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ANDREW LO: So what I want to do
in this lecture is to provide

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a quick overview of
the equity business,

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and then talk about a couple
of simple but rather powerful

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models to price equities-- we're
using the exact same tools that

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we've developed--

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and then talk a bit about
growth opportunities and growth

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stocks.

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OK, so industry overview.

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What is equity?

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As I said, it's an
ownership in a corporation.

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And typically, when you own
a piece of a corporation,

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you're owning that
sequence of cash flows.

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There are two components
of possible cash flows

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for a piece of equity security.

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One is dividends.

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But, of course, we know
that there are companies

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that don't pay dividends.

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Typically, companies that are
early stage growth companies,

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they want to conserve
their cash, because they've

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got lots and lots
of investment ideas

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that they want to implement.

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And so any cash that's
generated internally,

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they're going to be plowing
back into current operations.

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So growth companies typically
don't pay dividends.

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But you still get value
from the security,

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because as the firm grows,
as the corporation becomes

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more valuable, that piece
of paper that you hold

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becomes more valuable.

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00:01:39,740 --> 00:01:42,020
So in other words,
you get capital gains

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or price appreciation
of that piece of paper.

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And if you want to get value
out of that price appreciation,

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00:01:48,530 --> 00:01:51,660
you could always sell it, right?

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00:01:51,660 --> 00:01:55,980
So those are the two
ways of getting value.

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00:01:55,980 --> 00:01:58,170
It's dividends-- and
by the way, there

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are two different
forms of dividends.

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Cash dividends or
stock dividends,

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00:02:03,120 --> 00:02:07,200
both of which provide
additional value.

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00:02:07,200 --> 00:02:09,389
But also the fact is
that you could sell it,

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00:02:09,389 --> 00:02:12,330
and so you can get money
from capital gains.

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Now there are a couple of key
characteristics of common stock

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that are distinct from bonds.

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The cash flows we will
be able to analyze

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00:02:20,550 --> 00:02:23,970
using the same tools, but
those tools will ultimately

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give us different answers,
because the legal structure

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for equities is
different than for bonds.

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00:02:32,660 --> 00:02:36,380
And I have to say, that
whoever invented equities--

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this is many, many
centuries ago--

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really was a brilliant
financial innovator,

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because equities have just an
enormously powerful ability

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to provide proper motivation
and incentives for innovation,

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all sorts of innovation.

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And let me explain
what that means.

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First of all, one
aspect of equities

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that I think you
all probably know

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is that they are the residual
claimant to a corporation's

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assets after the bondholders.

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In other words,
bondholders have first dibs

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on the assets of the company,
but their claim on those assets

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is only equal to the face
value or promised payments

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of that debt, right?

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They don't have access
to any more than what

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the face value of that
bond is, as well as

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the coupons along the way.

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And to say that equity holders
are the residual claimant

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means that they get
everything else.

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00:03:39,790 --> 00:03:41,500
Now you might say,
gee, that's not really

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all that interesting, because
you're second in line.

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Well, it's very interesting
if being second in line

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means that you get access to
all of the upside of a company's

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growth and success.

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I'm sure that you've all heard
of stories of entrepreneurs

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that have made many hundreds
of times what they put

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into a company, whereas the
bondholders may have gotten

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a handsome return
of 10, 15, 20%,

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but that's the upper bound
as to what they can get.

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As a bondholder, your upside
is capped, it's limited, OK?

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Whereas, as the residual
claimant, as the equity holder,

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you have no limit on
your upside, right?

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Because once the bondholders get
paid, you get everything else.

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00:04:34,170 --> 00:04:38,210
Now the other aspect of
equity that's really important

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is something called
limited liability--

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00:04:41,060 --> 00:04:47,390
the fact that, as an equity
holder, the most you can lose

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is everything.

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Now that might not seem like
a good deal, but trust me,

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00:04:53,000 --> 00:04:55,490
it's an amazing deal.

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By everything, we mean
everything that you put in,

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00:05:01,170 --> 00:05:03,840
so it's not
literally everything.

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For example, you
don't lose your life.

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00:05:07,290 --> 00:05:08,880
You don't lose your freedom.

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00:05:08,880 --> 00:05:10,650
You don't lose your pinkie.

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You don't lose any other
body parts, or loved ones.

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All you are at risk of losing is
what you put in to the venture.

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So that's what limited
liability means.

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And the reason that
it's an innovation

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is, prior to the
modern-day corporation

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and limited liability,
it used to be

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the case that entrepreneurs
faced unlimited liability,

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00:05:36,360 --> 00:05:39,360
or you could be put
in prison if you were

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00:05:39,360 --> 00:05:42,480
to default on your obligations.

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00:05:42,480 --> 00:05:46,740
The fact that there is a
downside limit to what you

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00:05:46,740 --> 00:05:51,810
could possibly lose is a
tremendous boon to innovation,

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00:05:51,810 --> 00:05:56,490
because now it means that
each and every one of you

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00:05:56,490 --> 00:06:01,230
can go out and start
your own company

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00:06:01,230 --> 00:06:05,820
and risk whatever money you
want to put into the company,

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00:06:05,820 --> 00:06:07,610
but no more.

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00:06:07,610 --> 00:06:10,570
And if it doesn't
work out, well, you

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00:06:10,570 --> 00:06:14,150
can walk away and do it again.

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00:06:14,150 --> 00:06:17,390
And I suspect many
of you know of

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so-called serial entrepreneurs
that just go from one company

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to another to another.

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Many years ago, when I
was at the Wharton School,

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I heard a talk by the person
who started up Domino's Pizza.

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I unfortunately don't
remember his name,

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00:06:32,810 --> 00:06:35,570
but he was giving a talk
in one of these CEO series

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00:06:35,570 --> 00:06:42,410
and he's a billionaire, because
of the incredible growth

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00:06:42,410 --> 00:06:45,590
of Domino's Pizza
in the country.

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And somebody asked
this fellow, how

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did you know that having
a national pizza chain

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00:06:51,260 --> 00:06:54,070
was going to succeed
as well as it did?

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And he's very honest.

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He said, you know,
I didn't know.

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You know, this was
my ninth company.

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00:07:03,130 --> 00:07:05,524
The first eight went bankrupt.

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00:07:05,524 --> 00:07:06,940
And if this one
had gone bankrupt,

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I probably would've
started a tenth.

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And I think that's just
a wonderful expression

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of the power of
modern capitalism

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and limited liability, because
here's an individual that just

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really wanted to do
something on his own

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and wanted to make
a success of it,

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and was willing to
work his heart out time

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after time after time
until he hit upon something

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that was really valuable.

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And that's the power
of limited liability.

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Think what innovation
would be if we decided

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that if your first company
fails, from that point on,

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00:07:41,420 --> 00:07:44,140
you would never be allowed to
start a company ever again.

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00:07:44,140 --> 00:07:45,890
Think how many people
would take the risk

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00:07:45,890 --> 00:07:48,670
or take the plunge to do
something like starting up

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your own company.

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So the fact that we
have a security that

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limits your downside,
and that limits

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the downside of
other investors that

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want to join you in
your venture, really

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allows for capital
formation to occur at a rate

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00:08:04,960 --> 00:08:09,470
and at a scale that would
be impossible without it.

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Now there's also voting
rights and the ability

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to access public markets.

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What that means is
that you can actually

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get other people, large
numbers of people,

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to co-invest with you.

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So that's particularly
important when

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you're thinking about taking on
very, very ambitious projects.

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00:08:29,370 --> 00:08:33,890
For example, if you want to
start up a biotech company.

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Biotech companies require more
than a few hundred thousand

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dollars to get started.

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00:08:38,929 --> 00:08:41,059
I think a few hundred
thousand dollars would maybe

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00:08:41,059 --> 00:08:44,570
buy you a quarter of a
centrifuge these days.

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Doesn't really help for
starting up a biotech company.

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And so if we didn't
have the ability

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to access public markets, if
we didn't have the ability

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to bring the power
of the public to bear

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00:08:55,790 --> 00:08:58,490
on a particular
investment opportunity,

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it wouldn't get done.

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So that combination of
limited liability and ability

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00:09:05,460 --> 00:09:08,400
to access public markets,
and then voting rights

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that give investors some say
in how the company is run,

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00:09:12,990 --> 00:09:15,060
is really the
secret to unlocking

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the power of the masses for
development of innovation

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00:09:21,210 --> 00:09:23,112
and capital formation.

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Now there's another point
that I wanted to make here,

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which is short sales.

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00:09:26,520 --> 00:09:29,160
I think that by
now you should have

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00:09:29,160 --> 00:09:31,950
an appreciation for the
importance of short sales.

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Short sales allow information to
get into the market price that

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00:09:37,470 --> 00:09:40,500
may not be positive
news, but is nevertheless

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00:09:40,500 --> 00:09:42,850
important for people to have.

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00:09:42,850 --> 00:09:45,690
And so the ability to
short sell a security

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00:09:45,690 --> 00:09:48,840
is a method for
allowing investors

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00:09:48,840 --> 00:09:51,330
to get information
into the market price

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00:09:51,330 --> 00:09:54,780
as quickly and as
easily as possible.

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Those of you who participated
in the trading game

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00:09:57,150 --> 00:10:00,420
that we did a couple of
weeks ago on that Friday--

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00:10:00,420 --> 00:10:03,150
you know, when we go over
the results towards the end

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00:10:03,150 --> 00:10:05,820
of this course, when we talk
about efficient markets,

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00:10:05,820 --> 00:10:08,250
I'm going to show you
that the prices that

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00:10:08,250 --> 00:10:11,700
occurred in that marketplace
was not very efficient.

195
00:10:11,700 --> 00:10:13,700
Part of the reason that
it wasn't very efficient

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00:10:13,700 --> 00:10:15,980
is because we didn't
allow you to short sell.

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00:10:15,980 --> 00:10:20,210
And so those of you who had the
information that at one point

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00:10:20,210 --> 00:10:24,220
the stock was worthless,
the most you could have done

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00:10:24,220 --> 00:10:27,910
was to divest yourself of
shares that you already owned.

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00:10:27,910 --> 00:10:30,580
But once you did that,
that was the end,

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00:10:30,580 --> 00:10:31,990
and you're out of the market.

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00:10:31,990 --> 00:10:33,910
You couldn't do anything more.

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00:10:33,910 --> 00:10:37,210
If, on the other hand, we
allowed you to short sell,

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00:10:37,210 --> 00:10:39,700
you would have driven that
price down to 0, where

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00:10:39,700 --> 00:10:42,480
it belonged at that point.

206
00:10:42,480 --> 00:10:46,560
And so the ability to short
sell is a very, very important

207
00:10:46,560 --> 00:10:49,140
aspect of capital
market efficiency

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00:10:49,140 --> 00:10:53,970
and for making prices as
informative as you can.

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00:10:53,970 --> 00:10:57,540
Now there are two markets
for equities-- primary market

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00:10:57,540 --> 00:10:58,830
and secondary market.

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00:10:58,830 --> 00:11:03,360
Primary market means the
market where securities are

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00:11:03,360 --> 00:11:05,650
issued for the very first time.

213
00:11:05,650 --> 00:11:07,890
Primary, that's
what primary means.

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00:11:07,890 --> 00:11:12,870
Secondary you could think of as
the market for used securities.

215
00:11:12,870 --> 00:11:14,850
We have a market for used cars.

216
00:11:14,850 --> 00:11:16,770
You have a market
for used homes.

217
00:11:16,770 --> 00:11:18,640
And there's a market
for used securities.

218
00:11:18,640 --> 00:11:21,139
I know you don't really think
of the New York Stock Exchange

219
00:11:21,139 --> 00:11:23,370
as such, but, in fact, it is.

220
00:11:23,370 --> 00:11:26,490
It just turns out that
used securities are just

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00:11:26,490 --> 00:11:31,780
as good as new securities,
and in many ways, better.

222
00:11:31,780 --> 00:11:36,340
And so the steps for getting
a primary security issued

223
00:11:36,340 --> 00:11:39,070
is very different than
the steps for dealing

224
00:11:39,070 --> 00:11:40,972
with secondary markets.

225
00:11:40,972 --> 00:11:42,430
For the most part,
what we're going

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00:11:42,430 --> 00:11:43,870
to be talking about
in this course

227
00:11:43,870 --> 00:11:48,790
is secondary market
transactions and dynamics.

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00:11:48,790 --> 00:11:51,340
However, there is
obviously a lot more

229
00:11:51,340 --> 00:11:52,990
to be said about
primary markets.

230
00:11:52,990 --> 00:11:57,130
I'm going to leave that to other
courses in the Finance group,

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00:11:57,130 --> 00:12:03,490
including M&A and capital
budgeting and venture capital.

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00:12:03,490 --> 00:12:06,910
Those are courses that
deal with the dynamics

233
00:12:06,910 --> 00:12:08,450
of the primary market.

234
00:12:08,450 --> 00:12:11,440
These are the markets
that you would care about

235
00:12:11,440 --> 00:12:14,560
if you're doing an IPO,
launching a new company,

236
00:12:14,560 --> 00:12:17,796
and issuing securities
for the very first time.

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00:12:17,796 --> 00:12:19,420
So I won't spend too
much time on that.

238
00:12:19,420 --> 00:12:21,253
If you're interested,
you're welcome to read

239
00:12:21,253 --> 00:12:24,107
the relevant chapters
in the textbook.

240
00:12:24,107 --> 00:12:25,690
But what we're going
to do is to focus

241
00:12:25,690 --> 00:12:28,320
on the behavior of
secondary markets,

242
00:12:28,320 --> 00:12:30,250
in particular, in
the price formation

243
00:12:30,250 --> 00:12:35,080
mechanism for secondary
market securities.

244
00:12:35,080 --> 00:12:38,110
Here's a little bit
of a summary about how

245
00:12:38,110 --> 00:12:39,850
these markets have developed.

246
00:12:39,850 --> 00:12:42,850
You can see that
for primary markets,

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00:12:42,850 --> 00:12:45,520
the IPO market goes
through cycles.

248
00:12:45,520 --> 00:12:48,970
There are periods where the
market's very, very active,

249
00:12:48,970 --> 00:12:52,060
and there are periods where
the market is pretty quiet

250
00:12:52,060 --> 00:12:55,360
and not a lot is going on.

251
00:12:55,360 --> 00:12:58,990
That has to do a lot
with the business cycle

252
00:12:58,990 --> 00:13:02,217
and with the credit cycle-- how
much money there is out there.

253
00:13:02,217 --> 00:13:04,300
And it's obviously very
important for those of you

254
00:13:04,300 --> 00:13:05,883
who are thinking
about doing startups,

255
00:13:05,883 --> 00:13:08,410
because when you do a
startup and you get funding

256
00:13:08,410 --> 00:13:10,870
from a venture capitalist,
the way the venture

257
00:13:10,870 --> 00:13:13,810
capitalist ultimately
gets paid is not

258
00:13:13,810 --> 00:13:17,320
by the satisfaction of being
part of your wonderful company,

259
00:13:17,320 --> 00:13:20,410
but rather by having
your company go public

260
00:13:20,410 --> 00:13:24,010
and having securities be
issued so that the venture

261
00:13:24,010 --> 00:13:28,400
capitalist can cash out at
those public market prices.

262
00:13:28,400 --> 00:13:33,850
So the venture capital
and technology industries

263
00:13:33,850 --> 00:13:37,930
are very much caught up in the
business cycle and credit cycle

264
00:13:37,930 --> 00:13:39,760
as well, and so this
gives you a little bit

265
00:13:39,760 --> 00:13:43,490
of a picture of how
that's changed over time.

266
00:13:43,490 --> 00:13:46,180
On the other hand,
the secondary market

267
00:13:46,180 --> 00:13:47,950
has a somewhat different
set of dynamics.

268
00:13:47,950 --> 00:13:51,460
It's related, but not
nearly as highly correlated

269
00:13:51,460 --> 00:13:53,710
as you might expect.

270
00:13:53,710 --> 00:13:57,190
This is an example
of the dynamics

271
00:13:57,190 --> 00:14:02,500
of public secondary
markets, the NYSE and NASDAQ

272
00:14:02,500 --> 00:14:05,380
over the last few years.

273
00:14:05,380 --> 00:14:08,860
What this displays is
the trading volume,

274
00:14:08,860 --> 00:14:12,820
both measured in terms
of shares as well as

275
00:14:12,820 --> 00:14:17,510
in composite fraction
on the NYSE volume.

276
00:14:17,510 --> 00:14:20,320
And you can see that
over time that the share

277
00:14:20,320 --> 00:14:23,260
volume, the amount
of shares traded,

278
00:14:23,260 --> 00:14:27,516
has just gone up year
on year, and this year

279
00:14:27,516 --> 00:14:28,390
will be no different.

280
00:14:28,390 --> 00:14:31,720
2008 will be a tremendously
significant year

281
00:14:31,720 --> 00:14:34,780
for the amount of shares
traded on the exchange.

282
00:14:34,780 --> 00:14:39,220
Lots more participation in
public markets, and the volume,

283
00:14:39,220 --> 00:14:41,710
while there may be little bits
of a dip that are functions

284
00:14:41,710 --> 00:14:45,100
of business cycles,
not nearly as sensitive

285
00:14:45,100 --> 00:14:46,565
as the primary market is.

286
00:14:46,565 --> 00:14:47,065
Yeah.

287
00:14:47,065 --> 00:14:49,927
AUDIENCE: Is the internet
also, you know, more volume?

288
00:14:49,927 --> 00:14:51,010
ANDREW LO: Oh, absolutely.

289
00:14:51,010 --> 00:14:53,500
Well, there are a number of
technological innovations

290
00:14:53,500 --> 00:14:57,400
that have made this market
increase so quickly.

291
00:14:57,400 --> 00:14:58,570
So the internet is one.

292
00:14:58,570 --> 00:15:00,350
Now all of us can
trade on the internet.

293
00:15:00,350 --> 00:15:04,195
In fact, when I was teaching
Finance back in, let's see,

294
00:15:04,195 --> 00:15:07,900
was it 2000 or 2001?

295
00:15:07,900 --> 00:15:10,990
I remember during
the middle of the day

296
00:15:10,990 --> 00:15:15,670
one of the undergraduates
in the class

297
00:15:15,670 --> 00:15:19,900
looked at some kind of cell
phone device and then ran out.

298
00:15:19,900 --> 00:15:23,512
And he came back in shortly
before the end of class,

299
00:15:23,512 --> 00:15:24,970
and at the end of
class I asked him

300
00:15:24,970 --> 00:15:26,595
if everything was
all right, because he

301
00:15:26,595 --> 00:15:27,720
seemed really distressed.

302
00:15:27,720 --> 00:15:29,094
And then he said
that he just had

303
00:15:29,094 --> 00:15:32,260
to respond to a margin
call on his equity position

304
00:15:32,260 --> 00:15:34,240
that he'd put on the day before.

305
00:15:34,240 --> 00:15:35,810
This is an undergraduate.

306
00:15:35,810 --> 00:15:40,180
He's trading on his
little cell phone.

307
00:15:40,180 --> 00:15:41,740
That's a technological
innovation

308
00:15:41,740 --> 00:15:46,300
that has actually increased
the volume in these exchanges.

309
00:15:46,300 --> 00:15:48,280
But there are other
technological innovations

310
00:15:48,280 --> 00:15:49,100
as well.

311
00:15:49,100 --> 00:15:53,260
For example, something called
ECNs, electronic communications

312
00:15:53,260 --> 00:15:54,340
networks.

313
00:15:54,340 --> 00:15:57,940
These are-- essentially, they
started out as bulletin boards,

314
00:15:57,940 --> 00:16:00,430
where large buyers and
sellers of equities

315
00:16:00,430 --> 00:16:03,160
could come together
anonymously and transact

316
00:16:03,160 --> 00:16:07,240
with each other at relatively
inexpensive prices.

317
00:16:07,240 --> 00:16:10,510
They can cut out the middleman
and reduce the bid offer spread

318
00:16:10,510 --> 00:16:14,690
by hitting a transaction price
that was right in the middle.

319
00:16:14,690 --> 00:16:19,540
ECNs have grown tremendously
since the early, the mid 90s,

320
00:16:19,540 --> 00:16:21,790
when they started,
and now account

321
00:16:21,790 --> 00:16:23,790
for a pretty significant
fraction of the volume.

322
00:16:23,790 --> 00:16:27,280
Electronic order routing,
electronic trading,

323
00:16:27,280 --> 00:16:31,660
all of these technologies have
caused this kind of increase

324
00:16:31,660 --> 00:16:34,880
in the equity market trading
over the last several years.

325
00:16:34,880 --> 00:16:37,910
So today, as an
individual investor,

326
00:16:37,910 --> 00:16:39,760
you can trade much more quickly.

327
00:16:39,760 --> 00:16:41,910
You can trade much more cheaply.

328
00:16:41,910 --> 00:16:44,990
And you can trade much more
easily than ever before.

329
00:16:44,990 --> 00:16:47,440
So consumers have
benefited a great deal.

330
00:16:47,440 --> 00:16:52,750
Along the way, a number of
hedge funds and other investors

331
00:16:52,750 --> 00:16:55,630
have ended up going out of
business because they have not

332
00:16:55,630 --> 00:16:58,090
been able to compete
effectively with these kind

333
00:16:58,090 --> 00:16:59,365
of technological innovations.

334
00:16:59,365 --> 00:17:02,590
And this is what I mentioned
last time, that technology

335
00:17:02,590 --> 00:17:06,400
plays a very important role
in financial markets now,

336
00:17:06,400 --> 00:17:08,770
much more so than ever before.

337
00:17:08,770 --> 00:17:11,650
It used to be that it
mattered who you knew,

338
00:17:11,650 --> 00:17:13,220
rather than what you knew.

339
00:17:13,220 --> 00:17:15,790
That it was the old boys
network that mattered,

340
00:17:15,790 --> 00:17:17,609
instead of the computer network.

341
00:17:17,609 --> 00:17:19,359
And that the graduates
of Harvard and Yale

342
00:17:19,359 --> 00:17:23,752
had an advantage over the
graduates of MIT and Caltech.

343
00:17:23,752 --> 00:17:25,210
That's been flipped
on its head now

344
00:17:25,210 --> 00:17:26,376
over the last several years.

345
00:17:26,376 --> 00:17:31,270
It's what I call the revenge
of the nerds, which bodes well

346
00:17:31,270 --> 00:17:32,306
for all of you.

347
00:17:32,306 --> 00:17:33,060
[LAUGHTER]

348
00:17:33,060 --> 00:17:41,930
OK, so let me now turn to
the very first valuation

349
00:17:41,930 --> 00:17:46,010
model that was ever
developed for equities.

350
00:17:46,010 --> 00:17:47,390
It couldn't be simpler.

351
00:17:47,390 --> 00:17:49,190
It's a model that
I think all of you

352
00:17:49,190 --> 00:17:52,070
are going to
immediately understand,

353
00:17:52,070 --> 00:17:53,750
and yet the
implications are going

354
00:17:53,750 --> 00:17:57,380
to be really far-reaching
and profound.

355
00:17:57,380 --> 00:18:00,530
This is called the
Dividend Discount Model,

356
00:18:00,530 --> 00:18:03,320
and it starts with
the recognition

357
00:18:03,320 --> 00:18:06,320
that, when you invest in a
company, what you're getting

358
00:18:06,320 --> 00:18:09,230
for that piece of paper,
this common equity,

359
00:18:09,230 --> 00:18:14,120
you're getting the rights
to the flow of cash forever.

360
00:18:14,120 --> 00:18:16,050
And what kind of cash
are we talking about?

361
00:18:16,050 --> 00:18:18,250
Well, we're talking
about dividends.

362
00:18:18,250 --> 00:18:21,890
So it's true that not
all stocks pay dividends,

363
00:18:21,890 --> 00:18:26,000
but eventually you would figure
the stock will pay dividend

364
00:18:26,000 --> 00:18:27,500
at some point, right?

365
00:18:27,500 --> 00:18:31,010
For years, Microsoft
never paid a dividend.

366
00:18:31,010 --> 00:18:34,670
But about, was it five
years ago or six years ago?

367
00:18:34,670 --> 00:18:37,670
They announced that they're
starting to pay dividends.

368
00:18:37,670 --> 00:18:38,480
Why?

369
00:18:38,480 --> 00:18:41,180
Because they had
accumulated so much cash

370
00:18:41,180 --> 00:18:45,500
that they didn't have enough
things to invest that cash in,

371
00:18:45,500 --> 00:18:49,370
so they figured, let's give some
of it back to the investors.

372
00:18:49,370 --> 00:18:52,880
In their early days, they kept
every penny of their earnings

373
00:18:52,880 --> 00:18:55,700
to reinvest, because they had
so many different opportunities

374
00:18:55,700 --> 00:18:56,780
to take advantage of.

375
00:18:56,780 --> 00:18:59,660
But because they
became so mature

376
00:18:59,660 --> 00:19:02,035
and they had already a
number of investment projects

377
00:19:02,035 --> 00:19:03,410
that were quite
valuable, and yet

378
00:19:03,410 --> 00:19:05,332
were still generating
so much cash,

379
00:19:05,332 --> 00:19:07,290
they decided to return
some of it to investors.

380
00:19:07,290 --> 00:19:09,890
So at some point, you're
going to get dividends.

381
00:19:09,890 --> 00:19:13,200
And if a company never,
ever pays dividends,

382
00:19:13,200 --> 00:19:14,900
well, then, it should
be worth 0, right?

383
00:19:14,900 --> 00:19:17,210
If it pays you no cash
forever, then that

384
00:19:17,210 --> 00:19:18,680
seems like a very bad asset.

385
00:19:18,680 --> 00:19:19,190
Yeah.

386
00:19:19,190 --> 00:19:22,064
AUDIENCE: What stops the
board of directors [INAUDIBLE]

387
00:19:22,064 --> 00:19:26,189
really depends on [INAUDIBLE]
issuing dividends [INAUDIBLE]..

388
00:19:26,189 --> 00:19:28,480
ANDREW LO: Well, first of
all, if they issued dividends

389
00:19:28,480 --> 00:19:30,160
to pay themselves,
that's fine, as long

390
00:19:30,160 --> 00:19:33,080
as they pay all the other
shareholders at the same time.

391
00:19:33,080 --> 00:19:37,630
So the answer is, in
principle, nothing stops them,

392
00:19:37,630 --> 00:19:40,930
but what makes them
decide against that

393
00:19:40,930 --> 00:19:43,600
is if they have uses
for the cash other

394
00:19:43,600 --> 00:19:45,310
than paying themselves.

395
00:19:45,310 --> 00:19:48,460
If, as a company, you have no
idea what to do with the money

396
00:19:48,460 --> 00:19:50,530
you are generating,
well, first of all,

397
00:19:50,530 --> 00:19:52,180
that suggests that
maybe you're not

398
00:19:52,180 --> 00:19:54,220
doing your job,
because as a company,

399
00:19:54,220 --> 00:19:56,770
you're supposed to be coming up
with valuable ways of earning

400
00:19:56,770 --> 00:19:58,190
money for your investors.

401
00:19:58,190 --> 00:20:01,550
However, it may be that your
company is very mature, stable,

402
00:20:01,550 --> 00:20:03,469
there's no growth,
there's nothing going on,

403
00:20:03,469 --> 00:20:05,260
and all the cash that
you're generating you

404
00:20:05,260 --> 00:20:06,490
don't know what to do with.

405
00:20:06,490 --> 00:20:08,830
In that case, you may very
well return all of that money

406
00:20:08,830 --> 00:20:09,371
to investors.

407
00:20:09,371 --> 00:20:11,650
That's nothing wrong with that.

408
00:20:11,650 --> 00:20:13,950
The idea behind
having a vote though,

409
00:20:13,950 --> 00:20:16,560
is that you want to make sure
that the board of directors,

410
00:20:16,560 --> 00:20:19,770
who typically do own or are
responsible to shareholders

411
00:20:19,770 --> 00:20:23,470
that own large blocks of shares,
will be deciding in the best

412
00:20:23,470 --> 00:20:24,720
interests of the shareholders.

413
00:20:24,720 --> 00:20:27,090
And it could be that the best
interest of the shareholders

414
00:20:27,090 --> 00:20:28,500
is to give them
back their money,

415
00:20:28,500 --> 00:20:31,500
because we, the mature
company that we are,

416
00:20:31,500 --> 00:20:33,722
don't have any other
uses for the money.

417
00:20:33,722 --> 00:20:34,571
Yeah.

418
00:20:34,571 --> 00:20:36,570
AUDIENCE: [INAUDIBLE]
that, if the company never

419
00:20:36,570 --> 00:20:39,622
pays dividends, [INAUDIBLE].

420
00:20:39,622 --> 00:20:42,574
What about the [INAUDIBLE]?

421
00:20:42,574 --> 00:20:44,341
Is there no value [INAUDIBLE]?

422
00:20:44,341 --> 00:20:45,840
ANDREW LO: Well,
but think about it.

423
00:20:45,840 --> 00:20:48,700
If a company keeps on
appreciating in value,

424
00:20:48,700 --> 00:20:52,180
but never pays out a dividend,
what's happening to the cash?

425
00:20:52,180 --> 00:20:55,750
You know, when I say
never, I mean never.

426
00:20:55,750 --> 00:20:58,180
So I don't just mean like
in 10 years or in 20 years.

427
00:20:58,180 --> 00:20:59,440
I mean never.

428
00:20:59,440 --> 00:21:01,510
So can you think
of a company that

429
00:21:01,510 --> 00:21:03,970
appreciates in
value all the time,

430
00:21:03,970 --> 00:21:05,890
but never, ever,
ever pays a dividend?

431
00:21:05,890 --> 00:21:08,690
There's no cash, so
you'll never get any cash.

432
00:21:08,690 --> 00:21:09,190
That's--

433
00:21:09,190 --> 00:21:10,814
AUDIENCE: Well, then,
wouldn't you make a profit

434
00:21:10,814 --> 00:21:11,772
by selling [INAUDIBLE]?

435
00:21:11,772 --> 00:21:14,990
ANDREW LO: Oh, yes, you could
make a profit by selling,

436
00:21:14,990 --> 00:21:18,070
but if you sell a
security to somebody

437
00:21:18,070 --> 00:21:22,370
else and they know for a
fact that it never, ever,

438
00:21:22,370 --> 00:21:26,240
ever, ever pays any
money, well, then,

439
00:21:26,240 --> 00:21:28,902
that's called a
Ponzi scheme, right?

440
00:21:28,902 --> 00:21:30,860
In other words, you're
selling a piece of paper

441
00:21:30,860 --> 00:21:32,870
that's worthless to
somebody and hoping

442
00:21:32,870 --> 00:21:36,350
that they are a bigger fool than
you are for having bought it.

443
00:21:36,350 --> 00:21:39,620
So when I say it never pays
any cash, I really mean it.

444
00:21:39,620 --> 00:21:43,010
If it never-- if you know
for sure that it never, ever

445
00:21:43,010 --> 00:21:49,220
pays any cash, then it can't
be worth anything, right?

446
00:21:49,220 --> 00:21:51,874
If you don't believe that,
then I have a piece of paper

447
00:21:51,874 --> 00:21:53,540
that I would like you
to take a look at,

448
00:21:53,540 --> 00:21:56,320
and I would like
to sell you, OK?

449
00:21:56,320 --> 00:21:56,820
Yeah.

450
00:21:56,820 --> 00:21:59,214
AUDIENCE: Could it be like
coupons and, like, the company

451
00:21:59,214 --> 00:21:59,714
dissolves?

452
00:21:59,714 --> 00:22:00,560
ANDREW LO: What's that?

453
00:22:00,560 --> 00:22:01,400
AUDIENCE: Even if it
never pays dividends,

454
00:22:01,400 --> 00:22:02,620
you could still
get something back

455
00:22:02,620 --> 00:22:04,270
if the company
dissolves [INAUDIBLE]..

456
00:22:04,270 --> 00:22:05,600
ANDREW LO: Well, then
it does pay something.

457
00:22:05,600 --> 00:22:07,010
That's a liquidating dividend.

458
00:22:07,010 --> 00:22:09,230
Then that violates my
condition that it never, ever,

459
00:22:09,230 --> 00:22:11,720
ever pays anything, right?

460
00:22:11,720 --> 00:22:12,680
And that's the point.

461
00:22:12,680 --> 00:22:16,880
If the company is
growing and it has value,

462
00:22:16,880 --> 00:22:19,670
then you know for a
fact that either A,

463
00:22:19,670 --> 00:22:22,550
it will pay you a dividend
at some point, or B,

464
00:22:22,550 --> 00:22:24,200
if it doesn't and
it gets liquidated,

465
00:22:24,200 --> 00:22:25,700
then when it gets
liquidated, you'll

466
00:22:25,700 --> 00:22:27,440
get a pro rata
share of whatever's

467
00:22:27,440 --> 00:22:30,050
in the company, in which
case, that's a payment.

468
00:22:30,050 --> 00:22:34,160
So to say that a company
never, ever pays a dividend,

469
00:22:34,160 --> 00:22:38,750
I literally mean it will
never, ever pay anything, OK?

470
00:22:38,750 --> 00:22:41,020
And in that case, it
can't be worth anything

471
00:22:41,020 --> 00:22:42,480
if you know that.

472
00:22:42,480 --> 00:22:45,920
But if you can find somebody
who will buy it anyway,

473
00:22:45,920 --> 00:22:48,190
then that's an example
of an arbitrage.

474
00:22:48,190 --> 00:22:49,280
That's a free lunch.

475
00:22:49,280 --> 00:22:54,860
And so you can do that a lot if
you can find people like that.

476
00:22:54,860 --> 00:22:58,760
OK, so we're going to apply
the very basic principles

477
00:22:58,760 --> 00:23:04,190
of present value analysis to a
security that pays dividends.

478
00:23:04,190 --> 00:23:08,300
So let's let the
price of a stock, Pt,

479
00:23:08,300 --> 00:23:11,570
today, be given by that.

480
00:23:11,570 --> 00:23:15,350
Let Dt be the cash dividend
that gets paid at time t.

481
00:23:15,350 --> 00:23:18,860
And by the way, Dt could
be 0 for many, many years

482
00:23:18,860 --> 00:23:22,020
and at some point become
positive, all right?

483
00:23:22,020 --> 00:23:23,900
Dt can never be negative, right?

484
00:23:23,900 --> 00:23:26,510
We're not talking about
taking money from investors.

485
00:23:26,510 --> 00:23:30,710
It pays either a
positive amount or 0.

486
00:23:30,710 --> 00:23:35,390
And I'm going to let E
sub t be the expectation

487
00:23:35,390 --> 00:23:36,770
operator at time t.

488
00:23:36,770 --> 00:23:39,530
So now I'm going to
explicitly recognize

489
00:23:39,530 --> 00:23:43,400
that these dividends are
not known in advance.

490
00:23:43,400 --> 00:23:47,750
Unlike bonds, where you
know the coupons in advance,

491
00:23:47,750 --> 00:23:49,700
I don't know the
dividends in advance.

492
00:23:49,700 --> 00:23:50,950
So I'm going to have to guess.

493
00:23:50,950 --> 00:23:53,390
I'm going to have to make a
forecast as to what they are.

494
00:23:53,390 --> 00:24:00,170
And let me let r sub t be the
so-called risk-adjusted return

495
00:24:00,170 --> 00:24:04,130
that is commensurate with the
risks of the dividends that

496
00:24:04,130 --> 00:24:05,060
are there.

497
00:24:05,060 --> 00:24:07,700
I'm going to wave my
hands at this point

498
00:24:07,700 --> 00:24:10,940
as to how we get the
dividend discount

499
00:24:10,940 --> 00:24:14,210
return, the appropriate
risk-adjusted return,

500
00:24:14,210 --> 00:24:18,770
but I'll come back to that in
a few lectures, when we go over

501
00:24:18,770 --> 00:24:22,250
methods for determining the
appropriate risk adjustment,

502
00:24:22,250 --> 00:24:22,790
OK?

503
00:24:22,790 --> 00:24:25,250
But for now, let's
assume that we have it,

504
00:24:25,250 --> 00:24:28,110
and we get it from the
marketplace, right?

505
00:24:28,110 --> 00:24:31,010
Just like we got the yield
from the marketplace,

506
00:24:31,010 --> 00:24:34,070
it's a sum total of
everybody's fears,

507
00:24:34,070 --> 00:24:37,230
expectations, hopes, and so on.

508
00:24:37,230 --> 00:24:41,780
So with these
components defined,

509
00:24:41,780 --> 00:24:46,430
I'm now going to simply write
the price of my instrument

510
00:24:46,430 --> 00:24:50,834
as this value function of
the future cash flows, right?

511
00:24:50,834 --> 00:24:52,250
That's the most
general expression

512
00:24:52,250 --> 00:24:55,160
we started with on day one.

513
00:24:55,160 --> 00:25:00,350
And given what we now know about
present value and valuing cash

514
00:25:00,350 --> 00:25:04,970
flows that come in the future,
it's not a big leap of faith

515
00:25:04,970 --> 00:25:09,350
to put some structure on
this valuation operator, OK?

516
00:25:09,350 --> 00:25:14,230
The value of this sequence
of future cash flows

517
00:25:14,230 --> 00:25:19,950
is simply equal to the
expectation today, time t,

518
00:25:19,950 --> 00:25:25,320
of future dividends out
into the infinite future,

519
00:25:25,320 --> 00:25:31,260
discounted back by the
appropriate risk-adjusted rate

520
00:25:31,260 --> 00:25:32,650
of return.

521
00:25:32,650 --> 00:25:36,450
Now you'll notice that the
rate of return, this r, I

522
00:25:36,450 --> 00:25:41,400
put a subscript, t, plus
1, and t plus 2, and so on.

523
00:25:41,400 --> 00:25:44,640
I'm explicitly
recognizing the fact

524
00:25:44,640 --> 00:25:47,460
that the appropriate
risk-adjustment changes

525
00:25:47,460 --> 00:25:51,330
over time as market
conditions change

526
00:25:51,330 --> 00:25:57,640
and as the business changes, OK?

527
00:25:57,640 --> 00:26:01,600
So it could be that the
risk-adjusted return

528
00:26:01,600 --> 00:26:05,610
for a one-year
cash flow is this,

529
00:26:05,610 --> 00:26:09,000
but the risk-adjusted return
for a two-year cash flow

530
00:26:09,000 --> 00:26:10,320
is different.

531
00:26:10,320 --> 00:26:14,190
Just like we have a yield
curve for riskless bonds,

532
00:26:14,190 --> 00:26:20,460
we may have a yield curve
for risky cash flows, OK?

533
00:26:20,460 --> 00:26:22,380
And if I really wanted
to be a masochist when

534
00:26:22,380 --> 00:26:24,840
it comes to notation,
what I could do

535
00:26:24,840 --> 00:26:27,480
is to have a double
subscript that

536
00:26:27,480 --> 00:26:32,160
says that this is the
appropriate risk-adjusted

537
00:26:32,160 --> 00:26:35,790
return between years
t and t plus 1,

538
00:26:35,790 --> 00:26:39,390
and then this is between
years t and t plus 2,

539
00:26:39,390 --> 00:26:44,520
and so on, because these
discount rates may be

540
00:26:44,520 --> 00:26:46,830
completely different tomorrow.

541
00:26:46,830 --> 00:26:49,530
In other words,
tomorrow's discount rate

542
00:26:49,530 --> 00:26:54,390
for a one-year cash flow may be
different than today's discount

543
00:26:54,390 --> 00:26:58,080
rate for a one-year
cash flow, right?

544
00:26:58,080 --> 00:27:03,810
So I can have a whole string
of discount rates for today,

545
00:27:03,810 --> 00:27:07,440
and a completely different
string of discount rates

546
00:27:07,440 --> 00:27:11,040
for tomorrow and for
every day in the future.

547
00:27:11,040 --> 00:27:14,530
These things change
all the time.

548
00:27:14,530 --> 00:27:17,890
I think you'll see now why I
told you earlier equities is

549
00:27:17,890 --> 00:27:21,220
a lot more complicated than
fixed income instruments.

550
00:27:21,220 --> 00:27:25,250
It's because there are two
sources of uncertainty.

551
00:27:25,250 --> 00:27:31,690
One is the discount rate, and
the other is the cash flows.

552
00:27:31,690 --> 00:27:34,390
And moreover, the discount
rate that we're talking about,

553
00:27:34,390 --> 00:27:38,850
it's not the risk-free
discount rate,

554
00:27:38,850 --> 00:27:41,430
but it's the risk-adjusted
discount rate.

555
00:27:41,430 --> 00:27:44,180
And if risks change over
time, as certainly they

556
00:27:44,180 --> 00:27:47,300
have over the past
even few days,

557
00:27:47,300 --> 00:27:49,620
then the discount
rate should change.

558
00:27:49,620 --> 00:27:51,860
So in addition to
the term structure

559
00:27:51,860 --> 00:27:54,680
effect of different
yields, we also

560
00:27:54,680 --> 00:27:58,520
have the risk effect of looking
out into the future, given

561
00:27:58,520 --> 00:28:01,830
current market conditions.

562
00:28:01,830 --> 00:28:04,100
So while this
expression is tidy,

563
00:28:04,100 --> 00:28:07,050
and it looks nice
and clean, in order

564
00:28:07,050 --> 00:28:09,150
to turn this into
an actual number

565
00:28:09,150 --> 00:28:10,884
that you can look
at and decide, gee,

566
00:28:10,884 --> 00:28:12,300
do I want to invest
in this stock?

567
00:28:12,300 --> 00:28:14,640
Is it undervalued or overvalued?

568
00:28:14,640 --> 00:28:16,890
It's going to take
a lot of work.

569
00:28:16,890 --> 00:28:19,950
So before we get to
that work, I want

570
00:28:19,950 --> 00:28:23,730
to spend some time thinking
about simpler things,

571
00:28:23,730 --> 00:28:27,360
and try to come up with
relatively simple implications

572
00:28:27,360 --> 00:28:29,750
of this relatively robust model.

573
00:28:29,750 --> 00:28:30,527
Question?

574
00:28:30,527 --> 00:28:31,461
AUDIENCE: Yes, sir.

575
00:28:31,461 --> 00:28:34,263
Does rt take into
account the riskiness

576
00:28:34,263 --> 00:28:38,120
of the company itself, or
is it of the marketplace?

577
00:28:38,120 --> 00:28:40,391
ANDREW LO: The answer is yes.

578
00:28:40,391 --> 00:28:41,810
It's both.

579
00:28:41,810 --> 00:28:44,000
It's the riskiness
of the company,

580
00:28:44,000 --> 00:28:46,940
as well as the riskiness
of the aggregate set

581
00:28:46,940 --> 00:28:48,040
of market conditions.

582
00:28:48,040 --> 00:28:49,640
It's both.

583
00:28:49,640 --> 00:28:51,620
And so we have to figure
out how that factors

584
00:28:51,620 --> 00:28:53,364
into this equation.

585
00:28:53,364 --> 00:28:55,530
That's going to take us a
few lectures to get there.

586
00:28:55,530 --> 00:28:57,310
But the answer is both.

587
00:28:57,310 --> 00:28:57,960
Yeah.

588
00:28:57,960 --> 00:28:59,460
AUDIENCE: Would you
say it's related

589
00:28:59,460 --> 00:29:02,800
to the riskiness of the
expectation of the dividend

590
00:29:02,800 --> 00:29:06,362
being whatever it is at time t?

591
00:29:06,362 --> 00:29:07,070
ANDREW LO: Well--

592
00:29:07,070 --> 00:29:10,920
AUDIENCE: If I were to know that
the first dividend is absolute

593
00:29:10,920 --> 00:29:14,750
certain, but after
that, not so much,

594
00:29:14,750 --> 00:29:17,470
then could I replace rt
with a risk-free rate,

595
00:29:17,470 --> 00:29:22,640
but rt plus 2 with something
else, and so forth?

596
00:29:22,640 --> 00:29:25,670
ANDREW LO: Yes, assuming
that that dividend really

597
00:29:25,670 --> 00:29:26,630
was risk-free.

598
00:29:26,630 --> 00:29:28,220
Yes, that's right.

599
00:29:28,220 --> 00:29:30,680
So the idea behind
the discount rate--

600
00:29:30,680 --> 00:29:34,460
and, by the way, I'm going to
ask you to explain this to me.

601
00:29:34,460 --> 00:29:36,050
So I'm going to
make a statement,

602
00:29:36,050 --> 00:29:38,540
and then I'm going to ask
you to justify it, OK?

603
00:29:38,540 --> 00:29:40,010
The statement is this--

604
00:29:40,010 --> 00:29:44,240
the discount rate that's used
in the denominator of each

605
00:29:44,240 --> 00:29:47,670
of these fractions,
that discount rate

606
00:29:47,670 --> 00:29:51,420
has to be risk-adjusted
in a way to reflect

607
00:29:51,420 --> 00:29:55,710
the risks of the numerator,
as well as general market

608
00:29:55,710 --> 00:29:56,530
conditions.

609
00:29:56,530 --> 00:29:58,860
It has to be commensurate
with the risks

610
00:29:58,860 --> 00:30:00,720
of that particular numerator.

611
00:30:00,720 --> 00:30:06,270
So if this numerator is much
less risky than this numerator,

612
00:30:06,270 --> 00:30:08,370
I would argue that
you would have

613
00:30:08,370 --> 00:30:10,590
to use a different
discount rate, one

614
00:30:10,590 --> 00:30:13,530
that's higher for the
more risky numerator

615
00:30:13,530 --> 00:30:15,240
than for the less risky.

616
00:30:15,240 --> 00:30:18,780
Now justify that for me.

617
00:30:18,780 --> 00:30:23,087
Why is that a reasonable
thing to want to do?

618
00:30:23,087 --> 00:30:23,587
Yeah.

619
00:30:23,587 --> 00:30:26,128
AUDIENCE: Because you're getting
more return on [INAUDIBLE]..

620
00:30:28,310 --> 00:30:29,310
ANDREW LO: That's right.

621
00:30:29,310 --> 00:30:31,620
AUDIENCE: Your discount
rate would be [INAUDIBLE]..

622
00:30:31,620 --> 00:30:32,619
ANDREW LO: That's right.

623
00:30:32,619 --> 00:30:34,110
You get more return
on your capital

624
00:30:34,110 --> 00:30:36,240
for something of
greater risk on average,

625
00:30:36,240 --> 00:30:38,694
because you've got to be
rewarded for bearing that risk.

626
00:30:38,694 --> 00:30:40,110
And if you're not
rewarded, you're

627
00:30:40,110 --> 00:30:43,120
not going to take on that risk.

628
00:30:43,120 --> 00:30:44,020
How do you know that?

629
00:30:44,020 --> 00:30:46,061
How do you know that you're
going to get rewarded

630
00:30:46,061 --> 00:30:47,370
for taking on that risk?

631
00:30:47,370 --> 00:30:50,554
Where did you get
that from, besides me?

632
00:30:50,554 --> 00:30:52,970
AUDIENCE: That's just the law
of the jungle, I don't know.

633
00:30:52,970 --> 00:30:54,170
[LAUGHTER]

634
00:30:54,170 --> 00:30:55,680
ANDREW LO: You're right.

635
00:30:55,680 --> 00:30:56,940
It's a law of the jungle.

636
00:30:56,940 --> 00:30:58,765
But in this case,
what is the jungle?

637
00:30:58,765 --> 00:30:59,640
AUDIENCE: [INAUDIBLE]

638
00:30:59,640 --> 00:31:00,889
ANDREW LO: Exactly, thank you.

639
00:31:00,889 --> 00:31:01,800
The market.

640
00:31:01,800 --> 00:31:02,790
Excellent.

641
00:31:02,790 --> 00:31:03,360
The market.

642
00:31:03,360 --> 00:31:06,420
The market is the
jungle from which you

643
00:31:06,420 --> 00:31:08,680
compete for scarce resources.

644
00:31:08,680 --> 00:31:11,970
And in order to get
your pet project funded,

645
00:31:11,970 --> 00:31:14,550
you've got to provide the
right incentives for people

646
00:31:14,550 --> 00:31:17,200
to buy into your project.

647
00:31:17,200 --> 00:31:19,410
So that's the logic
of the justification.

648
00:31:19,410 --> 00:31:22,290
Now let me go one
step farther and say,

649
00:31:22,290 --> 00:31:26,560
suppose that you want to
replicate these cash flows.

650
00:31:26,560 --> 00:31:31,180
Suppose that you want to create
a portfolio that gives you

651
00:31:31,180 --> 00:31:33,080
these kind of cash flows.

652
00:31:33,080 --> 00:31:36,370
Well, then, you've got
to go to the marketplace

653
00:31:36,370 --> 00:31:39,340
and figure out what the
appropriate opportunity cost is

654
00:31:39,340 --> 00:31:42,045
for each of those cash flows
and then discount them,

655
00:31:42,045 --> 00:31:43,420
because that's
what the market is

656
00:31:43,420 --> 00:31:45,560
charging for those cash flows.

657
00:31:45,560 --> 00:31:48,940
So that's why you have to
get the appropriate discount

658
00:31:48,940 --> 00:31:53,440
rate matched to the appropriate
cash flow, all right?

659
00:31:53,440 --> 00:31:57,490
It comes straight out of what
we learned about bond pricing,

660
00:31:57,490 --> 00:32:00,670
but now we're adding an
extra dimension-- risk.

661
00:32:00,670 --> 00:32:03,430
And I'm not going to be able
to talk about it in any more

662
00:32:03,430 --> 00:32:06,490
detail than this until we put
more quantitative structure

663
00:32:06,490 --> 00:32:08,110
on what we even mean by risk.

664
00:32:08,110 --> 00:32:10,570
I mean, you all take for
granted, when I say risk,

665
00:32:10,570 --> 00:32:13,370
you say, yes, you
understand what risk is.

666
00:32:13,370 --> 00:32:17,350
But in order for us to justify
a particular expression for how

667
00:32:17,350 --> 00:32:19,660
to make that kind
of adjustment, we

668
00:32:19,660 --> 00:32:22,370
have to be very specific
about how to measure risk.

669
00:32:22,370 --> 00:32:24,740
So in about three
or four lectures,

670
00:32:24,740 --> 00:32:27,830
I'm going to actually propose
a method for measuring risk.

671
00:32:27,830 --> 00:32:29,720
And once we have
that method in hand,

672
00:32:29,720 --> 00:32:32,680
we can then make that
risk adjustment extremely

673
00:32:32,680 --> 00:32:33,280
explicitly.

674
00:32:33,280 --> 00:32:35,620
I'm going to give you a
formula that you can actually

675
00:32:35,620 --> 00:32:38,860
compute in an Excel spreadsheet
that will tell you exactly

676
00:32:38,860 --> 00:32:43,540
whether the number should
be 6.5% or 7.3% or 8.9%.

677
00:32:43,540 --> 00:32:46,163
You're going to actually
see how to do that yourself.

678
00:32:46,163 --> 00:32:47,462
Yeah.

679
00:32:47,462 --> 00:32:48,980
AUDIENCE: The score
wasn't implying

680
00:32:48,980 --> 00:32:52,296
that those time structured
to when dividends paid out.

681
00:32:52,296 --> 00:32:55,382
Like, the time between
t plus 1 and t plus 2

682
00:32:55,382 --> 00:32:57,590
doesn't have to be the same
as t plus 2 and t plus 3.

683
00:32:57,590 --> 00:32:59,090
ANDREW LO: Correct, correct.

684
00:32:59,090 --> 00:33:01,350
It doesn't have to be the same.

685
00:33:01,350 --> 00:33:04,670
And if it's not the same,
then the difference in horizon

686
00:33:04,670 --> 00:33:08,840
should be reflected by the
implicit size of that discount

687
00:33:08,840 --> 00:33:09,500
rate.

688
00:33:09,500 --> 00:33:11,097
Yeah.

689
00:33:11,097 --> 00:33:14,031
AUDIENCE: [INAUDIBLE]
the company's bond yield

690
00:33:14,031 --> 00:33:17,460
[INAUDIBLE]?

691
00:33:17,460 --> 00:33:19,850
ANDREW LO: Well, you tell me.

692
00:33:19,850 --> 00:33:23,290
Can we use the
company's bond yield

693
00:33:23,290 --> 00:33:26,040
to use as a discount
rate for the equity?

694
00:33:26,040 --> 00:33:27,130
Well, that depends.

695
00:33:27,130 --> 00:33:29,700
It depends on whether or
not the equity and the bond

696
00:33:29,700 --> 00:33:32,730
are of comparable risk, right?

697
00:33:32,730 --> 00:33:35,400
Remember, it's not
the company that

698
00:33:35,400 --> 00:33:37,230
determines the discount rate.

699
00:33:37,230 --> 00:33:38,520
It's not the company--

700
00:33:38,520 --> 00:33:41,640
or rather, it's not
determined by fiat,

701
00:33:41,640 --> 00:33:45,270
or by announcement of a
company's particular policies.

702
00:33:45,270 --> 00:33:49,260
What determines the
yield is the riskiness

703
00:33:49,260 --> 00:33:52,340
of that yield and
the marketplace.

704
00:33:52,340 --> 00:33:56,120
The market determines
that particular price,

705
00:33:56,120 --> 00:34:00,290
not the individual, or not
the sources of those funds.

706
00:34:00,290 --> 00:34:03,820
AUDIENCE: Whenever [INAUDIBLE]
of the company's bonds

707
00:34:03,820 --> 00:34:06,254
do not reflect on
the company's equity?

708
00:34:06,254 --> 00:34:07,670
ANDREW LO: Oh, of
course, they do,

709
00:34:07,670 --> 00:34:09,380
but they reflect in
a very specific way,

710
00:34:09,380 --> 00:34:10,340
and we're going to
talk about that when

711
00:34:10,340 --> 00:34:11,840
we get into capital structure.

712
00:34:11,840 --> 00:34:13,790
Companies that have
very high leverage

713
00:34:13,790 --> 00:34:15,889
are going to have more
risky equity than companies

714
00:34:15,889 --> 00:34:17,600
with very low leverage.

715
00:34:17,600 --> 00:34:20,719
So the leverage does have
an impact on the equity.

716
00:34:20,719 --> 00:34:22,699
We're going to come to
that in a little while.

717
00:34:22,699 --> 00:34:24,157
There is a
relationship, all right?

718
00:34:24,157 --> 00:34:27,440
But for now, let's look at
these securities in isolation

719
00:34:27,440 --> 00:34:28,790
and not worry about it.

720
00:34:28,790 --> 00:34:30,739
And I'm going to keep
coming back to the idea

721
00:34:30,739 --> 00:34:34,219
that it's not the company that
gets to determine the discount

722
00:34:34,219 --> 00:34:36,770
rate, but rather it's
the company's riskiness--

723
00:34:36,770 --> 00:34:40,949
or rather the riskiness of the
cash flows and the market's

724
00:34:40,949 --> 00:34:43,860
assessment of the cost
of that riskiness--

725
00:34:43,860 --> 00:34:45,570
that determines
the interest rate.

726
00:34:45,570 --> 00:34:48,900
A few years ago, there
was a faculty member

727
00:34:48,900 --> 00:34:52,550
at Carnegie Mellon
who won a Nobel Prize,

728
00:34:52,550 --> 00:34:57,600
and it ended up that he
was one of the highest paid

729
00:34:57,600 --> 00:35:00,300
professors at the time.

730
00:35:00,300 --> 00:35:05,080
And so he was being interviewed
by the school newspaper,

731
00:35:05,080 --> 00:35:07,047
and they said,
Professor So and So,

732
00:35:07,047 --> 00:35:09,130
do you think it's appropriate
that even though you

733
00:35:09,130 --> 00:35:11,850
won a Nobel Prize,
that you should get

734
00:35:11,850 --> 00:35:15,330
paid twice as much as some
of the other faculty who

735
00:35:15,330 --> 00:35:19,420
are Nobel Prize-winning
physicists and fields medalists

736
00:35:19,420 --> 00:35:21,840
in the Mathematics
department, and so on?

737
00:35:21,840 --> 00:35:25,740
I mean, do you think it's
fair that your salary is twice

738
00:35:25,740 --> 00:35:30,180
as high as other
people in the school?

739
00:35:30,180 --> 00:35:36,030
And the faculty member, who is
an economist, said, listen son.

740
00:35:36,030 --> 00:35:38,490
The university does not
determine my equilibrium

741
00:35:38,490 --> 00:35:39,510
salary.

742
00:35:39,510 --> 00:35:42,600
They only determine
what city I work in.

743
00:35:42,600 --> 00:35:45,330
In other words, the
salary of an individual

744
00:35:45,330 --> 00:35:48,290
is not determined by that
particular institution.

745
00:35:48,290 --> 00:35:50,250
It's determined by
the marketplace.

746
00:35:50,250 --> 00:35:53,082
The marketplace bids
on that faculty member,

747
00:35:53,082 --> 00:35:54,540
and the highest
bidder, presumably,

748
00:35:54,540 --> 00:35:56,850
will be able to get
that faculty member.

749
00:35:56,850 --> 00:35:59,040
The same thing with
these cash flows.

750
00:35:59,040 --> 00:36:01,246
It's not the company's
debt, or the company's

751
00:36:01,246 --> 00:36:02,620
weighted average
cost of capital,

752
00:36:02,620 --> 00:36:03,450
which we don't know
what it is yet,

753
00:36:03,450 --> 00:36:05,380
but I'll define a
little later on.

754
00:36:05,380 --> 00:36:07,200
It's not the company
that gets to choose

755
00:36:07,200 --> 00:36:08,580
what the discount rate is.

756
00:36:08,580 --> 00:36:12,900
The question is, given the
riskiness of that cash flow,

757
00:36:12,900 --> 00:36:17,040
what does the market tell me
is the fair rate of return

758
00:36:17,040 --> 00:36:18,090
for that cash flow?

759
00:36:18,090 --> 00:36:21,600
That's the number I want to
plug into that denominator.

760
00:36:21,600 --> 00:36:22,650
Yeah, question.

761
00:36:22,650 --> 00:36:25,450
AUDIENCE: The market may
determine the discount rate,

762
00:36:25,450 --> 00:36:28,697
but the company determines the
growth rate on the dividend,

763
00:36:28,697 --> 00:36:29,196
right?

764
00:36:29,196 --> 00:36:31,380
They get to decide
what the dividend is.

765
00:36:31,380 --> 00:36:33,150
ANDREW LO: Well,
they get to decide

766
00:36:33,150 --> 00:36:35,160
what the dividend is
subject to their ability

767
00:36:35,160 --> 00:36:36,467
to pay that dividend.

768
00:36:36,467 --> 00:36:38,550
But if it turns out that
they make a bad decision,

769
00:36:38,550 --> 00:36:39,630
and they pay out
all the dividends,

770
00:36:39,630 --> 00:36:41,421
and they have no more
money, and they can't

771
00:36:41,421 --> 00:36:43,260
grow the company
anymore, then who

772
00:36:43,260 --> 00:36:45,660
determines what's worth what?

773
00:36:45,660 --> 00:36:48,320
Ultimately, the market.

774
00:36:48,320 --> 00:36:52,730
The market is the final arbiter
in all of these calculations.

775
00:36:52,730 --> 00:36:54,950
At least that's the
theory of finance.

776
00:36:54,950 --> 00:36:58,670
That's the basic, plain
vanilla, frictionless model, OK?

777
00:36:58,670 --> 00:37:02,120
It's the market that determines
these interest rates.

778
00:37:02,120 --> 00:37:04,340
Later on, after we
go through the basics

779
00:37:04,340 --> 00:37:06,380
and you understand the
frictionless model,

780
00:37:06,380 --> 00:37:08,030
I'm going to
introduce frictions,

781
00:37:08,030 --> 00:37:11,810
and then you'll see what
impact corporate policies have

782
00:37:11,810 --> 00:37:13,010
on these implications.

783
00:37:13,010 --> 00:37:15,110
In some cases,
corporate directors

784
00:37:15,110 --> 00:37:19,580
can actually do a lot of harm
by making suboptimal decisions

785
00:37:19,580 --> 00:37:21,510
that go against the market.

786
00:37:21,510 --> 00:37:24,320
In other cases, you could argue
that corporate decision-makers

787
00:37:24,320 --> 00:37:26,120
know more than
the market and are

788
00:37:26,120 --> 00:37:29,330
able to make bets that the
market is not capable of doing.

789
00:37:29,330 --> 00:37:31,340
That's certainly possible,
because who knows

790
00:37:31,340 --> 00:37:33,110
the company better than you do?

791
00:37:33,110 --> 00:37:37,130
Although a market
expert would say

792
00:37:37,130 --> 00:37:39,650
it's not knowing the
company that will determine

793
00:37:39,650 --> 00:37:41,300
the value of the company.

794
00:37:41,300 --> 00:37:43,400
It's knowing how
that company compares

795
00:37:43,400 --> 00:37:46,019
to all the other companies that
are out there that determines

796
00:37:46,019 --> 00:37:47,060
the value of the company.

797
00:37:47,060 --> 00:37:48,980
And you, as the
corporate insider,

798
00:37:48,980 --> 00:37:50,720
may know your
business very well,

799
00:37:50,720 --> 00:37:52,370
but you don't know
how you stack up

800
00:37:52,370 --> 00:37:55,250
against the 25 other
businesses in your industry,

801
00:37:55,250 --> 00:37:59,110
and we, the market, know better
than you, the individual.

802
00:37:59,110 --> 00:38:01,720
That's the argument that
would be made against that.

803
00:38:01,720 --> 00:38:03,700
AUDIENCE: In the case
of refinanced stocks,

804
00:38:03,700 --> 00:38:04,887
can I use the same formula?

805
00:38:04,887 --> 00:38:06,470
ANDREW LO: We're
going to get to that.

806
00:38:06,470 --> 00:38:07,730
We're going to talk
about preferred stocks.

807
00:38:07,730 --> 00:38:09,080
That's a separate issue.

808
00:38:09,080 --> 00:38:12,000
Preferred stocks have a
different priority of claim,

809
00:38:12,000 --> 00:38:15,290
and that's going to require
some slightly different

810
00:38:15,290 --> 00:38:16,995
modifications to this formula.

811
00:38:16,995 --> 00:38:17,529
Yeah.

812
00:38:17,529 --> 00:38:19,820
AUDIENCE: So I had a question
about the expected value.

813
00:38:19,820 --> 00:38:24,090
So yesterday in the example,
you discounted the 1,000 to 900

814
00:38:24,090 --> 00:38:25,455
[INAUDIBLE] Et.

815
00:38:25,455 --> 00:38:28,991
So what else do you need
to discount in the r

816
00:38:28,991 --> 00:38:30,860
to account for the risk?

817
00:38:30,860 --> 00:38:32,480
ANDREW LO: Well,
I mean, you have

818
00:38:32,480 --> 00:38:36,170
to take into account the fact
that there are other competing

819
00:38:36,170 --> 00:38:38,060
opportunities for this
particular project

820
00:38:38,060 --> 00:38:39,450
in the marketplace.

821
00:38:39,450 --> 00:38:41,630
And so it's not just the
risk of this project,

822
00:38:41,630 --> 00:38:44,030
but rather how the
risk of this project

823
00:38:44,030 --> 00:38:48,260
stacks up against the risks
of all other possible projects

824
00:38:48,260 --> 00:38:51,040
that you would be competing
for in the open market.

825
00:38:51,040 --> 00:38:52,290
Let me put it to you this way.

826
00:38:52,290 --> 00:38:54,300
Let's do a simple
thought experiment.

827
00:38:54,300 --> 00:38:59,090
Suppose that instead of
these as being dividend

828
00:38:59,090 --> 00:39:03,740
streams for a given company,
let's do the following thought

829
00:39:03,740 --> 00:39:04,890
experiment.

830
00:39:04,890 --> 00:39:06,860
Let's imagine doing a strip, OK?

831
00:39:06,860 --> 00:39:08,660
You all know what
strips are now, right?

832
00:39:08,660 --> 00:39:11,090
So let's think about
stripping out dividends, OK?

833
00:39:11,090 --> 00:39:13,070
It's a very weird thought
experiment, granted,

834
00:39:13,070 --> 00:39:14,520
but just bear with me.

835
00:39:14,520 --> 00:39:17,760
Let's suppose that
instead of one company,

836
00:39:17,760 --> 00:39:21,290
I generate an
infinity of companies.

837
00:39:21,290 --> 00:39:25,820
Each company lives only
for one dividend payment,

838
00:39:25,820 --> 00:39:27,530
after which it gets liquidated.

839
00:39:27,530 --> 00:39:32,370
So each of these cash
flows, Dt plus 1, Dt plus 2,

840
00:39:32,370 --> 00:39:35,760
each one of these things is
a separate and independent

841
00:39:35,760 --> 00:39:38,220
company that gets
liquidated right

842
00:39:38,220 --> 00:39:42,070
after it pays the dividend, OK?

843
00:39:42,070 --> 00:39:45,910
Now how would you
value a portfolio

844
00:39:45,910 --> 00:39:49,240
of all of these companies?

845
00:39:49,240 --> 00:39:51,400
Well, you would do this, right?

846
00:39:51,400 --> 00:39:54,550
For each company,
you would figure out

847
00:39:54,550 --> 00:39:56,956
what the appropriate
discount rate is,

848
00:39:56,956 --> 00:39:58,330
and the appropriate
discount rate

849
00:39:58,330 --> 00:40:01,210
reflects not just the
time value of money,

850
00:40:01,210 --> 00:40:06,470
but the appropriate
riskiness of that cash flow.

851
00:40:06,470 --> 00:40:08,875
For example, if I took
that company-- let's

852
00:40:08,875 --> 00:40:11,000
actually do a thought
experiment of how we do that.

853
00:40:11,000 --> 00:40:13,400
Let's go through
the motions, OK.

854
00:40:13,400 --> 00:40:16,160
I've got a piece of
paper that is something

855
00:40:16,160 --> 00:40:22,490
that funds nanotechnology in
a very specific application.

856
00:40:22,490 --> 00:40:25,910
And this company
is going to require

857
00:40:25,910 --> 00:40:28,190
a certain amount of
investment, and then it'll

858
00:40:28,190 --> 00:40:34,250
pay off all of its
earnings in 2013, December,

859
00:40:34,250 --> 00:40:36,680
and then it'll liquidate
and be done with, OK?

860
00:40:36,680 --> 00:40:39,700
That's the company.

861
00:40:39,700 --> 00:40:43,830
How do I figure out the
price of the company today?

862
00:40:48,270 --> 00:40:48,770
Anybody?

863
00:40:48,770 --> 00:40:50,670
How do I figure out the price?

864
00:40:50,670 --> 00:40:53,630
I have this piece of
paper that says in 2013,

865
00:40:53,630 --> 00:40:56,569
the company will
liquidate, and I

866
00:40:56,569 --> 00:40:57,860
want to know what the price is.

867
00:40:57,860 --> 00:41:01,490
What's the first thing you
would do with that proposal

868
00:41:01,490 --> 00:41:02,914
if you got it in the mail?

869
00:41:02,914 --> 00:41:04,080
What would you want to know?

870
00:41:04,080 --> 00:41:04,600
Yeah.

871
00:41:04,600 --> 00:41:06,599
AUDIENCE: I would want
to know, like, if there's

872
00:41:06,599 --> 00:41:08,058
a security I can
buy in the market,

873
00:41:08,058 --> 00:41:09,515
is the company
going to pay for it?

874
00:41:09,515 --> 00:41:11,390
Because it's the same
risk return profile.

875
00:41:11,390 --> 00:41:13,190
And I look at the
marketplace for that.

876
00:41:13,190 --> 00:41:14,210
ANDREW LO: Why
would you do that?

877
00:41:14,210 --> 00:41:15,668
AUDIENCE: Because
there's no reason

878
00:41:15,668 --> 00:41:19,400
I would go through the hassle,
or friction, as you call it,

879
00:41:19,400 --> 00:41:21,110
of pricing a new
company if I could just

880
00:41:21,110 --> 00:41:22,340
go online and buy it.

881
00:41:22,340 --> 00:41:23,990
ANDREW LO: Right,
that's one logic,

882
00:41:23,990 --> 00:41:29,282
but another logic is that you
have money looking for a home.

883
00:41:29,282 --> 00:41:30,740
You can put it in
this new venture,

884
00:41:30,740 --> 00:41:32,900
or you can put it in
this existing company.

885
00:41:32,900 --> 00:41:34,696
And if they're
comparable, then at least

886
00:41:34,696 --> 00:41:36,320
you have some sense
of what it's worth.

887
00:41:36,320 --> 00:41:37,940
Exactly.

888
00:41:37,940 --> 00:41:39,740
In order to figure
out whether or not

889
00:41:39,740 --> 00:41:41,960
you can get a
comparable security,

890
00:41:41,960 --> 00:41:45,150
you need to know what the cash
flow is for that nanotechnology

891
00:41:45,150 --> 00:41:46,210
startup, right?

892
00:41:46,210 --> 00:41:50,000
So you might think first about
estimating the expected cash

893
00:41:50,000 --> 00:41:54,610
flow in the liquidating
dividend in 2013.

894
00:41:54,610 --> 00:41:59,650
OK, so you calculate the
numerator, all right?

895
00:41:59,650 --> 00:42:01,600
And you find a company
out there that has

896
00:42:01,600 --> 00:42:03,730
that same kind of cash flow.

897
00:42:03,730 --> 00:42:06,070
You have to find one that
has the same profile,

898
00:42:06,070 --> 00:42:10,900
so it does it in 2013, at
which point it gets liquidated.

899
00:42:10,900 --> 00:42:12,190
But let's even forget about--

900
00:42:12,190 --> 00:42:14,080
suppose we didn't
have such a company.

901
00:42:14,080 --> 00:42:16,280
Suppose we didn't have
an existing security.

902
00:42:16,280 --> 00:42:19,270
So this is literally
a fresh start.

903
00:42:19,270 --> 00:42:21,490
You've got a piece of
paper that gives you

904
00:42:21,490 --> 00:42:25,330
the claim to a company that
liquidates in 2013 with one

905
00:42:25,330 --> 00:42:26,680
cash flow only.

906
00:42:26,680 --> 00:42:28,870
And now you've estimated
that cash flow to be

907
00:42:28,870 --> 00:42:34,750
approximately $27 million, OK?

908
00:42:34,750 --> 00:42:36,570
So now you've got the numerator.

909
00:42:36,570 --> 00:42:39,987
A piece of paper that
pays $27 million.

910
00:42:39,987 --> 00:42:41,320
How do you figure out its price?

911
00:42:44,040 --> 00:42:44,990
What would you do?

912
00:42:44,990 --> 00:42:46,520
Yeah.

913
00:42:46,520 --> 00:42:50,335
AUDIENCE: Calculate the risk
that it's going to [INAUDIBLE],,

914
00:42:50,335 --> 00:42:52,930
also you have the
time [INAUDIBLE]..

915
00:42:52,930 --> 00:42:54,430
ANDREW LO: OK, and
you've done that,

916
00:42:54,430 --> 00:42:55,360
and that's the $27 million.

917
00:42:55,360 --> 00:42:57,151
AUDIENCE: That's included
in the valuation.

918
00:42:57,151 --> 00:42:58,720
ANDREW LO: Right,
the $27 million

919
00:42:58,720 --> 00:43:02,290
includes the probability
that it actually is 0,

920
00:43:02,290 --> 00:43:05,710
so the expected
value is 27 million.

921
00:43:05,710 --> 00:43:07,693
How would you go about-- yeah.

922
00:43:07,693 --> 00:43:09,818
AUDIENCE: Wouldn't it
actually be two [INAUDIBLE],,

923
00:43:09,818 --> 00:43:12,188
so when the 27
million liquidates,

924
00:43:12,188 --> 00:43:14,895
you get the value of the assets?

925
00:43:14,895 --> 00:43:17,647
ANDREW LO: The liquidation value
is the 27 million on average.

926
00:43:17,647 --> 00:43:19,480
AUDIENCE: [INAUDIBLE]
two payments for that.

927
00:43:19,480 --> 00:43:21,396
ANDREW LO: No, no, no,
it's just one payment--

928
00:43:21,396 --> 00:43:23,110
27 million on expectation.

929
00:43:23,110 --> 00:43:24,670
Oh, it may be two possibilities.

930
00:43:24,670 --> 00:43:28,900
Maybe you either get 54
million with 50% probability,

931
00:43:28,900 --> 00:43:31,360
or nothing with 50%
probability, so the expectation

932
00:43:31,360 --> 00:43:34,001
is 27 million.

933
00:43:34,001 --> 00:43:34,750
What would you do?

934
00:43:34,750 --> 00:43:34,960
Yeah.

935
00:43:34,960 --> 00:43:36,418
AUDIENCE: I think
if you're already

936
00:43:36,418 --> 00:43:41,800
weighted in the probability
[INAUDIBLE] 0 [INAUDIBLE]

937
00:43:41,800 --> 00:43:43,720
ANDREW LO: Suppose you
don't know what to use.

938
00:43:43,720 --> 00:43:45,819
Suppose you want to figure
out what the price is.

939
00:43:45,819 --> 00:43:47,110
AUDIENCE: [INAUDIBLE] discount.

940
00:43:47,110 --> 00:43:48,910
ANDREW LO: Yeah, I
know what you mean.

941
00:43:48,910 --> 00:43:50,990
But suppose that you
didn't have that.

942
00:43:50,990 --> 00:43:51,957
What would you do?

943
00:43:51,957 --> 00:43:56,860
AUDIENCE: [INAUDIBLE]
at the yield curve just

944
00:43:56,860 --> 00:44:01,080
to get an idea of
what in 2010, at least

945
00:44:01,080 --> 00:44:03,582
either a risk-free
security or a security

946
00:44:03,582 --> 00:44:06,700
with that same credit risk.

947
00:44:06,700 --> 00:44:09,160
You know, what discount
rate that would go in there,

948
00:44:09,160 --> 00:44:10,500
discounting by that [INAUDIBLE].

949
00:44:10,500 --> 00:44:12,420
ANDREW LO: You could
do that, but now we're

950
00:44:12,420 --> 00:44:13,836
getting more and
more complicated.

951
00:44:13,836 --> 00:44:16,750
Isn't there an easier way to
figure out what the price is?

952
00:44:16,750 --> 00:44:17,500
Exactly.

953
00:44:17,500 --> 00:44:19,270
You know, let's let
the market decide.

954
00:44:19,270 --> 00:44:20,730
Auction it off.

955
00:44:20,730 --> 00:44:24,460
Now when you auction it off, you
take the highest bidder, right?

956
00:44:24,460 --> 00:44:25,606
And you get a number.

957
00:44:25,606 --> 00:44:26,980
I don't know what
that number is,

958
00:44:26,980 --> 00:44:29,970
but let's just say the number
is, I don't know, 15 million.

959
00:44:32,485 --> 00:44:34,610
You've got somebody who's
willing to pay 15 million

960
00:44:34,610 --> 00:44:39,740
today for a cash flow that
gives them expected 27 million

961
00:44:39,740 --> 00:44:42,180
in 2013.

962
00:44:42,180 --> 00:44:49,160
With those two numbers, that
gives you r, doesn't it?

963
00:44:49,160 --> 00:44:51,170
That's how r is established.

964
00:44:51,170 --> 00:44:53,030
It's established
the exact same way

965
00:44:53,030 --> 00:44:56,540
that we establish r
for riskless bonds.

966
00:44:56,540 --> 00:44:58,160
The way that US
treasuries ended up

967
00:44:58,160 --> 00:45:01,280
being three basis points
on September 18th was,

968
00:45:01,280 --> 00:45:03,680
basically, tons of people
wanted to buy these securities,

969
00:45:03,680 --> 00:45:06,920
bidding down the yield
and bidding up the price.

970
00:45:06,920 --> 00:45:10,160
So if we had this piece of
paper that paid only one

971
00:45:10,160 --> 00:45:13,580
dividend in 2013 and
we auctioned it off,

972
00:45:13,580 --> 00:45:14,870
we would get a yield.

973
00:45:14,870 --> 00:45:17,694
The yield would be a
risk-adjusted yield.

974
00:45:17,694 --> 00:45:19,610
I don't know how the
risk adjustment got made.

975
00:45:19,610 --> 00:45:22,831
So you could be quite right that
you take the risk-free yield,

976
00:45:22,831 --> 00:45:24,580
and you add on top of
that a credit spread

977
00:45:24,580 --> 00:45:26,060
and who knows what.

978
00:45:26,060 --> 00:45:29,430
The point is, the market
did it for us, OK?

979
00:45:29,430 --> 00:45:32,010
So what I'm getting
after with this formula

980
00:45:32,010 --> 00:45:37,590
is I want to use those discount
rates that are determined

981
00:45:37,590 --> 00:45:39,240
by the marketplace.

982
00:45:39,240 --> 00:45:41,880
Because if ever I have
to sell my company,

983
00:45:41,880 --> 00:45:43,380
if ever I have to
take this company

984
00:45:43,380 --> 00:45:45,452
and break it apart
and get rid of it,

985
00:45:45,452 --> 00:45:47,160
and the market is
going to pay me for it,

986
00:45:47,160 --> 00:45:49,140
the way that the market
is going to evaluate

987
00:45:49,140 --> 00:45:51,830
the different pieces is just
the way that I described.

988
00:45:51,830 --> 00:45:55,260
It'll look at each cash flow,
look at how risky it is,

989
00:45:55,260 --> 00:45:57,370
look at the opportunity
cost of other investments

990
00:45:57,370 --> 00:46:00,360
that they can get the same
risk return profile for,

991
00:46:00,360 --> 00:46:03,780
and they'll pay that amount,
which will implicitly

992
00:46:03,780 --> 00:46:06,720
give me the appropriate yield.

993
00:46:06,720 --> 00:46:07,442
Yeah.

994
00:46:07,442 --> 00:46:09,150
AUDIENCE: So let's
say that me purchasing

995
00:46:09,150 --> 00:46:11,810
a stock with this
calculation, do

996
00:46:11,810 --> 00:46:14,832
I have to assume that
this calculation is wrong?

997
00:46:14,832 --> 00:46:16,790
Because why would I pay
out money for something

998
00:46:16,790 --> 00:46:21,340
that's going to be exactly the
same, kind of discounted, cash

999
00:46:21,340 --> 00:46:22,964
flow back to right now?

1000
00:46:22,964 --> 00:46:24,380
ANDREW LO: So
that's a good point.

1001
00:46:24,380 --> 00:46:25,550
Let me repeat the question.

1002
00:46:25,550 --> 00:46:27,844
The question's why-- in order
for you to buy the stock,

1003
00:46:27,844 --> 00:46:29,260
would you have to
assume that this

1004
00:46:29,260 --> 00:46:33,260
is wrong, or rather, that
the market price is not

1005
00:46:33,260 --> 00:46:35,130
equal to this?

1006
00:46:35,130 --> 00:46:37,721
Well, the answer is
no, you don't have to.

1007
00:46:37,721 --> 00:46:40,220
Although if you did, that would
provide a motivation for you

1008
00:46:40,220 --> 00:46:42,200
to want to do that.

1009
00:46:42,200 --> 00:46:45,680
But it could be that you
simply want the risk and reward

1010
00:46:45,680 --> 00:46:48,230
of this particular cash flow.

1011
00:46:48,230 --> 00:46:49,940
What's wrong with that?

1012
00:46:49,940 --> 00:46:52,640
Suppose that the security
is fairly priced.

1013
00:46:52,640 --> 00:46:54,680
So this equation
at the very bottom

1014
00:46:54,680 --> 00:46:56,900
says that the price
of the security

1015
00:46:56,900 --> 00:47:00,350
is equal to the present value
of all the future expected

1016
00:47:00,350 --> 00:47:06,320
cash flows discounted at
the fair rate of return.

1017
00:47:06,320 --> 00:47:08,180
That's a perfectly
reasonable thing

1018
00:47:08,180 --> 00:47:09,800
for somebody to
want to invest in,

1019
00:47:09,800 --> 00:47:14,210
if they like that kind of
risk/reward combination.

1020
00:47:14,210 --> 00:47:17,360
So some people want to
put their money in Google,

1021
00:47:17,360 --> 00:47:20,510
and some people want to
put their money in IBM,

1022
00:47:20,510 --> 00:47:23,654
and some people want to put
their money in US Steel.

1023
00:47:23,654 --> 00:47:25,070
Those are different
companies that

1024
00:47:25,070 --> 00:47:27,200
have different rates
of return based

1025
00:47:27,200 --> 00:47:30,230
upon their different
risks and cash flows,

1026
00:47:30,230 --> 00:47:33,970
and even if those things
are fairly priced,

1027
00:47:33,970 --> 00:47:36,550
it's not like you're
going to make no money.

1028
00:47:36,550 --> 00:47:40,180
You're going to make money
based upon the fair market rate

1029
00:47:40,180 --> 00:47:42,460
of return for that security.

1030
00:47:42,460 --> 00:47:45,220
Now if you think you've
got a better mousetrap,

1031
00:47:45,220 --> 00:47:47,950
and you can identify
mispriced securities,

1032
00:47:47,950 --> 00:47:52,340
that gives you a whole
another reason for investing.

1033
00:47:52,340 --> 00:47:54,980
But even without
any mistakes being

1034
00:47:54,980 --> 00:47:58,892
made, even with if market
prices are perfectly fair,

1035
00:47:58,892 --> 00:48:00,350
people want to
invest, because they

1036
00:48:00,350 --> 00:48:03,320
want the return that
those kind of investments

1037
00:48:03,320 --> 00:48:06,170
give them, right?

1038
00:48:06,170 --> 00:48:10,460
OK, so let's consider
some simple cases.

1039
00:48:10,460 --> 00:48:13,010
In order for us to really make
use of this formula, which

1040
00:48:13,010 --> 00:48:17,720
at this level of generality
really is useless,

1041
00:48:17,720 --> 00:48:20,010
let's try to simplify
and see what we get.

1042
00:48:20,010 --> 00:48:21,890
And we're going to
simplify in the ways

1043
00:48:21,890 --> 00:48:23,180
that we've done before.

1044
00:48:23,180 --> 00:48:29,100
Let's assume that dividends
are fixed throughout time,

1045
00:48:29,100 --> 00:48:33,050
and given by a number D, OK?

1046
00:48:33,050 --> 00:48:37,140
And let's assume that the
risks don't change over time

1047
00:48:37,140 --> 00:48:42,130
and are given by
a discount rate r.

1048
00:48:42,130 --> 00:48:48,800
Well, if you fix D and you
fix r, magically, what you get

1049
00:48:48,800 --> 00:48:51,440
is that the price
of the security

1050
00:48:51,440 --> 00:48:56,820
is equal to our old friend, the
perpetuity formula, D over r,

1051
00:48:56,820 --> 00:48:57,650
OK?

1052
00:48:57,650 --> 00:48:59,180
Not that surprising.

1053
00:48:59,180 --> 00:49:01,460
If you have a constant
stream of dividends,

1054
00:49:01,460 --> 00:49:04,420
with a constant discount
rate, then the price

1055
00:49:04,420 --> 00:49:06,200
is equal to D over r.

1056
00:49:06,200 --> 00:49:09,500
Now, again, this may seem
totally trivial to you,

1057
00:49:09,500 --> 00:49:13,490
but it does provide a very
interesting observation.

1058
00:49:13,490 --> 00:49:16,340
Number one, the
price of common stock

1059
00:49:16,340 --> 00:49:19,910
is an increasing function
of the expected cash

1060
00:49:19,910 --> 00:49:22,410
flows in the form
of future dividends.

1061
00:49:22,410 --> 00:49:26,630
So if you expect there to be
higher dividends going forward,

1062
00:49:26,630 --> 00:49:28,160
the price should
go up, and if you

1063
00:49:28,160 --> 00:49:30,500
expect lower dividends
going forward,

1064
00:49:30,500 --> 00:49:31,590
the price should go down.

1065
00:49:31,590 --> 00:49:33,122
So that's a nice insight.

1066
00:49:33,122 --> 00:49:35,330
Another insight, though, is
that the price of a stock

1067
00:49:35,330 --> 00:49:39,390
is inversely proportional
to its discount rate.

1068
00:49:39,390 --> 00:49:42,140
If interest rates
go up in general,

1069
00:49:42,140 --> 00:49:44,420
if interest rates
go up, what should

1070
00:49:44,420 --> 00:49:46,568
happen to the stock price?

1071
00:49:46,568 --> 00:49:47,456
AUDIENCE: [INAUDIBLE]

1072
00:49:47,456 --> 00:49:48,940
ANDREW LO: Exactly,
it should go down.

1073
00:49:48,940 --> 00:49:50,606
There are two ways
of thinking about it.

1074
00:49:50,606 --> 00:49:53,680
One is that future
cash flows are

1075
00:49:53,680 --> 00:49:57,490
going to have to be
discounted at a higher price.

1076
00:49:57,490 --> 00:50:00,190
Or two, the demand
for stocks will not

1077
00:50:00,190 --> 00:50:04,060
be as great, because now the
opportunity for earning higher

1078
00:50:04,060 --> 00:50:07,570
return exists in other
securities like bonds,

1079
00:50:07,570 --> 00:50:09,790
and so that will reduce
the demand for stocks

1080
00:50:09,790 --> 00:50:14,460
and the price will
come down, right?

1081
00:50:14,460 --> 00:50:17,630
So that's a very
nice model, but we

1082
00:50:17,630 --> 00:50:19,970
can make it a little
bit nicer by allowing

1083
00:50:19,970 --> 00:50:21,350
the dividends to grow.

1084
00:50:21,350 --> 00:50:23,750
So now suppose you have a
growth company, a company

1085
00:50:23,750 --> 00:50:27,230
where the dividends are
expected to grow at a rate of g

1086
00:50:27,230 --> 00:50:28,830
every period.

1087
00:50:28,830 --> 00:50:32,870
Well, then, once again, we have
our old friend, the perpetuity,

1088
00:50:32,870 --> 00:50:35,420
with growing coupons, right?

1089
00:50:35,420 --> 00:50:39,170
D over r minus g.

1090
00:50:39,170 --> 00:50:42,580
And now, as I think I
alluded to early on when

1091
00:50:42,580 --> 00:50:47,030
we went through this formula, we
have in this very, very simple

1092
00:50:47,030 --> 00:50:52,210
expression one explanation
for the technology

1093
00:50:52,210 --> 00:50:59,040
bubble, both how it got so big,
and secondly, how it burst.

1094
00:50:59,040 --> 00:51:04,750
If r is close to g, if the
growth rate is very large,

1095
00:51:04,750 --> 00:51:07,040
you're going to get
a very big price.

1096
00:51:07,040 --> 00:51:13,520
And if there are rapid changes
in what people expect g to be,

1097
00:51:13,520 --> 00:51:15,890
or what people
estimate g to be, you

1098
00:51:15,890 --> 00:51:19,880
can get very rapid shocks
in the level of prices,

1099
00:51:19,880 --> 00:51:25,720
including price one-ups
and then crashes, right?

1100
00:51:25,720 --> 00:51:26,320
Yeah.

1101
00:51:26,320 --> 00:51:29,900
AUDIENCE: What kind of confuses
me is that, I mean, yeah,

1102
00:51:29,900 --> 00:51:32,130
so is r greater than g?

1103
00:51:32,130 --> 00:51:34,010
And r greater than
g is necessary

1104
00:51:34,010 --> 00:51:36,190
in order to get that
[INAUDIBLE] efficient.

1105
00:51:36,190 --> 00:51:39,630
But is there any
more meaning to that,

1106
00:51:39,630 --> 00:51:41,221
or is this just a
mathematical thing?

1107
00:51:41,221 --> 00:51:42,720
ANDREW LO: There
is meaning to that.

1108
00:51:42,720 --> 00:51:44,580
The meaning is
actually quite simple,

1109
00:51:44,580 --> 00:51:46,260
and we alluded to
it when we first

1110
00:51:46,260 --> 00:51:47,880
went through this formula.

1111
00:51:47,880 --> 00:51:51,030
Suppose that r were
not greater than g.

1112
00:51:51,030 --> 00:51:53,854
Suppose r were less than g.

1113
00:51:53,854 --> 00:51:57,280
What that's telling you
is that the rate of growth

1114
00:51:57,280 --> 00:52:00,160
of this security, or this
cash flow, or this dividend,

1115
00:52:00,160 --> 00:52:05,350
the rate of growth is much
faster than the interest rate,

1116
00:52:05,350 --> 00:52:06,400
all right?

1117
00:52:06,400 --> 00:52:10,990
So you've got wealth that's
growing over time faster

1118
00:52:10,990 --> 00:52:14,950
than the interest rate, which
means that if it really is true

1119
00:52:14,950 --> 00:52:17,740
that it'll last out
into perpetuity, then

1120
00:52:17,740 --> 00:52:20,590
in very short order you
should become bigger

1121
00:52:20,590 --> 00:52:24,065
than the entire
planet's GDP, right?

1122
00:52:24,065 --> 00:52:26,440
Because you're going to be
bigger than the interest rate.

1123
00:52:26,440 --> 00:52:29,050
So the rate at which
assets in the future

1124
00:52:29,050 --> 00:52:31,540
are being deflated
to the present

1125
00:52:31,540 --> 00:52:33,610
is actually less
than the rate of what

1126
00:52:33,610 --> 00:52:35,260
you're growing your wealth.

1127
00:52:35,260 --> 00:52:39,860
Pretty soon, you're going to
become richer than God himself,

1128
00:52:39,860 --> 00:52:41,500
and we know that
that can't happen.

1129
00:52:41,500 --> 00:52:42,708
AUDIENCE: But isn't it that--

1130
00:52:42,708 --> 00:52:45,970
I mean, so right now,
the inflation rate

1131
00:52:45,970 --> 00:52:48,220
is greater than the interest
rate, for example, right?

1132
00:52:48,220 --> 00:52:49,564
ANDREW LO: That's right now.

1133
00:52:49,564 --> 00:52:51,730
That's right now, but this
is out of the perpetuity.

1134
00:52:51,730 --> 00:52:53,334
Do you believe that
that's sustainable

1135
00:52:53,334 --> 00:52:54,250
out of the perpetuity?

1136
00:52:54,250 --> 00:52:54,819
AUDIENCE: No.

1137
00:52:54,819 --> 00:52:56,860
ANDREW LO: Well, then,
this formula doesn't work.

1138
00:52:56,860 --> 00:53:01,240
This formula is a formula
that's predicated on infinity,

1139
00:53:01,240 --> 00:53:03,872
not 10 years, not 20 years.

1140
00:53:03,872 --> 00:53:05,830
As we mentioned, when we
went over the formula,

1141
00:53:05,830 --> 00:53:11,180
China has been growing at a rate
of 10% for the last 15 years.

1142
00:53:11,180 --> 00:53:13,720
Do you think 10% growth
rate is sustainable?

1143
00:53:13,720 --> 00:53:16,504
If China continues
to grow at 10%,

1144
00:53:16,504 --> 00:53:18,670
pretty soon we're all going
to be speaking Mandarin.

1145
00:53:18,670 --> 00:53:22,750
I mean, it's just not
possible for a country

1146
00:53:22,750 --> 00:53:26,020
to both be reasonably-sized
and not totally dominant,

1147
00:53:26,020 --> 00:53:27,940
and to have a rate
of growth so much

1148
00:53:27,940 --> 00:53:30,160
larger than what
can be sustained

1149
00:53:30,160 --> 00:53:31,860
over a long period of time.

1150
00:53:31,860 --> 00:53:33,160
And so that's the key.

1151
00:53:33,160 --> 00:53:35,430
This is a formula
that's about infinity.

1152
00:53:35,430 --> 00:53:38,160
It's not about five
years or 10 years.

1153
00:53:38,160 --> 00:53:39,800
OK, another question.

1154
00:53:39,800 --> 00:53:41,100
No.

1155
00:53:41,100 --> 00:53:45,630
OK, so in this case,
the Gordon growth model

1156
00:53:45,630 --> 00:53:48,630
allows us to get an
expression that tells us

1157
00:53:48,630 --> 00:53:52,320
if there are very,
very significant growth

1158
00:53:52,320 --> 00:53:54,810
opportunities that
can actually push up

1159
00:53:54,810 --> 00:53:57,450
the price of a
stock dramatically.

1160
00:53:57,450 --> 00:54:00,750
If somehow all of us decide that
those growth opportunities no

1161
00:54:00,750 --> 00:54:04,620
longer exist because we have
new information, then boom,

1162
00:54:04,620 --> 00:54:06,600
it disappears, OK?

1163
00:54:06,600 --> 00:54:08,850
A good example of
this is cold fusion.

1164
00:54:08,850 --> 00:54:11,540
I don't know how many of you
remember, 15 or 20 years ago,

1165
00:54:11,540 --> 00:54:14,820
there was a big controversy
about the Pons and Fleischmann

1166
00:54:14,820 --> 00:54:17,760
experiment, where they did
an experiment where it seemed

1167
00:54:17,760 --> 00:54:21,520
like they generated heat,
but heat not from a chemical

1168
00:54:21,520 --> 00:54:24,250
reaction, but from
a nuclear reaction

1169
00:54:24,250 --> 00:54:26,890
in a standard
laboratory setting.

1170
00:54:26,890 --> 00:54:30,580
And typically, you need
very, very unusual conditions

1171
00:54:30,580 --> 00:54:33,610
to generate thermonuclear
reactions that

1172
00:54:33,610 --> 00:54:35,320
can create that kind of heat.

1173
00:54:35,320 --> 00:54:40,780
Now in the end, they were
discredited and, apparently,

1174
00:54:40,780 --> 00:54:43,750
although there's still
controversy out there,

1175
00:54:43,750 --> 00:54:46,180
it doesn't seem like it
was a nuclear reaction.

1176
00:54:46,180 --> 00:54:50,880
But if it were, if it
was possible to generate

1177
00:54:50,880 --> 00:54:55,830
a nuclear reaction at room
temperature, what that could

1178
00:54:55,830 --> 00:55:00,550
have meant is that
it would eliminate

1179
00:55:00,550 --> 00:55:02,770
all of the energy
problems of the world,

1180
00:55:02,770 --> 00:55:06,580
because you'd be able to
run your car on tap water.

1181
00:55:06,580 --> 00:55:09,550
And the amount of energy
in an ounce of tap water

1182
00:55:09,550 --> 00:55:13,100
is enough to fuel your
car for about a year.

1183
00:55:13,100 --> 00:55:14,320
So think about it.

1184
00:55:14,320 --> 00:55:19,176
If that technology really
worked to have worked out,

1185
00:55:19,176 --> 00:55:21,050
what do you think the
value of that would be?

1186
00:55:21,050 --> 00:55:23,150
What's the g in that case?

1187
00:55:23,150 --> 00:55:25,550
And you can
understand why people

1188
00:55:25,550 --> 00:55:29,960
would have invested hundreds
of billions of dollars

1189
00:55:29,960 --> 00:55:31,550
into that kind of
an opportunity,

1190
00:55:31,550 --> 00:55:34,730
if it were, in fact,
a real opportunity.

1191
00:55:34,730 --> 00:55:37,820
There was a short time
where we didn't know,

1192
00:55:37,820 --> 00:55:41,740
and during that time, r
minus g looked pretty small.

1193
00:55:41,740 --> 00:55:45,230
g looked big relative
to r, all right.

1194
00:55:45,230 --> 00:55:49,190
And so that created
very, very large swings

1195
00:55:49,190 --> 00:55:52,599
in prices of both
traditional energy companies

1196
00:55:52,599 --> 00:55:53,390
like oil companies.

1197
00:55:53,390 --> 00:55:55,730
You can imagine what oil
companies would be worth

1198
00:55:55,730 --> 00:55:58,820
if we figured out how to
run cars on water, right?

1199
00:55:58,820 --> 00:56:03,470
That would maybe be justifiable
in light of how much they've

1200
00:56:03,470 --> 00:56:05,220
made over the years.

1201
00:56:05,220 --> 00:56:08,570
But the point is that it
creates enormous opportunity

1202
00:56:08,570 --> 00:56:12,080
and potential dislocation
so that the expectations

1203
00:56:12,080 --> 00:56:14,240
of the market matter a
great deal, and this is why.

1204
00:56:14,240 --> 00:56:17,520
This is how it actually
gets incorporated.

1205
00:56:17,520 --> 00:56:19,820
Now I'm going to
take that equation

1206
00:56:19,820 --> 00:56:23,030
and turn it around,
turn it on its head,

1207
00:56:23,030 --> 00:56:25,490
and it'll give us
another insight into how

1208
00:56:25,490 --> 00:56:32,720
to think about the discount rate
and the value of corporations.

1209
00:56:32,720 --> 00:56:36,980
If the price of a stock today
is given by D over r minus g,

1210
00:56:36,980 --> 00:56:42,620
then I can flip things
around and say that r minus g

1211
00:56:42,620 --> 00:56:44,990
is equal to D over P, right?

1212
00:56:44,990 --> 00:56:52,910
The dividend price ratio is
equal to r minus g, or r--

1213
00:56:52,910 --> 00:56:56,690
the discount rate that I'm
using for the cash flows--

1214
00:56:56,690 --> 00:57:02,330
is given by the dividend
yield plus the rate of growth

1215
00:57:02,330 --> 00:57:08,440
implicit in that company's
investment opportunity set.

1216
00:57:08,440 --> 00:57:09,920
Now why is this interesting?

1217
00:57:09,920 --> 00:57:12,160
Well, in order for
you to understand

1218
00:57:12,160 --> 00:57:14,080
the importance of
this expression,

1219
00:57:14,080 --> 00:57:17,230
you have to realize
that, for many years,

1220
00:57:17,230 --> 00:57:21,580
stock analysts would look
at a company's discount rate

1221
00:57:21,580 --> 00:57:26,600
or cost of capital by simply
using the dividend yield.

1222
00:57:26,600 --> 00:57:29,470
So in the exact same way
that if you have a bond,

1223
00:57:29,470 --> 00:57:32,320
and you see what the coupons
are, and you take the coupon

1224
00:57:32,320 --> 00:57:34,810
and divide it by the
price, that gives you

1225
00:57:34,810 --> 00:57:39,160
a sense of what your rate of
return is over a given period.

1226
00:57:39,160 --> 00:57:41,650
When you look at a stock, and
you want to ask the question,

1227
00:57:41,650 --> 00:57:43,390
how much am I earning
on that stock?

1228
00:57:43,390 --> 00:57:46,000
What is the rate of return
on that stock for me,

1229
00:57:46,000 --> 00:57:47,130
the investor?

1230
00:57:47,130 --> 00:57:49,550
You take the dividends that
you get paid every quarter,

1231
00:57:49,550 --> 00:57:50,650
and you take that
dividend and you divide it

1232
00:57:50,650 --> 00:57:52,060
by the stock price,
and that gives you

1233
00:57:52,060 --> 00:57:53,170
a sort of rate of return, right?

1234
00:57:53,170 --> 00:57:54,545
Because if you
think about buying

1235
00:57:54,545 --> 00:57:58,210
the stock for a price, P, and
then getting cash flows of D

1236
00:57:58,210 --> 00:58:01,540
every quarter, or every
period, then your yield,

1237
00:58:01,540 --> 00:58:04,180
your rate of
return, is D over P.

1238
00:58:04,180 --> 00:58:09,010
That's called the dividend
price ratio, or dividend yield.

1239
00:58:09,010 --> 00:58:11,140
What this expression
says is something

1240
00:58:11,140 --> 00:58:15,430
that every MIT graduate knows
in his or her heart, which

1241
00:58:15,430 --> 00:58:19,180
is that technology
adds value above

1242
00:58:19,180 --> 00:58:22,270
and beyond what you observe
in current cash flows.

1243
00:58:22,270 --> 00:58:26,080
It's not just the dividend
that gives a company value,

1244
00:58:26,080 --> 00:58:29,720
it's the ability for
companies to grow over time.

1245
00:58:29,720 --> 00:58:32,320
It's not just the company's
current plant and equipment

1246
00:58:32,320 --> 00:58:34,420
and operations
that give it value,

1247
00:58:34,420 --> 00:58:38,530
it is all of the interesting,
wonderful, innovative, creative

1248
00:58:38,530 --> 00:58:41,440
ideas that are locked
up in that company that

1249
00:58:41,440 --> 00:58:43,480
may one day be
implemented and allow

1250
00:58:43,480 --> 00:58:46,660
it to grow far beyond the
founders' wildest dreams.

1251
00:58:46,660 --> 00:58:49,150
That also has to be factored
into the rate of return

1252
00:58:49,150 --> 00:58:50,540
of the company.

1253
00:58:50,540 --> 00:58:54,220
And this simple little dividend
yield model tells us this.

1254
00:58:54,220 --> 00:58:57,130
It says that the
required rate of return,

1255
00:58:57,130 --> 00:59:00,320
the risk-adjusted discount rate,
the cost of capital, the user

1256
00:59:00,320 --> 00:59:03,750
cost, whatever you want
to call it, this r,

1257
00:59:03,750 --> 00:59:05,290
has two pieces to it.

1258
00:59:05,290 --> 00:59:10,140
One is the cash that you get on
a regular basis, the dividends

1259
00:59:10,140 --> 00:59:13,600
that the current
operations generate,

1260
00:59:13,600 --> 00:59:21,770
plus the growth opportunities
of those dividends

1261
00:59:21,770 --> 00:59:25,680
out into the
infinite future, OK?

1262
00:59:25,680 --> 00:59:29,180
Now remember, the way that
we structured this dividend

1263
00:59:29,180 --> 00:59:33,140
payment, the way that we
had our formula set up,

1264
00:59:33,140 --> 00:59:35,090
the dividends are the
dividends that get

1265
00:59:35,090 --> 00:59:37,400
paid next period, right?

1266
00:59:37,400 --> 00:59:40,290
If you go back and
look at the formula,

1267
00:59:40,290 --> 00:59:45,590
this is the price
today, and it's

1268
00:59:45,590 --> 00:59:49,280
given by the dividends
paid at time t plus 1.

1269
00:59:49,280 --> 00:59:52,160
So this price that I'm
using in my notation

1270
00:59:52,160 --> 00:59:55,850
is the current
ex-dividend price,

1271
00:59:55,850 --> 00:59:59,740
meaning this period's dividend
has been paid already,

1272
00:59:59,740 --> 01:00:02,710
and now the value to
this piece of paper

1273
01:00:02,710 --> 01:00:08,950
is the future dividend,
starting next period, t plus 1.

1274
01:00:08,950 --> 01:00:15,290
So when I say D is
fixed, it's fixed,

1275
01:00:15,290 --> 01:00:19,460
but it's getting
paid next period, OK?

1276
01:00:19,460 --> 01:00:23,660
So in this expression,
this D is actually

1277
01:00:23,660 --> 01:00:26,460
next period's dividend.

1278
01:00:26,460 --> 01:00:28,530
But remember that
when I'm trying

1279
01:00:28,530 --> 01:00:32,700
to value the company today,
I don't observe next period's

1280
01:00:32,700 --> 01:00:35,040
dividend, which is random,
but I know how much was just

1281
01:00:35,040 --> 01:00:38,270
paid in the most recent period.

1282
01:00:38,270 --> 01:00:41,677
So if I want to use
D, and there's growth,

1283
01:00:41,677 --> 01:00:44,260
I actually have to take the most
recent dividend, the one that

1284
01:00:44,260 --> 01:00:47,890
just got paid, and
multiply that by 1 plus g

1285
01:00:47,890 --> 01:00:51,400
to get the value of
next period's dividend.

1286
01:00:51,400 --> 01:00:55,516
So that's why this
expression I've corrected--

1287
01:00:55,516 --> 01:00:56,890
not corrected,
it's not that it's

1288
01:00:56,890 --> 01:01:00,880
wrong-- it's just I've changed
the expression so that it

1289
01:01:00,880 --> 01:01:05,680
is D sub 0, which is the most
recent dividend that was just

1290
01:01:05,680 --> 01:01:11,010
paid multiplied by 1
plus g divided by P.

1291
01:01:11,010 --> 01:01:11,950
So I just do that--

1292
01:01:11,950 --> 01:01:13,950
if you want to use this
formula, and by the way,

1293
01:01:13,950 --> 01:01:15,750
you can actually go
out and use this now.

1294
01:01:15,750 --> 01:01:17,458
I would actually
encourage you to use it.

1295
01:01:17,458 --> 01:01:19,590
Go out and take a look
at your favorite stock,

1296
01:01:19,590 --> 01:01:21,360
and take a look at
its dividend yield.

1297
01:01:21,360 --> 01:01:23,850
You can find it on
yahoofinance.com as well as

1298
01:01:23,850 --> 01:01:25,320
other web sites.

1299
01:01:25,320 --> 01:01:29,880
And then you make a guess as
to what the appropriate growth

1300
01:01:29,880 --> 01:01:33,210
rate is, and try to
figure out whether it

1301
01:01:33,210 --> 01:01:35,760
fits this equation, OK?

1302
01:01:35,760 --> 01:01:38,040
You can observe dividends.

1303
01:01:38,040 --> 01:01:40,740
You can observe today's price.

1304
01:01:40,740 --> 01:01:43,080
And you have to make an
assumption about what

1305
01:01:43,080 --> 01:01:44,430
you think the growth rate is.

1306
01:01:44,430 --> 01:01:46,740
And when you plug that
in, that will give you

1307
01:01:46,740 --> 01:01:49,080
an estimate of what
the cost of capital

1308
01:01:49,080 --> 01:01:51,430
is for that particular company.

1309
01:01:51,430 --> 01:01:51,930
Yeah.

1310
01:01:51,930 --> 01:01:55,470
AUDIENCE: So like this exercise
without the [INAUDIBLE],,

1311
01:01:55,470 --> 01:01:59,560
with just the perpetuity
formula, D over r, incurs--

1312
01:01:59,560 --> 01:02:01,500
I mean, every stock
that I look at

1313
01:02:01,500 --> 01:02:07,290
seems to be more than the
dividends divided by--

1314
01:02:07,290 --> 01:02:08,490
ANDREW LO: That's right.

1315
01:02:08,490 --> 01:02:09,720
Exactly.

1316
01:02:09,720 --> 01:02:12,006
That's because why?

1317
01:02:12,006 --> 01:02:14,850
Why is it, if you
just use D over P,

1318
01:02:14,850 --> 01:02:17,490
every single stock looks
like it's overvalued.

1319
01:02:17,490 --> 01:02:18,446
What are you missing?

1320
01:02:18,446 --> 01:02:18,832
AUDIENCE: g.

1321
01:02:18,832 --> 01:02:19,873
ANDREW LO: Yeah, exactly.

1322
01:02:19,873 --> 01:02:20,970
Right, you're missing g.

1323
01:02:20,970 --> 01:02:25,580
AUDIENCE: But then g turns out
to be higher than r, right?

1324
01:02:25,580 --> 01:02:27,040
ANDREW LO: Well, no, no, no.

1325
01:02:27,040 --> 01:02:27,810
How did you get r?

1326
01:02:27,810 --> 01:02:28,250
AUDIENCE: OK, OK.

1327
01:02:28,250 --> 01:02:28,850
We don't know r

1328
01:02:28,850 --> 01:02:29,975
ANDREW LO: We don't know r.

1329
01:02:29,975 --> 01:02:32,060
That's what we're trying
to figure out, right?

1330
01:02:32,060 --> 01:02:34,961
So you just said you're
looking at D over P,

1331
01:02:34,961 --> 01:02:36,710
and you're trying to
figure out implicitly

1332
01:02:36,710 --> 01:02:40,740
what that implies for the
growth rate of stocks.

1333
01:02:40,740 --> 01:02:44,179
Take a look at this expression
in light of future growth

1334
01:02:44,179 --> 01:02:46,470
opportunities and you'll see
that dividend yield is not

1335
01:02:46,470 --> 01:02:47,400
the only story.

1336
01:02:47,400 --> 01:02:50,190
You've got to use
other expressions.

1337
01:02:50,190 --> 01:02:50,861
Yeah.

1338
01:02:50,861 --> 01:02:53,266
AUDIENCE: So looking at
that [INAUDIBLE] about it

1339
01:02:53,266 --> 01:02:57,120
on an annualized basis or
between dividend payment?

1340
01:02:57,120 --> 01:02:59,790
ANDREW LO: Well it should
be on an annualized-- well,

1341
01:02:59,790 --> 01:03:03,042
it should be on whatever
cycle the dividends get paid.

1342
01:03:03,042 --> 01:03:04,500
So if dividends
get paid quarterly,

1343
01:03:04,500 --> 01:03:06,210
then it's a quarterly
growth rate.

1344
01:03:06,210 --> 01:03:08,940
If it's an annual payment, then
it's an annual growth rate.

1345
01:03:08,940 --> 01:03:11,040
So the benefit of
this expression

1346
01:03:11,040 --> 01:03:13,870
is that there is no timing
that's been assumed.

1347
01:03:13,870 --> 01:03:17,040
It's just whatever
the periods are.

1348
01:03:17,040 --> 01:03:21,976
So if it's quarterly dividends,
use quarterly growth rate.

1349
01:03:21,976 --> 01:03:22,600
Yeah, question.

1350
01:03:22,600 --> 01:03:25,001
AUDIENCE: We can't just
go out and use this model

1351
01:03:25,001 --> 01:03:26,925
on just about any
company, right?

1352
01:03:26,925 --> 01:03:28,820
Doesn't the company
have to, I guess,

1353
01:03:28,820 --> 01:03:31,110
pay dividends and use
dividends as, perhaps,

1354
01:03:31,110 --> 01:03:34,455
a way to represent the
[INAUDIBLE] of the company?

1355
01:03:34,455 --> 01:03:35,330
ANDREW LO: Well, yes.

1356
01:03:35,330 --> 01:03:37,820
So if it doesn't have
dividends, then this formula

1357
01:03:37,820 --> 01:03:39,920
is not going to be all
that interesting, right?

1358
01:03:39,920 --> 01:03:41,150
D's going to be 0.

1359
01:03:41,150 --> 01:03:43,400
But remember, this
is not the current D.

1360
01:03:43,400 --> 01:03:47,660
This is the steady state
D. And if companies

1361
01:03:47,660 --> 01:03:49,820
are in the early part
of their growth phase,

1362
01:03:49,820 --> 01:03:52,153
it's going to be hard to
estimate what that steady state

1363
01:03:52,153 --> 01:03:52,679
D is.

1364
01:03:52,679 --> 01:03:54,470
So there'll be other
expressions that we're

1365
01:03:54,470 --> 01:03:56,420
going to derive
in a few minutes,

1366
01:03:56,420 --> 01:03:59,420
where we use accounting
identities to relate dividends

1367
01:03:59,420 --> 01:04:02,180
to earnings or to cash flows.

1368
01:04:02,180 --> 01:04:04,730
It used to be the case that
instead of using dividends,

1369
01:04:04,730 --> 01:04:06,380
you would use
earnings, because even

1370
01:04:06,380 --> 01:04:08,840
though companies that
don't pay out dividends,

1371
01:04:08,840 --> 01:04:10,940
they still have earnings.

1372
01:04:10,940 --> 01:04:13,840
Well, that is until the
internet came about, right?

1373
01:04:13,840 --> 01:04:17,260
Then you had companies that
actually had no earnings.

1374
01:04:17,260 --> 01:04:20,320
So how do you valuate a
company that has no dividends

1375
01:04:20,320 --> 01:04:22,750
and has no earnings, and
has negative cash flows?

1376
01:04:22,750 --> 01:04:25,390
In fact, if you use those
models, the more negative

1377
01:04:25,390 --> 01:04:27,610
the cash flow, the
higher the value.

1378
01:04:27,610 --> 01:04:30,280
So something weird is going on.

1379
01:04:30,280 --> 01:04:32,260
It has to do with
the fact that these

1380
01:04:32,260 --> 01:04:35,230
are meant to be steady
state formulas, and not

1381
01:04:35,230 --> 01:04:37,900
formulas for individual
time periods.

1382
01:04:37,900 --> 01:04:39,820
If there are individual
time periods where

1383
01:04:39,820 --> 01:04:42,460
you have zero cash flows or
negative cash flows because

1384
01:04:42,460 --> 01:04:45,400
of growth, you'll have to make
adjustments in the formulas,

1385
01:04:45,400 --> 01:04:47,495
and I'll show you how to
do that in a few minutes.

1386
01:04:47,495 --> 01:04:47,994
Yeah.

1387
01:04:47,994 --> 01:04:49,785
AUDIENCE: Do you have
to change the formula

1388
01:04:49,785 --> 01:04:53,980
if, let's say, the board decides
to change dividend [INAUDIBLE]??

1389
01:04:53,980 --> 01:04:56,140
ANDREW LO: Well,
again, this formula

1390
01:04:56,140 --> 01:04:58,390
is really meant to be steady
state dividends, right.

1391
01:04:58,390 --> 01:05:01,420
So if they change the dividends,
what you should not use

1392
01:05:01,420 --> 01:05:02,290
is this.

1393
01:05:02,290 --> 01:05:04,420
What you should go
back and use, which

1394
01:05:04,420 --> 01:05:06,880
is going to be a bit
more complicated,

1395
01:05:06,880 --> 01:05:10,720
is this, the bottom
equation, right?

1396
01:05:10,720 --> 01:05:13,250
So this equation
is always correct,

1397
01:05:13,250 --> 01:05:14,770
because this is
completely general.

1398
01:05:14,770 --> 01:05:17,510
Dividends at time t plus
k out into the future.

1399
01:05:17,510 --> 01:05:21,100
And so if you know the
future path of dividends,

1400
01:05:21,100 --> 01:05:24,610
or if you have an expectation
of what that future path is,

1401
01:05:24,610 --> 01:05:26,060
you can use this formula.

1402
01:05:26,060 --> 01:05:28,240
But look how difficult this is.

1403
01:05:28,240 --> 01:05:30,730
I mean, think about
how an equity analyst

1404
01:05:30,730 --> 01:05:33,324
has to make his living.

1405
01:05:33,324 --> 01:05:34,990
They've got to figure
out, not only what

1406
01:05:34,990 --> 01:05:37,850
the appropriate discount rate
is, which is hard enough,

1407
01:05:37,850 --> 01:05:39,350
but they've going
to figure out what

1408
01:05:39,350 --> 01:05:41,890
the appropriate path
of dividends are,

1409
01:05:41,890 --> 01:05:45,550
not just what the dividends
will be in steady state,

1410
01:05:45,550 --> 01:05:48,100
because they may not
be able to do that.

1411
01:05:48,100 --> 01:05:50,260
They may want to figure
out what the dividends are

1412
01:05:50,260 --> 01:05:53,080
going to be next year, the year
after, the year after that.

1413
01:05:53,080 --> 01:05:55,200
So there's a lot
of work to be done.

1414
01:05:55,200 --> 01:05:55,700
It's hard.

1415
01:05:55,700 --> 01:05:57,220
It's hard work.

1416
01:05:57,220 --> 01:06:00,220
But more importantly,
it's not just hard work,

1417
01:06:00,220 --> 01:06:02,527
it's actually very
inaccurate work.

1418
01:06:02,527 --> 01:06:04,360
In other words, it's
really hard to estimate

1419
01:06:04,360 --> 01:06:06,860
this thing with any degree of
accuracy, so what do you know?

1420
01:06:06,860 --> 01:06:09,390
You know you're going to
be wrong most of the time.

1421
01:06:09,390 --> 01:06:15,080
Imagine a job where you go into
the job knowing that if you do

1422
01:06:15,080 --> 01:06:17,510
really well, you're a genius.

1423
01:06:17,510 --> 01:06:19,010
You're at the top of your class.

1424
01:06:19,010 --> 01:06:22,850
You're the best that's
ever done this thing.

1425
01:06:22,850 --> 01:06:27,510
And in that case, you're going
to be right 52% of the time.

1426
01:06:27,510 --> 01:06:29,100
52% of the time.

1427
01:06:29,100 --> 01:06:31,680
That means you're
wrong 48% of the time.

1428
01:06:31,680 --> 01:06:33,180
That's pretty discouraging.

1429
01:06:33,180 --> 01:06:35,790
But that's really the
nature of this task.

1430
01:06:35,790 --> 01:06:37,020
It's really hard.

1431
01:06:37,020 --> 01:06:40,110
You know, it's like trying
to do weather forecasting,

1432
01:06:40,110 --> 01:06:43,440
but weather forecasting
over the next 30 years,

1433
01:06:43,440 --> 01:06:46,140
and then taking the sum total
of all of those decisions,

1434
01:06:46,140 --> 01:06:48,300
putting it into a portfolio,
and then investing

1435
01:06:48,300 --> 01:06:51,100
your life savings in that.

1436
01:06:51,100 --> 01:06:52,850
That's kind of tough, right?

1437
01:06:52,850 --> 01:06:54,670
But it's also exciting.

1438
01:06:54,670 --> 01:06:57,470
Yeah, question?

1439
01:06:57,470 --> 01:06:59,010
OK, oh yes.

1440
01:06:59,010 --> 01:07:05,494
AUDIENCE: [INAUDIBLE]
If dividend

1441
01:07:05,494 --> 01:07:07,478
is going to change
in the future,

1442
01:07:07,478 --> 01:07:11,942
wouldn't this formula be
likened to the annuity equation?

1443
01:07:11,942 --> 01:07:15,117
So that point in time when
it changes, for which--

1444
01:07:15,117 --> 01:07:15,950
[INTERPOSING VOICES]

1445
01:07:15,950 --> 01:07:18,810
ANDREW LO: You would use
the annuity discount formula

1446
01:07:18,810 --> 01:07:20,050
in pieces.

1447
01:07:20,050 --> 01:07:23,790
So for example, if the cash
flows for the first 10 years

1448
01:07:23,790 --> 01:07:26,370
look like one thing, and
then the next 20 years

1449
01:07:26,370 --> 01:07:27,764
look like another
thing, and then

1450
01:07:27,764 --> 01:07:30,180
the next 30 years look like
something else, what you could

1451
01:07:30,180 --> 01:07:35,169
do is apply the annuity discount
formula to the first 10 years,

1452
01:07:35,169 --> 01:07:36,960
and then apply the
annuity discount formula

1453
01:07:36,960 --> 01:07:39,480
with a different discount
rate and a different cash flow

1454
01:07:39,480 --> 01:07:42,330
to the next 20, and then
discount that back and then

1455
01:07:42,330 --> 01:07:44,290
discount that back
10 more years,

1456
01:07:44,290 --> 01:07:48,030
and then do that to the next
30, and then discount it back

1457
01:07:48,030 --> 01:07:49,020
to the very beginning.

1458
01:07:49,020 --> 01:07:50,550
So exactly.

1459
01:07:50,550 --> 01:07:54,510
That's the way to do it,
which is effectively doing it

1460
01:07:54,510 --> 01:07:58,470
like this, but it's hard.

1461
01:07:58,470 --> 01:08:03,750
I mean, it's hard enough to
estimate cash flows next year.

1462
01:08:03,750 --> 01:08:06,060
And I can tell you
there are a lot of firms

1463
01:08:06,060 --> 01:08:09,695
that have forecasted this
year's cash flows last year are

1464
01:08:09,695 --> 01:08:11,070
scratching their
heads, wondering

1465
01:08:11,070 --> 01:08:13,050
how they can be so far off.

1466
01:08:13,050 --> 01:08:17,580
Now imagine doing
it 30 years hence.

1467
01:08:17,580 --> 01:08:20,430
I mean, it's an impossible task.

1468
01:08:20,430 --> 01:08:23,374
But at the end of the
day, it has to be done.

1469
01:08:23,374 --> 01:08:26,040
In other words, whether you want
to make those forecasts or not,

1470
01:08:26,040 --> 01:08:28,327
people are going to
trade your stock.

1471
01:08:28,327 --> 01:08:30,160
And so if you're not
making those forecasts,

1472
01:08:30,160 --> 01:08:32,160
well, somebody else is
going to, because they've

1473
01:08:32,160 --> 01:08:33,569
got to trade the stock.

1474
01:08:33,569 --> 01:08:35,520
So what we want to
do is to figure out

1475
01:08:35,520 --> 01:08:39,510
a slightly better mousetrap
of understanding what

1476
01:08:39,510 --> 01:08:41,729
those forecasts are telling us.

1477
01:08:41,729 --> 01:08:46,760
And if we can literally
get 52% correct rates,

1478
01:08:46,760 --> 01:08:49,609
we're going to be rich beyond
our wildest expectations.

1479
01:08:49,609 --> 01:08:51,481
That's really hard to do.

1480
01:08:51,481 --> 01:08:53,689
And it's just the nature of
this particular endeavor.

1481
01:08:53,689 --> 01:08:57,620
It's very difficult to estimate
cash flows, discount rates,

1482
01:08:57,620 --> 01:09:02,984
and risk conditions so
far out into the future.

1483
01:09:02,984 --> 01:09:04,427
Question, yes.

1484
01:09:04,427 --> 01:09:06,806
AUDIENCE: You said we could
use this formula to calculate

1485
01:09:06,806 --> 01:09:09,770
the firm's cost of capital.

1486
01:09:09,770 --> 01:09:11,859
I'm wondering why
would we do that?

1487
01:09:11,859 --> 01:09:13,760
Why do I care about
the firm's cost?

1488
01:09:13,760 --> 01:09:16,729
I think it's much more
interesting to calculate

1489
01:09:16,729 --> 01:09:18,651
the growth rate [INAUDIBLE].

1490
01:09:18,651 --> 01:09:21,109
ANDREW LO: Well, in order to
calculate the cost of capital,

1491
01:09:21,109 --> 01:09:22,468
you need the growth rate.

1492
01:09:22,468 --> 01:09:27,630
AUDIENCE: OK but,
I mean, I think

1493
01:09:27,630 --> 01:09:29,799
it's easier to get
the cost of capital

1494
01:09:29,799 --> 01:09:32,250
and guess the growth rate.

1495
01:09:32,250 --> 01:09:35,387
I just don't understand why I
would be interested in getting

1496
01:09:35,387 --> 01:09:36,696
to know this firm's cost--

1497
01:09:36,696 --> 01:09:38,279
ANDREW LO: In the
cost of capital, OK.

1498
01:09:38,279 --> 01:09:42,359
Well, you would have to wait
about another seven lectures

1499
01:09:42,359 --> 01:09:45,132
for that, because there
is a reason why you care

1500
01:09:45,132 --> 01:09:46,590
about the cost of
capital, and that

1501
01:09:46,590 --> 01:09:50,850
is that if you're trying to
decide how to spend your firm's

1502
01:09:50,850 --> 01:09:55,140
money, if you're a CFO
and you're allocating cash

1503
01:09:55,140 --> 01:09:57,450
across different
activities, you need

1504
01:09:57,450 --> 01:10:00,000
to know what your
firm's cost of capital

1505
01:10:00,000 --> 01:10:02,940
is so that you get a sense
of what the opportunity cost

1506
01:10:02,940 --> 01:10:04,980
versus taking that
money and investing it

1507
01:10:04,980 --> 01:10:07,960
in other opportunities
outside the firm.

1508
01:10:07,960 --> 01:10:10,290
So in order to make decisions,
you need that number.

1509
01:10:10,290 --> 01:10:13,650
AUDIENCE: If I'm in [INAUDIBLE],,
as an investor outside,

1510
01:10:13,650 --> 01:10:16,380
like, looking at the
stock market, [INAUDIBLE]??

1511
01:10:16,380 --> 01:10:17,922
ANDREW LO: Well,
you do, in the sense

1512
01:10:17,922 --> 01:10:19,671
that you want to know
whether you're going

1513
01:10:19,671 --> 01:10:20,770
to get your money's worth.

1514
01:10:20,770 --> 01:10:23,910
I mean, if you're investing
in one company versus another,

1515
01:10:23,910 --> 01:10:25,530
in order to make
that decision, you

1516
01:10:25,530 --> 01:10:28,130
need to know what the
rate of return is, right?

1517
01:10:28,130 --> 01:10:30,270
So it's actually
quite important.

1518
01:10:30,270 --> 01:10:32,540
It's very important
for decision-making

1519
01:10:32,540 --> 01:10:34,322
what that number is.

1520
01:10:34,322 --> 01:10:35,530
AUDIENCE: Right after return.

1521
01:10:35,530 --> 01:10:37,350
It's not cost of capital.

1522
01:10:37,350 --> 01:10:39,432
If I look it that way.

1523
01:10:39,432 --> 01:10:41,390
ANDREW LO: So let's call
it the rate of return.

1524
01:10:41,390 --> 01:10:42,520
That's right, yeah.

1525
01:10:42,520 --> 01:10:45,560
Well, and by the way,
the reason that I always

1526
01:10:45,560 --> 01:10:48,140
use four or five names
for the same quantity

1527
01:10:48,140 --> 01:10:50,777
is to sensitize you to
the fact that people

1528
01:10:50,777 --> 01:10:52,860
look at these numbers from
different perspectives.

1529
01:10:52,860 --> 01:10:55,800
So when I use the
term cost of capital,

1530
01:10:55,800 --> 01:10:58,380
I'm thinking about it as
a corporate manager who

1531
01:10:58,380 --> 01:11:01,050
has internal funds that
are going to be deployed

1532
01:11:01,050 --> 01:11:02,490
in different activities.

1533
01:11:02,490 --> 01:11:09,060
And the cost of that capital
as a CFO is given by r.

1534
01:11:09,060 --> 01:11:11,790
Now as an investor
external to the company,

1535
01:11:11,790 --> 01:11:13,960
I'm thinking about how
to invest my money.

1536
01:11:13,960 --> 01:11:16,920
I want to know what
my rate of return is.

1537
01:11:16,920 --> 01:11:21,060
And as a regulator that
wants to understand

1538
01:11:21,060 --> 01:11:23,670
what the appropriate
capital charge is

1539
01:11:23,670 --> 01:11:26,460
for different kinds of
activities that are going

1540
01:11:26,460 --> 01:11:28,980
to be appropriate for
borrowing and lending,

1541
01:11:28,980 --> 01:11:32,730
I also need to know what the
appropriate risk adjustments

1542
01:11:32,730 --> 01:11:34,930
are to that particular number.

1543
01:11:34,930 --> 01:11:36,650
Yeah.

1544
01:11:36,650 --> 01:11:40,350
AUDIENCE: I was
wondering how frequently

1545
01:11:40,350 --> 01:11:43,760
the companies actually
change their dividend policy.

1546
01:11:43,760 --> 01:11:45,530
Is it every year,
every few years?

1547
01:11:45,530 --> 01:11:48,290
And also are there exceptions?

1548
01:11:48,290 --> 01:11:51,290
Like is there a
reason sometimes where

1549
01:11:51,290 --> 01:11:54,190
a company who is, like,
growing to issue dividends,

1550
01:11:54,190 --> 01:11:57,320
or for a company that's got
a lot of cash to not do so?

1551
01:11:57,320 --> 01:11:59,400
ANDREW LO: So that's
a great question.

1552
01:11:59,400 --> 01:12:02,030
The question is how companies
set their dividend policy.

1553
01:12:02,030 --> 01:12:04,550
The short answer
is that companies

1554
01:12:04,550 --> 01:12:09,980
don't like to pay dividends
unless they know for a fact

1555
01:12:09,980 --> 01:12:14,760
that they can maintain the level
for a good long period of time.

1556
01:12:14,760 --> 01:12:16,460
And the reason is simple.

1557
01:12:16,460 --> 01:12:20,840
When a company cuts dividends,
that's considered bad news.

1558
01:12:20,840 --> 01:12:23,570
No matter how you slice
it, when a company decides

1559
01:12:23,570 --> 01:12:27,560
to reduce its dividends, the
typical response is uh oh, it's

1560
01:12:27,560 --> 01:12:31,250
cash-strapped, or it's in
trouble, there's a problem.

1561
01:12:31,250 --> 01:12:34,280
So once you know that, then
as a corporate financial--

1562
01:12:34,280 --> 01:12:35,900
chief financial officer--

1563
01:12:35,900 --> 01:12:37,520
you will not
recommend to the board

1564
01:12:37,520 --> 01:12:41,330
to cut dividends unless there's
a really significant issue

1565
01:12:41,330 --> 01:12:42,200
with the firm.

1566
01:12:42,200 --> 01:12:44,690
And therefore, as
a result, you're

1567
01:12:44,690 --> 01:12:47,720
not going to either
pay or raise dividends

1568
01:12:47,720 --> 01:12:50,030
unless you think you
can support that level

1569
01:12:50,030 --> 01:12:52,550
for a good long time.

1570
01:12:52,550 --> 01:12:54,560
So because of that
reason, you're right,

1571
01:12:54,560 --> 01:12:57,560
dividends don't get
changed very often.

1572
01:12:57,560 --> 01:13:01,100
And actually, it's quite
costly in some senses

1573
01:13:01,100 --> 01:13:03,044
to change that dividend
policy, not just

1574
01:13:03,044 --> 01:13:05,210
from the corporate perspective,
but from shareholder

1575
01:13:05,210 --> 01:13:05,780
perception.

1576
01:13:05,780 --> 01:13:07,113
AUDIENCE: What about exceptions?

1577
01:13:07,113 --> 01:13:10,080
Like why would a
company currently

1578
01:13:10,080 --> 01:13:12,200
do something that
is different from--

1579
01:13:12,200 --> 01:13:14,280
ANDREW LO: There are
exceptions because

1580
01:13:14,280 --> 01:13:16,770
of certain circumstances that
are unique to the company.

1581
01:13:16,770 --> 01:13:19,800
For example, a company
could be in a cash crunch,

1582
01:13:19,800 --> 01:13:22,560
like, right now, because of
some kind of capital charge

1583
01:13:22,560 --> 01:13:27,660
due to a certain underperforming
securities, in which case

1584
01:13:27,660 --> 01:13:32,190
they may declare a temporary
suspension of dividends.

1585
01:13:32,190 --> 01:13:34,440
The other side of the
equation is that a company

1586
01:13:34,440 --> 01:13:35,920
may have gotten a big windfall.

1587
01:13:35,920 --> 01:13:38,156
They just decided
to sell a division,

1588
01:13:38,156 --> 01:13:39,780
and they've got a
large amount of cash.

1589
01:13:39,780 --> 01:13:41,220
They don't know what to
do with all the cash,

1590
01:13:41,220 --> 01:13:43,140
so what they'll do is
that they'll pay out

1591
01:13:43,140 --> 01:13:45,240
an extraordinary dividend.

1592
01:13:45,240 --> 01:13:47,700
Extra ordinary
dividend, which means

1593
01:13:47,700 --> 01:13:50,790
that it's a one-time thing,
and then from that point on,

1594
01:13:50,790 --> 01:13:53,458
they'll go back to a
regular dividend policy.

1595
01:13:53,458 --> 01:13:53,958
Yeah.

1596
01:13:53,958 --> 01:13:55,902
AUDIENCE: What
does a [INAUDIBLE]..

1597
01:14:05,690 --> 01:14:09,172
How you want to invest
in billions of dollars.

1598
01:14:09,172 --> 01:14:12,420
Do you borrow money to invest
versus [INAUDIBLE] dividend

1599
01:14:12,420 --> 01:14:13,009
[INAUDIBLE]?

1600
01:14:13,009 --> 01:14:15,300
ANDREW LO: Well, it depends
on how much money you have.

1601
01:14:15,300 --> 01:14:18,602
It depends upon what your
shareholders want to have done.

1602
01:14:18,602 --> 01:14:20,060
I mean, that's
certainly a decision

1603
01:14:20,060 --> 01:14:21,726
that a corporate
financial manager would

1604
01:14:21,726 --> 01:14:24,050
have to make in concert
with the shareholders,

1605
01:14:24,050 --> 01:14:25,850
as well as the CEO.

1606
01:14:25,850 --> 01:14:27,992
And that's a strategic decision.

1607
01:14:27,992 --> 01:14:29,450
But in order to
make that decision,

1608
01:14:29,450 --> 01:14:31,574
you've got to have a few
things at your fingertips.

1609
01:14:31,574 --> 01:14:34,052
You've got to have the
opportunity cost of capital.

1610
01:14:34,052 --> 01:14:36,260
You've got to figure out
what your borrowing cost is.

1611
01:14:36,260 --> 01:14:37,400
And in order to figure
out your borrowing

1612
01:14:37,400 --> 01:14:39,780
cost, what do you need
to know about your debt?

1613
01:14:39,780 --> 01:14:43,555
AUDIENCE: [INAUDIBLE]

1614
01:14:43,555 --> 01:14:44,430
ANDREW LO: How risky.

1615
01:14:44,430 --> 01:14:47,292
And how do we measure
risk with corporate debt?

1616
01:14:47,292 --> 01:14:48,750
We just talked
about it last class.

1617
01:14:48,750 --> 01:14:49,534
Hint, hint.

1618
01:14:49,534 --> 01:14:50,320
AUDIENCE: You got to rate it.

1619
01:14:50,320 --> 01:14:51,986
ANDREW LO: Yeah, you
need a rate, right.

1620
01:14:51,986 --> 01:14:54,540
So you have to figure
out whether or not

1621
01:14:54,540 --> 01:14:57,450
the cost of funds from
internally-generated sources

1622
01:14:57,450 --> 01:14:59,670
is cheaper or more
expensive than going

1623
01:14:59,670 --> 01:15:01,470
to the external capital markets.

1624
01:15:01,470 --> 01:15:05,400
Right now, I would say that
it's extremely expensive

1625
01:15:05,400 --> 01:15:08,280
to go out into capital markets,
if you could do it at all.

1626
01:15:08,280 --> 01:15:10,530
If you're going to
raise money, you're

1627
01:15:10,530 --> 01:15:12,270
going to be paying
up through the nose.

1628
01:15:12,270 --> 01:15:16,170
General Electric credit
default swap today

1629
01:15:16,170 --> 01:15:19,440
was priced at 700 basis points.

1630
01:15:19,440 --> 01:15:23,420
This is AAA-rated security,
at 700 basis points credit.

1631
01:15:23,420 --> 01:15:25,020
It's crazy!

1632
01:15:25,020 --> 01:15:27,077
But people don't want
to lend right now.

1633
01:15:27,077 --> 01:15:29,160
So if you want to borrow
in capital markets today,

1634
01:15:29,160 --> 01:15:31,010
good luck.