's a quick class recap my 140 character or less is more summery.
Longer term forecasts are annual estimates percentage of sales is the most important part of modeling
expenses are really easy to tweak.
Spend most of your time forecasting revenue.
Everything else is a percent of revenue.
Thank you.