0:16

So a quick question.

Let's try to figure this out.

I have two questions here.

What is the growth rate of the policy?

And that gave you a hint, and actually we did it together [LAUGH].

Is that if I'm not reinvesting anything, the growth rate is 0.

If I'm reinvesting 70%, it has to be a function of that 70% and for

convenience, we're going to do it on an ongoing basis.

1:10

It's not possible, it's not possible.

You can grow very fast for a short period of time.

But after that you gotta slow down, and the main reason is competition.

I mean, that's why we have laws that if you're really good at what you do you

tend to become a monopolist but sometimes, in fact, I would say many times,

you become a monopolist by actually screwing the customer.

1:36

So I just want you to recognize that 7% growth is really, really difficult.

Now people see this and say, what will happen to price?

So suppose we are standing today, what was the price already?

50 bucks, no growth.

1:55

The generic answer to this is price will go

up because of this and the answer is wrong.

I don't know,

probably most of you are very young to know about cholesterol, right?

So turns out there is two types of cholesterol.

First, everybody thought cholesterol is bad.

No, there's a good cholesterol and there's a bad cholesterol.

3:10

To create this growth how much of this did you take?

70%.

You cannot, therefore, have dividend to of 6 bucks anymore, so you see the trade-off?

For growth to occur, you have to give up something.

Who's you?

You are the shareholder, right?

I mean.

So what is 30% of 6 bucks?

1.8.

And I'm not, this is not magic, right?

3:37

So 70%, so 1 minus b times 6, I believe is 1.8.

Right?

So what have you done?

You have, and this is true of any growth, you will be willing to give up

some dividend next year for some exciting things the firm is planning to do.

But what is the r of the firm?

3:57

Nothing to do with the firm.

We are in the same business, 0.12.

And what is the g?

0.07.

What's the answer to this?

You can do this in your head, and that's the easy part.

0.12 minus 0.07 is what?

0.05.

Dividing anything by 0.05 is what?

Multiplying it by 20.

4:33

The stock price has plummeted to 36.

I want to take this opportunity to explain two things.

The main thing I want to explain is growth in

the earnings is being generated by investing in what?

You should be able to guess.

Investing in ideas that are going to earn how much rate of return?

Look at the rate of return built into my formula, into my plan, 10%.

But what is the opportunity cost of capital?

In other words, what are other people in this business already earning and

capable of earning?

12%.

So what is true?

Remember, IRR conceptually is not a problem.

So, let's say IRR,

in this case it will work because the cash flows are well behaved.

There's no long term, short term.

It's one problem.

Everything is perpetuity.

So IRR should be greater than r.

What's true here?

My IRR is 10%.

My r is what?

12%.

So actually, I'm throwing money on negative NPP projects.

5:57

Many times, not by design,

you make mistakes, but many times perhaps by design.

And the reason is quite straightforward.

The firm is long lived.

The stock is long lived, but the management is short lived by definition.

There's a conflict.

Remember I said people use IRR?

6:26

And you say, oh, 10% is great and you try to go after it and

generate cash flows that grow, but

having cash flows grow in the short term is not necessarily value generation.

You want to grow cash flows, but

by investing in ideas that are really powerful.

6:45

That's the first lesson.

The second lesson is, how come today as soon as you announced this,

the price dropped by 14 bucks, which is what?

28%, 14 on 50 is a 28% stock price drop.

Do you see such changes in the stock market?

Sure.

They bounce all over the place.

But this example assumes what?

That people know what's going on, that those are the analysts, and

have the courage to kind of dig through the numbers and say, you know what?

If you do this plan, the price will drop $14.

Why? Because the plan is not value generating,

it's quite the opposite.

7:22

So the reason I'm bringing up this example is that we are focused actually

fundamentally, on the wrong thing that's growing.

Growth in your assets is what it's all about.

That's how value is generated, not by growing just your cash flows.

Okay?

So let me continue now and give you one more example, and

then you'll understand what's going on.

7:53

There's a Macrosoft that suddenly emerges with the different alternative

growth policy.

Obviously in the real world, the two things can't happen simultaneously.

But I'm giving you a sense of what are the two directions growth policy could take.

So what's scenario number two?

Scenario number two does two things.

It says we are going to grow, but we are going to plow back 50%.

Okay.

What was the plow back rate in the first?

70%.

And I have my ideas are going to earn 14%.

So the first question is, what is the growth rate of this policy?

8:34

And if you bear with me, and as I said, regardless of whether I take a break or

not, you've got to understand this.

So take a break if you want to, but the growth rate is not tough to do.

8:50

G, we know, requires some reinvestment.

And that's already a fraction.

And then some ROI.

Look, I've been a little naughty.

What's the growth rate?

0.50 times 14%.

The growth rate is what?

7%.

You see why I have been naughty?

There's no difference in the growth rates of the two examples.

And that's what we are fixated on.

9:22

Okay.

That's what we are fixated on.

Everybody is fixated on growth rate of cash flows.

Now tell me, in this case is it good news or bad news?

And you should tell me what will happen to the share price, directionally and why.

You just have to think very simple.

What is your rate of return on this new ideas?

14%.

What is the competition earning?

12%.

What's going to happen to the stock price as soon as you make this announcement, and

people actually believe you can deliver?

10:00

Stock price will go up, why?

Because in this scenario with our problems of IRR, r compares enough reasonable.

14%, where it's greater than 12%.

Let's do the actual price, okay?

So, I'm going to go on to the next page on this right next slide and

just give you a sense, finally, of what's going on.

Okay.

So my dividend 1 is now what?

50% of $6 in the first period.

Why?

Because I am plowing back only 50%.

So how much am I left with?

50% which is $3.

What is my growth?

7%.

What is my little r?

12%.

Remember little r, you can't touch.

You can't touch this, that's another MC Hammer thing.

11:05

You should touch your financing to figure out the value of your project and

you cannot touch r.

R belongs to the world.

[LAUGH] It's not yours.

Okay, so anyway, so what is the p naught now?

Div 1 over r minus g, which is equal

to $3 over good old 0.07,

which is also equal to $60.

11:33

So what has happened to stock price?

It's gone up from how much to how much?

Before this announcement it was 50, now it's 60.

A 20%, 10, sorry, 10 over 50, yeah that's right.

A 20% increase in stock price which is phenomenal.

What does that 20% reflect?

A continued strategy of picking great projects.

Right, that's what's built in for simplicity in this model.

Can you have a growth strategy that lasts for a little bit?

Yes, that's the real world.

But this is simply to show you that this is good growth.

Why?

Because it's actually generating value.

Remember the value is in the stock price, not in the cash flow.

12:49

Why is that?

I think it's a function of simply the fact that our horizons are too short.

And people call this myopia, people call this selfishness, whatever.

I think it's simple fact that we have an agency problem.

And anybody I talk to agrees that it's very tough to measure but

it's all over the place.

What does that mean?

That we manage wealth creation for

our shareholders who are all over the world now, and

many are not even participating, cannot even participate, and we, the managers.

And that's why I love teaching at a business school is because we are,

things are changing and people are becoming aware of this.

That we, without even knowing it leave alone cheating,

have a much shorter horizon.

And we try to worry about the short run.

And what policies will you prefer if your salary is based on the short run?

I'm not saying you should, many people do.

So if you're ethical, you look for the long run.

And I'm sorry I'm use that word, but yeah, good people care about the long run.

And the reason is, not because they are good people,

because they recognize they're working for an entity that's longer than that.

However, the pressures are growth, growth, growth, and flow wrong.

14:15

Could be good or bad.

I just told you, and it's very simple to figure out how good or bad.

But in reality it can be difficult, because firms do tend to be,

in spite of all our assumptions, kind of black boxes.

14:30

And it's tough to get all this information.

And many times you make bad decisions and grow bad.

I'm more worried about the systematic growth focus on cashflows.

Now this in the real world, is this only corporations?

14:48

That's the part which I'm not sure about, and I disagree with in the public debate,

is that yes, corporations grow, have a focus, but look at our government.

Look at the whole nation.

What do you read in the press everyday?

Growth and what?

15:24

So you can have a binge by putting a straw inside the Earth, right?

And grow really fast.

But then you come to a point, where there is nowhere to go.

So that's the point is that don't be so focused on the flow.

Sorry I'm, because the value creation is not easy.

And on top of it, if there is perverse incentives or

whatever to grow the flow you can make really bad decisions.