My name is Boris Zimmern of. I'm delighted to be here. I'm a graduate of Rahman Commerce, it's exciting to be back at the alma mater and I am also extremely, extremely delighted to welcome here professor me here decide. Excited for a whole slew of reasons, one of them also, in addition to being an alumnus of Rothman, being an alumnus of Harvard Business School and professor Desai being a professor at both the Harvard Business School and Harvard Law School. So extremely delighted and wanted to share with you folks, ahead of welcoming professor Desai on stage, wanted to share a tiny bit about his background with you, but but before I do that, I wanted to also acknowledge that the land in which the University of Toronto operates has, for thousands of years, been the traditional land of Huron, when dot, the Seneca and, most recently, the Mississauga's of the Credit River. Today, this meeting place is still home to many indigenous people from across Turtle Island and were grateful to have the opportunity to work on this land. Thank you, in terms of introducing professor Desai, he is the Missoula Financial Group, professor of finance at Harvard Business School and, as I mentioned, a professor of law school. At Harvard Law School, he is an award-winning teacher and a leading scholar of corporate finance and tax policy, who has been educating students for over 20 years, students which include corporate executives, MBAs and undergraduates, as well as lawyers. He has published over 25 cases and a several of his books. Two of his books have been published already, that I understand. There's a third one on the way. The first, which is called the wisdom of finance, was the 2017 Financial Times and McKinsey business book for 2017, and now
we're here to talk about how finance works- the HBR guide to thinking smart. Many of you have been handed a copy of the book, a signed copy, when you arrived, and there will also be a number of copies available later for a sale when we adjourned at 6:00 pm. Before here joins us on stage, I wanted to just very quickly share a couple of interesting tidbits that I gleaned from from his background. One is: we're all very international, multicultural here in Toronto and in Canada in general, so it's interesting to know that Professor Desai was, was raised in India, in Hong Kong, in New Jersey, and then, in addition to that, he is prominently featured in something called the elevator mentor, which is a very, very nice, fun video with with him, and, and further, he is a co-host of After Hours, a podcast, and in looking at the podcast, I saw that the podcast talks about it being a professor's in cars with coffee getting coffee with professors in the car, something of the sort. If you're familiar with the comedian's getting getting coffee and in cars the the YouTube video. So enough for me, and I want to welcome professor mahir
Desai on stage. Please give a huge round of applause. [applause]. Thanks so much. It's such a pleasure to be here in Toronto and thank you for all for coming out on such a night. It's really kind of you. Everyone, in fact, has been so wonderfully kind, including Unr and Boris, who are sponsoring this, and Steve who made everything happen. Everyone's been so kind. The weather is so terrible it's. It's unfortunate when stereotypes live up to what they say they are supposed to be. So let me just get started on this and feel free to come a little closer. We're hopefully gonna make this somewhat interactive. I'm gonna go for maybe 45 minutes and then we'll do some QA, but I do have a couple of interactive things. So if you'd like to come a little closer, that would be great. So let me just begin with a little story, which is: this book came out in April and when your book comes out. And you know, I guess I'm still Ikki enough to do this. What you do on publication day is you go to every bookstore you can find because you want to know if your publishers are doing their job. Of course I go to every bookstore that I can find and I go. And I go to the Harvard bookstore right on Mass Ave in Cambridge and I walk in and of course it's rather awkward thing to do because you're asking if they have your own book, but that doesn't deter you because you're so excited because your book has just come out. And so I go up to the guy at the counter and I said: you know, just curious, you know, do you have this book? It's called how finance works. And he smiles and I'm thinking this is great, must be flying off the shelves. And then he says: does that have a
question mark? At the end, and in the moment I was so nervous about what he was going to say, whether they had the book or not. I didn't understand what he was saying. But of course what he was saying is how finance works, like as if finance works. And that, of course, is the prevailing skepticism about finance, which is: it doesn't work and it isn't working, and how could you be writing a book called how finance works, having thought
over that? Just so you know the end of the story. They were there well-stocked and I was very happy, but it's struck me as a reminder of how skeptical people are about what finance is, and in part, the book is an effort to address that and to demystify finance. As with the other book that I've written, I think finance gets demonized, sometimes for very good reasons, but a lot of it comes from the fact that people outside finance are intimidated
by finance, and we have to open up the world of finance to people, and these books are efforts to do that, and so I'll take you through a couple of ideas about that. Let me just begin by saying I'm going to start with a story, and in truth, I'm doing a little market research for my next book. So this is meant to be the opening story of the next book, and I'm just curious if it resonates with you, but it also can serve a little bit for this book as well. So here's the story. Can anybody actually see this?
Okay, great, so if you're in the back, I'll try to read this for you. But here's the story. So it's about four or five years ago and iconic hedge fund guy Bill Ackman is asked about iconic corporation GE and iconic CEO Jeff Immelt at the time. Ge has just announced they're divesting their financial business. This was a big deal at the time, okay, okay. So I want to just tell you what Ackman said, because I think it speaks volume volumes about the state of capitalism. Now I'm going to tell you what he said and I'm hoping you'll tell me what you think it means. If it's just a story about GE and Bill Ackman, I don't really care. So I think it's a story about something much more. So I'm curious what you make of this story. So here's what Bill's Ackman says- and I apologize, they'll have to stay here for this microphone.
What do you think about GE and Immelt and so a lot of very talented CEOs, training programs I'll greet here. And then he says: but there's always a but, but I think it's been a terrible place to learn how to invest money. Ackman Qi is actually an extremely well operated company and, as you may know, it was a. It was a factory for producing CEOs and other companies. And then he says: but it's a. It's been an absolute failure in terms of the way they've allocated capital. They've not done a good job with capital generated by the Corps. But now I think GE peers have gotten religion. Headline
Ackman says: General Electric, great operator, terrible investor. Okay, so no pressure. But I'm kind of hanging the next book on this story. What do you think he means? And if this is just a story about GE and Bill Ackman, I don't really care. But what is he really saying about what it means, about the nature of capitalism today? Any ideas? Oh, by the way, later we'll be running a little few contests and I'll give away a few copies of the previous book, so we'll try to make it interactive that way, but for this question, there's no copy giving away. What do you think he's saying here? I'm just curious. What do you think he means? Any ideas? What he means: yes, capitalism has nothing to do it. Capital has nothing to do with producing widgets. Indeed, and what's he saying about what
the job of a CEO is? What do you think he's saying? Yes, yeah, sorry, you are fantastic, Alfie. No, so I think you're getting at this. I think what Ackman is saying is at its harshest. He's saying: managing is nice, but it doesn't really matter. What matters is investing, and in fact I think that says a lot about what it means to be a CEO today. I think what Ackman is saying- Alfie knows along your lines- which is
managing is good, but you know, what what really matters is investing, which is unsurprising cuz that's what Ackman does with his life. But it's also something he's saying about CEOs, and I think this signifies the rise of investor capitalism, not shareholder capitalism, but investor capitalism. The rise of professional investors is the defining feature of the last 40 years. It has happened without us even knowing it, and they have a very specific world view, and that world view is both fantastic and kind of horrible when taken to excess and money. The problems that we witnessed today are the culmination of that world of you. So, in part, what I want to do in this book and in this talk is take you through that world view and try to explain to you what that world view is, and then in the next book I'm gonna try to explain why it's both fantastic and terrible that they've come to dominate capitalism. So let's just talk about what that world view is. You know, said another way. This statement is: you make one big capital allocation miss pay mistake. You make one ten billion dollar merger mistake, you cannot manage your way out of it. You can try, but it's over. That's the essence of this view, okay, so let's try to walk through what that view is. I'll try to walk you through a couple of
ideas about what that view is. The first is just to try to explain why finance is so complicated and why life can't be more simple, which is a question I asked myself more and more. Second, try to think about the defining nature of what it means to be an investor and the way they look at the world, because, for better or worse, that world view infects every part of capitalism, it infects every nonprofit, it infects the way governments think about policymaking and it is infecting everything. It infects academia, and so we've to kind of think about what that worldview is. So I'll try to take you through that, and then maybe I'll take you through, if we have time, a little bit of an outline of the next book, and hopefully along the way we'll play a few games and have some fun as well. All right, so here's the question that we should just ask, which
is: why can't life be more simple? So I'm not sure if you can see this picture, but in this picture, life is simple, which is what: there are companies who need capital and there are households who supply it. If only life were so simple, because this is what finance is supposed to be about. Finance is supposed to be about getting capital from people who have it- suppliers of capital- to people who demand it- firms. Now why is life in fact, not so simple? Because life does not look like this. Life instead looks like this and if you
can see this in the back, in short, it's a picture of the mess of capital markets and, in fact, life is not simple. In fact, life looks like this and is filled with a bunch of people who are doing various things called finance and that many
people look at it and view it entirely with skepticism. On the screen here you have institutional investors and page funds and pension funds and sovereign wealth funds. You have broker dealers, you have analysts, you have the media, you have a complex web of dollar flows, incentives and information. It's a mess. Many people look at this world and they say: occupy. It's a little bit of a dated reference. There's this thing called Occupy Wall Street. Anyway, forget it. Ok, it's like eight years ago now, but they basically say: look at all that disgusting stuff in the middle, look at all those gross people in the middle. It's all financed and they're a bunch of leeches. Because, you know, the only real people is us households and the real companies. Those people do real things, we're real. And then there's all this junk in the middle and all they do is they suck value. I'm open to that view, but before we end up with that view, we should try to give the alternative view. What are all those people in the middle doing? What problem are they solving? Because if they're just sucking value, we should get rid of them all. What are all those people in the middle doing? What problem are they solving? I'm sorry, it helped determine the prices. Why do we need so much help determine the prices? I don't know. It's not that complicated. I'll tell you what. Why don't we just listen to what those people tell us
about their projects and then we'll put their money, our money, in them and we could get rid of all this garbage? If they're not solving like a really big problem, we should get rid of them because they're sucking a lot of value out of the system. What problem are they solving? Yes, they're bridging the gap between who needs capital and who has capital. Guess what? We have these things called pipes that could bridge the gap. Pipes don't get paid a lot of money. We'll put the money in one end of the pipe. It'll come out the other end of the pipe. I'll tell you what. You spread it evenly. Why not? What problem? What problem are they solving if it's just a pipe? Pipes don't
get paid a lot of money. Pipes just don't get paid a lot of money. What's wrong? There has to be some deep, deep problem. If they're not solving a deep problem, we should totally do the Occupy thing, expedited the acquisition of knowledge. You know what? We have these things called computers, okay, but now it's like
super fast and like I don't know. Why do we need them? Occupy? Can households really interpret the financial information? Why do we need to interpret it? We'll just read it whatever it says. It says: what's the deep problem here? Yes, well, we're trying to use that capital in its most efficient way. That's what capitalism is. But why do we need all that junk in the middle to do that?
We don't need all those people in the middle. We just have these good people who are called managers and we have good people called households, and life is good and life is simple and and occupy. What's the problem they're solving? Yes, sorry, people lie. Ah-hoo lies, everybody lies. Ok, so it's an uplifting thought. So I think you're onto something. You are sorry, goal, Joel. So, Joel, I think Joel's on to something. All those people in the middle are solving the biggest problem in modern capitalism. Which is what? Which is asymmetric information, and it is the principal-agent problem. You know what does that mean? What that means is, 150 years ago, most of us had the privilege of working for ourselves, and now managers are different than owners. And guess who has all the information? Managers, and who doesn't have all the information? Owners? And that problem is the problem of modern capitalism.
Once you see it, it is everywhere. The scale of enterprise has demanded the separation of ownership and control. And guess what people lie? Who has all the information about the companies? The managers. Can you believe them? No, not because they're bad, but some of them are, and so we have to be really thoughtful. And that information problem is the deep problem. Once you think about that problem, you will see it everywhere. I'll walk you through a couple of examples and then we'll play a game. So, CEO announces a small earnings Mis.
I promised you 25 cents of earnings per share. I delivered 24 cents. It was the web there, don't worry about it. Stock price drops by 10%. Ceo says it was the weather. Why does the stock price drop by 10%? What is everyone thinking when he says it's the weather, don't worry about it. Liar, liar, liar, liar. Ceo announces: as part of my normal portfolio rebalancing, I will be liquidating a small fraction of my shares. What are you thinking if you hear that? Liar, liar, liar, liar, the person with all the information is selling? Ceo. Cfo announces share buyback. Ooh, very interesting. The people with all the information are buyers. Very nice, bye, bye, bye. This is everything that's going on in capital markets is an interpretation and a feeling about what that game is. Private equity becomes a major asset class in the last 20 years. Why, in part, don't deal with all that garbage.
I'll come along, I'll be one big owner, I will solve this for you and I will sit on you like a hawk and watch you like a hawk. That's the private equity answer. Is that a salvation to this problem? That turns out they have their own problems, cuz guess what they're gonna monetize their investment by doing what, taking their company public back into that game right there, and they're gonna make themselves look particularly good right before they do that. Everything in finance is one big informational problem. That's what this whole game is about. The people who you think of as being terrible activists and short sellers, those nasty people, maybe they're the heroes. They're the only ones who will tell you the negative news. Everyone else is positive. They may be the ones who will say: no, wait a second, it's a liar. Now, of course, they're not really heroes because they have their own incentive and information problems, because they are allocated capital and they have to get their returns for their funders. Life is one big daisy chain of principal-agent problems. Think about it this way: you're some Canadian pension,
you have appointed an agent- it's called the CPP, IB or OMERS or whoever- and that Canadian pension fund manager is your agent. Guess what? She, the woman who runs those Canadian pension funds, has appointed David Einhorn, some hedge fund guy, to be her agent because she has allocated capital to him. Well, guess what? David Einhorn has decided to invest in tim club an apple. So Tim Cook is the agent of the principle, David Einhorn, David Einhorn is the agent of the principle, the Canadian pension plan manager and the kitchen. Canadian pension plan manager is the agent of some principle. You all of modern capitalism is a daisy-chain of principle agent problems, and that's why Finance is so much fun, because it turns out that set of problems is really hard. Ok, so this will give us a way to start playing our
game and have some fun. So and understand the first big principles that we'll learn about: the way people in finance and investors think about the world. So the first big pillar that we'll talk about is: we only believe in one thing: we don't believe in accounting. You think accounting and finance like each other. They're the same. We actually hate each other. Finance is a reaction against accounting. Why? Because we only believe in one thing in finance, we only believe in cash. Why do we only believe in cash? Because they're liars.
Cash is something that you can't change and it's not subject to manipulation. So what have we developed over the last 50 years? We've developed a vocabulary around cash. This is gonna sound a little extreme, but I'll try it out for you. Which is here's? There's a little short history of modern capitalism. The way we've talked about businesses have changed. What do we do? 50 years ago, we talked about the top line.
Then we start talking about the bottom line, that's net income, and then we're like, now, that's not the right thing to talk about. We should talk about EBIT, create finance acronym- earnings before interest in taxes. We're like, nah, that's not a good way to talk about business. We should talk about EBIT da. What does iva da, ub, da is? Yeah, we got to add back some of that non-cash expenses, that depreciation, amortization, and then we're like nan, that's not a good way to talk about business. We should have an operating cash flow. And they're like mad, that's not a good way to talk about business. We're gonna talk about business in the finance nirvana way, which is free cash flow. Free cash flow did not show up in conference calls 20 years ago. It is now the dominant way we talk about business. That doesn't happen by accident. That happens because investors are dominant. These are very different ways
to talk about a business and they have consequences for the way you run businesses. When people start talking about free cash flow, when they never used to, people behave differently. So just briefly, because there's gonna be a quiz that follows this in about two minutes, here's the way to think about this. So what's the difference. Yeah, revenue can't quite be right because you
got to think about costs. Obviously we should be talking my profit. And then you're like, now we shouldn't really be talking about net income, why not? Well, you don't want to talk about all costs, you don't wanna somewhat interest in taxes? Will somebody bit operating income? And then you're like now we're gonna add back that da. And they're like, yeah, there's all that working capital stuff that really matters for a company that actually has cash flow consequences. And then we're like, nah, you got to worry about catbacks. That's the recipe for free cash flow. That's why people in finance get so excited about it. Okay, so now we can play a game. It's going to be hard. This is a hard game to play in any space, but in this space is gonna be really hard. But I have faith in you. So here we go. If you get this right, you get to win a book, not the book you have, but the previous book. I will say I did this at a reunion recently. It did not go well, so I'm hopeful someone will get this. We'll see. I think you have like a one in six chance. Here we go, and given the logistics, it might be
worse. Okay, can anybody see this in the back a little bit? Nobody wants to play the game. I can tell already this: the excitement is: it's, it's not. It's not a quiz, it's just a game. Okay, here come three companies. The three companies are Amazon, Tesla, Netflix. We just tell you briefly about each one. Amazon is an e-commerce company with one largest cloud computing companies buried inside of it. Tesla is an electric car manufacturer and a solar company. Netflix is a video streaming business. Okay, every, okay with that. Okay, all you have to do is tell me which ones which? Okay, I'll describe them to you. Company. Can you, even in the middle, like right there, can you see this? Okay, feel free to come on up. There's a book at stake. So here's the first one. The first one: hey, nothing much happening. Profitability looking fantastic. Whoa, operating cash flow- disaster. And free cash flow- just like operating cash flow. Very interesting company too: h, nothing much happening, no profits. Operating cash flow- always better than profits. A lot better, hugely better. Free cash flow used to be less than operating cash flow. Now it's a lot less than operating cash flow. Hcompany, three things are moving along: blue line is the profit line and not so great. Operating cash is looking better. Yeah, free cash flow- disaster, but maybe free cash flows coming back most recently. Okay, all you gotta do is tell me who's who. Okay, you take 30 seconds, you talk to the person next to you and you figure out which is which. Let me just remind you of a quick thing. What's the difference between
these measures? Oh yeah, profitability is just accounting, that's just costs. Operating cash flow takes into account all the working capital of a business. I know this is hard, but don't worry, it's okay, it's it's only gonna get harder. And then, finally, free cash flow is. Let's take out the capex. I need to keep investing in. All right, everybody ready. Take talk to the person next to you, just tell me who's who. You have 30 seconds to figure it out, alright. Alright,
let's do this. Stakes are high. We're giving away a book. Pressures intense. You have a one in six chance. You have to get all three correct. You have to get all three correct to win the book. All right, we have a gentleman right there. Let's give that gentleman of a chance with. So number one is Amazon, number two is, and number three is great. You are woman, ok, huaman.
How do we feel about Wallman? Okay, sorry, woman, one out of three. Woman, one out of three. So now, if you go next, you better not make it worse. Anybody got a strong feeling about this and we want to give it a shot. Give it a shot. Let's get somebody in the back way back. Hello back there. Somebody back there. Give it a shot. You got a microphone? Okay, doubt you are. My name is a Shub and I think you can see this from here. I'm trying to show it. So, if it's worse, you know what's been the factors. So, yeah, so I think the first one is actually with the second one, that's Amazon, third one is Tesla and first is Netflix. That's my guess. How do we feel? A shot by the shop, yes, wins a book. Send me an email, I'll send you a copy in the book. A shop, that's fantastic. I job, all right. So let's just talk about this and understand why. It tells you why we, the way we measure business matters. So a shot. Let's talk about number one, that's Netflix. What's the dead giveaway that this is Netflix? Ishod? Forget about the stock price job it on the rise, with investors speculation because they're looking as let's talk about this. So their profits are like this, yeah, and their cash flows are going like this, basically because they've taken up a lot of investment in terms of in-house production and they haven't been producing the cash that's necessary. So profit and cash: there's a disconnect. And, just to be clear, profit looks fantastic and their working capital is actually fifteen billion dollars a year of content. Okay, that is not running through their income statement but is running through their cash flow statement exactly. And then there's no capex, because that's not what they do. They just invest in content. Free cash flow and operating cash flow are kind of the same mm-hmm. And that tells you to defray different stories. A shop about Netflix. Story number one is: life is going to be fantastic as long as you're watching Netflix and chilling. And just to be clear, here's the full story: a job. The full story is: I got pricing power in the us- 1199, $12.99 North America. I'm gonna start charging higher and higher prices. They won't even notice. It'll be fantastic. Then I go to India and then I go to Brazil and then I go to China and I pump out the same content there and life is fantastic. And then everybody's watching Delhi, crime everywhere all around the world and life is good, mm-hmm. And the alternative view is, you will never generate a dime of cash, and you never have, because you will be writing a hundred million dollar checks to Dave Chappelle for as long as matters. And that's before you have to compete with Disney plus an Apple Plus for content. Oh and by the way, Disney's at $4.99 a month and apples at $5.99 a month. There goes your pricing power. One of those two stories will turn out to be true if we meet. In ten years. Amazon profits were never that great. Operating cash flow has always been fantastic. For a long time, people said, Oh, Jeff Bezos doesn't know how to make money. They didn't realize they were looking in the wrong place. They were looking at profits. Bezos always made tons and tons of cash. How does Bezos make so much cash? He pays very little. What does that mean? Well, but that wouldn't make sense of May. That may be true, but that doesn't make sense of my. Operating cash flow is amazing and profits are not. What is he doing? What is he running? That is amazing. That generates mountains of cash even though people are like you don't make any money. And of course, he's like sitting on piles of cash. Cuz, yes, he does. Yes, right there, he's got negative working capital, which is a way of saying he takes a long time to pay his suppliers. He collects quickly. The whole business was built on that model. That's how he funded his huge growth. That's no accident. That's a finance view of the world. And then, by the way, more recently capex turns out has gotten big. If you look at them now, they're actually capex intensive. That's AWS, that's Whole Foods, that's retail Tesla final version, operating cash flow better than profits. Those are all the customer pre payments. That makes them really cash flow positive. They've been investing a ton of money into the ground. That means free cash flow is really low. And what's gonna happen over time? Two very different views. One view is: we poured all this money into the ground. We're now a technology company. Life is great. Other view: you're gonna be putting money into the ground for the next 30 years. You'll never generate an ounce of cash, SIA in bankruptcy court again. One of those two views will turn out to be true in ten years. But this gives you a sense of why cash is so important in the finance world view. Leading companies do this in a very different way. I'll give you one more picture. So are you are the person to talk about negative working capital. Your? What's your name? Wally? So, Wally, let's just talk about this idea. So this is what life looks like for most
people. This is like the mundane part of running a business. Like you're running a hardware store. You have to buy hammers, you sell hammers, takes you a while to collect the cash while a and then you have to pay for the hammer. That sounds like operations. It's really finance. While they. Okay, I'm gonna show you one more company and give away one more book. Here we go. This is gonna be really hard. Last time you have like a one six chance ashab of getting it. Now it's like 1 in 5000. I'm gonna show you a
picture. You just have to tell me what company it is, and there's like 5,000 or 10,000 choices. Okay, here we go. This is 30 years of data. I'll just walk you through the colors and you just tell me what this is. So this is just that mundane stuff. You're like this is in finance, except it really is. So the red line- I'm sorry, no, let's do. The green line- is how much inventory they hold. Used to be like 60 days of inventory is now 3, ok. The red line is how quickly they collect from their customers used to be 60, now it's 20, and the purple line is how long they take to pay. Their suppliers used to be 40, it's now 120. You have a 1 in 10,000 chance. Take 30 seconds, talk to the person next to you. What company is this? This is ridiculous, but you got the last one right, so sorry. And that last line, the blue line, is the
working capital, the net of those three. While I so, they used to have positive working capital. Now they have huge negative working capital. So it's just the difference between those three things. Before it's kind of, now it's
flipped. The time they take to pay somebody is far longer than the time they need their cash for all. Right, let's do this. Gentleman in the argyle sweater: it is not Procter and Gamble, it is not. They would not. It would look somewhat similar, but they haven't done anything so dramatic. Well, a lot of people don't. But who is this? This is somebody very distinctive who I think somebody's going to get. Only, we don't want to have 10,000 guesses. So if you're feeling confident in the back right there, yes, it is not Walmart. They've made changes in this direction, but nothing so dramatic. Who is this? No clues, come on you. This is like that. There's a book at stake here. Yes, you are sorry, it's not coca-cola. I think this is simpler than you think it might be. The problem with this company is: people don't admire it for this. They admired for other stuff, but it turns out this is like what you should be admiring about this company. Yes, right here on the Isle, this is Apple. Indeed, this is Apple.
This is what you should be admiring about Apple, not as iPhone 11. What have they done over the last thirty years? They have transformed themselves. How did they do it? First, they went into retail. That means you collect really quickly from your customers. Look at that inventory. They went into retail and they operate with three days of inventory. That is absurd. How do you operate a retailer with three days of inventory? Where is all the inventory? When you go to New York, to the new Fifth Avenue store, and you say, can I have the new MacBook? Will it be there? Yeah, it'll be there. How do you operate a retailer with three days of inventory? So are you are, Jason. Send me an email, I'll send you a
book, Jason, how do you run a retailer with three days of inventory? Just in time, where is all the inventory, Jason, I'm sorry. Sorry, on-site, it's not in the store, it's not on Apple's balance sheet, it's with the suppliers. What does Apple do? Every night down Fifth Avenue, they call up Foxconn and they say: I'd like a thousand Mac books at 7:00 am in the morning. And what does Foxconn say? Yes, sir. And then what does Apple say? I'll pay you when I feel like it. And what does Foxconn say? Yes, sir, this is what Tim Cook built. This does not happen by accident. It is an incredible financial model and it's using cash. It's using suppliers to finance themselves. It does not happen by accident and it's about generating operating cash flow far in excess of profits. That's why they're sitting on piles of cash. Okay, it also helps explain why they have a
beautiful balance sheet. Let's just take a look at the Apple balance sheet so you can appreciate the finance perspective. This is a very simplified version of their balance sheet. I'll just walk you through quickly. You tell me what's beautiful about it. They have net cash of around a hundred and thirty billion. I say they have a lot more cash. You take out the debt. That's their net cash. They got equity of one hundred and eighteen. They got total assets of 374, we've got total liabilities and Charles negative. 370 for operating assets have got to be 240, for operating liabilities it's got to be 256. Anybody see anything amazing
in this picture? This should bring a tear to your eye. What's beautiful about this picture? Take 20 seconds. Just talk to the person next to you. What's beautiful about this picture? Look at the symmetry and see if you see. If you see, if you see a beautiful symmetry, okay. So let's go to
the symmetries. One possible symmetry is: some people look at the cash number and they're like: oh, that looks a lot like the equity number. That's interesting. Other people look at the operating assets and see it's the same number as the operating liabilities and they say that's interesting. Some people look at the totals and they say they're the same and that's interesting. That's not interesting. In fact, I think the interesting thing is not that cash looks like equity. The interesting thing is that operating assets look like operating liabilities. Why is that beautiful? What does that a mean? It means there's no debt, that's for sure. But it means more than that: operating assets are the same as operating liabilities. What does that mean? They could handle a downturn. That should really bring a tear to your eye. What does that imply? Yes, I shot, I'm sorry. Their liquidity is good. It implies more than that. Here's what it implies: they don't need any capital from outside to run the business. The capital intensity of this business is negative. That's a beautiful thing. They don't actually use external capital. That's amazing. That's a incredible financial model. That's why this is what Tim Cook built. How did he do it? You outsource everything and then you run your suppliers ragged and you push them hard. If anyone's ever been a supplier to Apple, it is miserable. They've been accused of bankrupting their suppliers. They've run roughshod over them and you get a beautiful economic model that looks like this, which means you use nobody's external capital, which is amazing. Okay, let's do a couple more things and we'll give away one or two more books. Then we'll pause. The next big question in finance is
where the heck does value come from. It's like the biggest question in the world. What is value? Where does it come from? Turns out there are pictures like the one on the left, that's Apple. Turns out they're pictures like the one on the right, that's Avon. A lot of value creation is a lot of value destruction. How does that happen? So Finance has got a simple answer to that. Okay, where does value come from? Am i creating value? It's like the biggest question in life. What's the Finance answer to that? Let's play a little game to see if we can do it together. By the way, sometimes it looks kind of like in
the middle. This is BP. Are they creating value? I don't know. So let's play a little game to talk about where value comes from. This will be even harder, but you did well when you one in 10,000 chance, so I have faith. Here comes a little exercise. This will be really hard, but hopefully it'll give
you a sense of the big ideas of Finance in a simple way. All right, I'm gonna give you a couple of facts and here's what you have to tell me. We're gonna talk about Finance versus accounting. There's this thing called Book value. That's accounting. What does that mean? How much money did you put in? And there's this thing called market value. That's finance. What does that mean? Look into the future. Tell me what you're worth today. Okay, we're gonna compare those things in something called a market to book ratio: market value over book value, finance over accounting. Okay, here we go. This is gonna be really hard, but it's gonna get better. I'm gonna tell you a couple of things.
You're gonna put a hundred dollars into this business. The return on capital is going to be twenty percent. You're gonna do it for ten years and then you're gonna liquidate it and you're gonna give the money back and then, finally, you're gonna keep half the money in the business. You're gonna pay out half. Everybody understand basics of the business, everybody. Okay, okay, all you have to do is tell me what's the market to book ratio. Here's the good news. There's only four choices, so you have a one in four chance. First choice: the market to book ratio is bigger than one. Second choice: the market to book ratio is equal to one. Third choice: the market to book ratio is less than one. Fourth choice: I don't know, why did I come here tonight? I didn't know there was gonna be a quiz. Every understand the choices. Greater than 1. Equal to 1. Less than 1. I don't know. Ok, let's try to get participation rates in this vote greater than typical American electoral participation rates, more like Canadian electoral participation rates. So let's see if we can do this. Everybody has to vote, ok, ready. Greater than one smattering equal to one
slightly smaller smattering. Less than one similar kind of smattering, I don't know. Oh, get me out of here. Fantastic, so are you. Are you said I don't know? Indeed, you need the book. Actually, you probably don't, because you have the right answer. Why is the right answer? I don't know. You have a great intuition. Not enough information. You are Fiona.
What's missing? You don't know the answer. This because you don't have enough information. If you don't know what's missing from this little story? Not everything, just one thing: you'd risk always a good thing to say in finance, absolutely, you're who said risk risks always a good thing. Yeah, and in particular, the thing we're missing is a discount rate. To think about value, you need a discount rate. What does that mean? What do we do in finance? We look into the future. You have all the information of the future. What you don't have is the risk penalty that you apply to those. Treat your cash flows to bring them back to the present. That's the essence of value. Okay, now you have a
discount rate. This is really hard, but I think if you get this intuition, it's a big idea and you'll walk away with a big idea tonight, okay, so here we go. Now there's only three possibilities. You can only vote for one of three things you can't say. I don't know anymore. So are you, are Fiona, so Fiona, this time? No more. I don't know. Is the market to book ratio bigger than 1, equal to 1 or less than 1? Everybody ready to vote? By the way, participation rates in the voting last time we're pretty American, not terribly Canadian, so
let's try to get them a little bit higher. Here we go. Who says it's bigger than 1? A little bit more equal to 1? 1 or 2, less than 1? Bunch, fantastic. Anybody want to explain? Who said bigger than 1 in the red sweater? Sorry, right there. Yes, you. You want to explain why. So the return on investments higher than the, then the cost of capital? That's all you needed. That's it. You are Isabel. Fantastic, Isabel. Let's take a look at Isabel. This is the spreadsheet that you can build this weekend with your loved
one. You do that. What do you do? Oh, you make twenty percent every year. You pay out half, Isabel, you discounted back at fifteen percent. You put the money back. That's left. You do it again, and you do it again, and you do it again, and you do it again, and you do it again, and at the end of the ten years you have the present value of all those future cash flows. That's today's value. And you're right, Isabel, it's greater than one. Fantastic, Isabel. Let's do it again. Everything's the same, except now.
The return on capital is 15- 20 seconds. Talk to the person next to you. Greater than 1, equal to 1. Less than 1- 20 seconds. What is the market to book ratio going to be? 20 seconds. Talk to the person next to you. This is gonna get. This is hard, but actually I think there's gonna be a payoff to it. This is really, really hard. Anybody got a good feeling about this? Greater than 1, equal to 1. Less than 1, the market to book ratio is going to be: give it a shot. Sorry, you are in the black turtleneck. Yup, sorry, Martin, it's greater than 1. Why so? It's greater than 1- fantastic. Anybody want to disagree? And we want to disagree just right in front it with the jacket. Less than 1, why half of it? Fair enough. Anybody want to put the last thing up, which is it's gonna be equal to 1 in the back? Yes, yes, you, sorry. You are sorry, Tiffany. So what do you? What's the answer? Equal to 1, sorry, they balance each other out. Tiffany, tiffany, tiffany, tiffany. The market, raesha will be one. Will it be 1.000000? Oh, Tiffany, yes, it will be Tiffany, and this is the harsh logic of finance. You think you're a king or a queen, because you've got a 15% return. And what does finance a? Yeah, you could have stayed in bed. The world is no better for you. That is the harsh logic of Finance.
One last time: return on capitals: 10%. Everything else is the same, Tiffany. What's the answer? Gonna be less than one, not, Tiffany, you could have stayed in bed, Tiffany. You should have stayed in bed, Tiffany. This is the harsh logic of Finance. Okay, if we understand this, we should be able to do this final little game and then we can pause. Here's the final game. This will be really, really hard, but I have faith in you now, and especially tiffany. Tiffany, i know this
is hard to see. Here's this entire table. We're gonna vary the return on capital. Those are the columns. We're gonna vary how long you do this- for five years, ten years, twenty years or thirty years, and then we're in a very. How much of the earnings are reinvested? Thirty percent, seventy percent, over 100 percent ever? To understand the basic configuration, okay, all you have to do is the following: and you win a book. Where's the highest market to book ratio, where's the lowest? And will there be any more Tiffany's? Tiffany's are 1.000000. The discount rate is always fifteen percent. This is really hard, but if you get this, you walk away with a big lesson from finance about where value comes from. Take twenty seconds. We need the highest market to book ratio, the lowest market to book ratio and are there any Tiffany's? And a book is on the line. You have to get all three questions right. Take twenty seconds and talk to the person next to you and try to figure it out. Alright, let's do this. Anybody feeling it? And how many earnings
are reinvested? So all the way on the bottom right, you say, is gonna be the highest. You are, mark. Where's the lowest number going to be? All the way in the bottom left, there, and will there be any Tiffany's? All the 15s or Tiffany's, no matter what, it's Tiffany all the way down, fantastic. How do we feel about mark? Mark, that is fantastic, exactly right. What is
this telling us? Where does value come from? Tiff, mark, where's the really exciting stuff? You beat your cost of capital. That's Isabel, 25 versus 15. But you don't do it for one year or two years, mark. That's not interesting. You have to beat your cost of capital for 30 years. Then it gets exciting and mark what's really exciting- you redeploy all those earnings inside the company at that higher rate of return. Now you're talking about 12 x value creation. That's wonderful, mark. What's the disaster? The bottom left mark. You're not beating your cost of capital, you're doing it for 30 years. You're doing something stupid. You're doing it for a long time. Oh, and then, by the way, we're gonna keep the money in the company and just keep doing stupid stuff. That's massive value destruction. And, Tiffany, it doesn't matter, because nothing matters in Tiffany's world. Keep it in, take it out, do it, Lord dude, let's do it for long, we do it for sure. Nothing matters because you're in Tiffany's world where you can just stay in bed. That's the essence of value creation, which is a way of saying finance has a very simple
recipe for value creation. It is what you gotta beat: your cost of capital, Isabel, if you're not beating across the capital, it's it. That's it. It's game over. Second, you got to do that for a long time. And third, you got to grow. And, by the way, Finance is no different than
strategy. Finance and strategy are the same. You got to beat your cost of capital. What do we call that? Product and process innovation? You got to keep that gap open a long time. What do we call that? Patents, brands, barriers to entry, and then finally you got to grow if you want the real value creation stuff that we think matters in life. Okay, and of course
that's kind of showing up when you look at a company like BP, who used to beat their caustic apple and no longer does. I won't do this too much, but it's from the previous book. The previous book is a way of saying that recipe of value creation is actually inherent in the human condition. This is the parable of the talents from the Bible in the book of Matthew. It's a story which basically has the same recipe for value creation and leading a good life that we teach in finance. The stories that come out of finance are not some alien thing coming out of portfolio theory in the last 30 years. They're deep in the human condition, and that's one example from that book. Okay, I've already gone way too
late. Capital allocation is, I think, just like free cash flow, a dominant frame on the way businesses run themselves. Today wasn't even showing up on conference calls thirty years ago. What is capital allocation? It's actually really simple.
What are you gonna do with all that free cash? Answer number one: you keep it. And it's number two: you pay it out. If you keep it, what are you gonna do? Organic or inorganic? You pay it out. What are you gonna do? Dividends or buybacks? What's been the pressure for the last ten years? Everybody's migrated down to the bottom. Buybacks, buybacks, buybacks- like you wouldn't believe, all around the world. That's either a fantastic deployment of capital or one of the great tragedies of modern capitalism. This looks simple. Bill Ackman is basically telling you: all you have to do right is get this right. You don't have to do anything else right to be a good manager. Why is it so hard? Well,
it's pretty simple. Actually. If you got positive NPV projects, what does that mean? Are you creating value, just like we talked about? You keep it. If you're not, you don't. Do you build or buy and similarly, do you pay it out as a dividend or buy back? Here's why it gets really hard. It turns out there's tons of pathologies involved in this, which is it's actually really hard to get right, and most of modern management is about trying to get this right and according to Akron and according many, that's what a manager does today: they allocate capital and that's all they have to do. Well, but that means internalizing a lot of the lessons that we've been talking about. Okay, I'm already over time. I won't do this last piece except to say, well, let me just show you. This is actually the new book, which is about the way these
investor capitalism arose and whether it's a good thing or a bad thing, and about how that happened. We can talk more if you're interested, and then finally, hopefully, what you take away from this. Most people think finance is about money. It's not. Finance is about the hardest problem of modern capitalism, which is that picture that we started with, and it turns out it's all about information and incentives. Everything that you see in finance is a reaction to that information and incentive problem, and once you put that front and center, everything else becomes more clear. There are the numbers of great ideas that are there. I do, the ideas around where value creation comes from, ideas about the way you kind of capture economic returns and the ideas of capital allocation. So hopefully that gives you a little bit of a taste of the book and it gives you a little taste of what finance is, most of all with the book endeavors to do, and hopefully what you take away from today, even though it was very tough, is many people are intimidated by finance and that's because people in finance like to intimidate you. The ideas in finance are actually very transparent. They are not rocket science and they're actually quite intuitive, and hopefully for the rest of your life, people won't be able to intimidate you, because that is a very hard way to live and there's nothing in finance that is particularly complicated, any more complicated than what we just did tonight.