What is a stock? What is equity? What are shares? What an animal is or a thing is, is extremely important to understand before getting caught up with numbers. Let's look at it. Boring part. What is it? Another form of financing. If you give me that answer I would have to say you right but it's not very uplifting. We already know that. How's it different from a bond? Think about the word equity stock share. It doesn't necessarily show a contract or a relationship that are specific. We know what a bond is. A bond is a contract. If I don't know how much you're going to pay me back in the future. I'm not going to sign up and give you money today. Is it an IOU, really? Now let's think about a stock. What is stock? Is stock an IOU, really? Answer is maybe. Let me show you what a bond does. This is so fascinating. Here's a bond and let's stick with our long-term bond. It says 10 years and in your head what are you thinking 20 periods. It says face value 1,000 and says coupon rate of 6 percent. You know that actually, 10 years is 20 periods, you know 1,000 will come at the end and you know that every six months you'll be paid three percent, which is 30. This to me is an IOU. Suppose this is issued by say, IBM. You know the entity that's issuing it and you know that the rating companies will tell you whether it's a good bond, AAA, whatever. I want you to recognize though the relationship between the yield to maturity of the bond and the risk of the bond is a very intimate one. I want you to remember this. I'll say this many times. There's no such thing as a good risk or a good return. Risk and return match each other. This is one of the things that is very, very profound about finance. You get what you pay for typically. This is an IOU. What does a stock [inaudible] IBM same. You've got a piece of paper? Sure. It says you own one share of IBM. Now tell me, is that an IOU? The beauty about this is you are willing to give money without a promise and that's so awesome. Think about it. I know the Wall Street and financial markets and financial institutions are getting beat up by the public. In my view, you have to remember this very clearly. One of the most awesome things created by people, by us, is a stock. A willingness to give money without a contract in return. It's the most fascinating thing created, but it's like the ring in Lord of the Rings. It's a good ring, not a bad one like that one. However, everything great created has been abused by humanity. That to me is not the problem of the stock it's the problem of humanity. Let's keep going. Who gets paid first? You are a company who's going to borrow, you issuing a bond or directly from a bank. You also issue stock, but who gets paid first? The contract, the bond. What good does the stock get? Whatever is left over. How are you paid back? This is the definition. You could pay back in two ways. For a bond, what is the periodic one? Coupon. Here it's called dividend. What is the other way you get paid in a bond? You get the face value. What's the difference between a bond and a stock? A bond as a contract has an end. A stock doesn't have an end. If you want to end the stock what do you have to do? Remember one thing very simply, you always control things. Don't let others control you. You could always sell the stock. Selling price. This could be a capital gain or a loss. Let me just share a couple of things about this and we'll get into detail. Companies do not have to pay dividends. It's not a contract. Similarly, companies don't know their own stock price in the future. They're not promising you anything yet you are investing. The reason is very simple. This is how most value is created by taking on new ideas, new risks. Does equity have a life? Answers what? No, fundamentally. Of course, do companies disappear over time? Yes, they do. In fact, that's the beauty of competition. Competition if let loose means that you will not survive forever. However, you have to recognize that when stocks are issued they are not a contract. Unlike a bond, they don't promise you anything and unlike a bond, there's no finite life. Now, tell me what else in life except love is similar to this, where you give in the expectation of getting but you don't have a contract signed. That's what I really like about stocks. Stocks is our ultimate belief in the future. Clearly you want something in return. But it's not, you don't want to tie down and make it a contract. Just so that I get into this a little bit better and get you a feeling of what's going on. Believe, this is far more important than understanding the mechanics of things. Both will be covered in this class but not. Let me repeat some things to show you the beauty of bonds and stocks. Equity also is called stocks and we have also started off with, we know what bonds are. Here's the thing, where is value created quickly? Here. This is where value creation happens. The thing that your idea does is, it generates cash flow. Do you know what it's going to be in the future? Answer is no and that's the beauty of it. Because things are not known, the cash flow bounces around. But the cash flow is generated by your real asset, your ideas. Then what happens? You have to finance it. But when you go financing it, you start with equity always. Because why would anybody give you a loan if you don't have your skin in the game. Typically when things start, entrepreneur start, they put in their own money, the family money and so on, I'm doing a fascinating venture fund at the Ross School of Business as part of a bigger structure. What we do is we try to invest in companies that are creating value and also having social impact. The reason I'm bringing it up is equity investment is the first thing any entrepreneur does and borrow and gets from other people to participate in. The equity happens and what is happening, you're giving up your resources or money in the creation of value over here. But then many companies also have debt. But this is right, this is an explicit contract. Just recognize one thing. If I make $10 million tomorrow, who gets paid first? First of all, very obviously, this guy because it's an explicit contract. Then what do we do? We pay the stockholders. But we may not necessarily pay the stockholders. In fact, let me give you an example. If you think of Microsoft in 1980s, '90s, the one thing you'll see is it never paid dividends, never paid out anything yet the price kept going up. We'll talk about these issues in a second as we go deeper down this week. But I want you to recognize that just because it's paying out money it doesn't mean it's good news. In fact, companies with great ideas do what with that 10 million after they've paid the bondholders? They reinvest in better ideas for the future. We'll talk about that in a second. But the point I'm trying to make here is, the key difference is, you generate 10 million from your existing ideas you first pay off your bondholders. Last point, very important. In generating your real asset value, your cash flows, remember how did we go from cash flows? How did we get cash flows? Revenues minus costs, minus capital expenditures and so on. Each one of those is also a contract. Why? Because if you are working in a fair competitive market, every supplier should have a contract and revenue is generated through contracts. In fact, if you walk into a store, the price should be on the commodity. That's a contract already. Why I'm raising all these important issues is everything on that snapshot is a contract, except what? Stocks. That's why it's one of the most fascinating things to understand and to see a thriving market in. I wish almost all of us have the ability to own the future of what we collectively are trying to create. I repeatedly come back to the issue. Stock markets have done great but the day they are the greatest it is when almost all people in the world have the option to participate. It's like it would be better than elections. What I want you to do now is just before we get into the pricing, I want you to take a little break. Think about what I've just said because what I've said is not simple. It's not widely understood and is extremely important to jumping into the pricing of a stock because we are going into La La Land now. We're going to know a dimension where things are not written on a piece of paper, we have to use our imagination. See you soon. Bye
