Video transcript
Welcome to my presentationon return on capital. Let me write that down. I'm using the wrong color. Let me use a nicer color. Let me go to white. I want to do this presentationfirst, because I think this is really going to give you the bigpicture on how you should think about what somethingis worth. Whether you should investyour money into it. And how you should weigh thedifferent options you have in terms of what you actually haveto do with your money, in terms of where youwant to put it. Do you want to putit in the bank? Do you want to buy a house? Do you want to pay offyour credit cards? Et cetera, et cetera. So let's just definereturn on capital. And just so you know, I'm notnecessarily going to be strict on the accounting conventions,or the GAP conventions -- that's the accountingconventions in this country. I'm going to do it more on ahands-on, how Joe Investors should think abouttheir money. So in this scenario, I definereturn on capital as just the cash you get per year divided bythe total cash you put in. And, well, I don't wantto just say, cash. There's other ways tomeasure return. But actually, to keep it simple,let's just say cash. So let's think abouthow this works out. Let's say, I have an idea. I have a restaurant. And that restaurant, it'llcost $1 million. It'll cost $1 million investmentin this restaurant. It's going to be a $1million investment. And let's say that, per year,after paying all the expenses, after paying the utility, afterpaying the employees, after repairing, andmaintenance, and after paying taxes, everything, let'ssay this restaurant makes $100,000 a year. And that's after taxesand everything. That's what goesinto my pocket. So in this situation, my returnon capital, the way I've defined it, is $100,000divided by $1 million, or we could just say a thousandthousand dollars, equals 10%. Pretty straightforward. You're probably saying,Sal, this is silly. Why are you wasting my time? Well, maybe it is. But I think you'll find thatthis is going to lay a foundation that will eventuallyblow your mind. So let's keep going. Let me do another. OK, so I said the restaurant-- let's make it a pizza restaurant -- let's just say,the restaurant return on capital is equal to 10%. Right? I can put in $1 million and I'llget in $100,000 per year. That's where I got 10%. Let me write that down. I get $100,000 per year offof $1 million investment. Now, that's one project. I'm not going to factor inthings like risk and probabilities just yet. Let's just say, for sure, I knowthat if I put my money here, I'm going to get10% on my money. And let's say the otheroption with my money is a beauty parlor. And let's say that thatalso costs $1 million. And this beauty parlor getsme $50,000 a year. I think it's very obvious to youalready which investment you'd rather invest in. Because the return on capital onthis beauty parlor is only 50,000 divided by amillion, or 5%. So this is obvious. You'd rather do the restaurantthan a beauty parlor. And in general, after adjustingfor risk, you always want to go with the projectthat has the higher return on capital. And, later on, there will benuances in terms of when you get that return. Maybe you would rather have aslightly lower return if you get the money faster. Or a slightly higher return ifyou're taking on risks, et cetera, et cetera. Or to compensate for risk. So we know we want todo the restaurant. But do we definitely wantto do the restaurant? We'd rather do the restaurantthan the beauty parlor, right? But my question to you is, dowe definitely want to do the restaurant? And this is where the returnon capital becomes interesting. Because what matters, beforewe put the money into the restaurant, is to thinkabout what the cost of that money is to us. And this is what I think willbe a little bit of a new concept to you. So I'm going to introduce you,now, to the notion of a cost of capital. So let me erase this. OK. So the restaurant costs$1 million. And it gives me $100,000a year. And that's a 10% returnon capital. Now, let's say I have toborrow all the money. And there's some bank that'swilling to give me all the money for this restaurant. And the interest rate on thisloan is, let's say, 15%. Is it still a good idea for meto open up the restaurant? Well, if I have a loan and Ihave to borrow the whole amount -- so I'm going to havea loan for $1 million to buy that same restaurant. And I'm going to be charged 15%in interest every year . And I'm not going to take taxes,and the fact that you could deduct taxes, et cetera,et cetera , into account just yet. Let's assume that my totalcost is 15% per year in interest. So I'm going to haveto spend $150,000 per year in interest. So my question to you is, doesit still make sense for me to open up this restaurant? Every year, I'm going to bemaking $100,000 from the restaurant itself. But I'm going to be paying$150,000 a year in interest. So you'll probably say, Sal,once again, you have just restated the obvious. No, you would not want todo this restaurant. Because every year,$50,000 will be burning out of your pocket. Now, you might think that thisis obvious, but I'm going to show you many, many examples ofwhere people are actively doing this. People who you would otherwiseassume could do this type of math. And it's especially happeningin the housing market. But anyway. So in this situation, youwouldn't want to invest in it. And a very simple way ofthinking about this is you'd only want to invest, you onlywant to do a project, if your return on capital is greaterthan your cost of capital. This is the only time that youwant to invest in a project. With that said, I'm notgoing to go back to what we just did. I just showed you something thatwe thought was obvious, but I'm going to re-askyou a question. So we had the restaurant. And we have the beauty parlor. Let's call it BP for short. They both cost $1 million. Let me write ROC. The ROC of the restaurant,we said, was 10%. And the ROC on the beautyparlor, we said, was 5%. So right now, superficially, itlooks like the restaurant is just a better project. But then we said the cost ofcapital, so the interest rate. How much does it cost for usto get that $1 million? The interest rate to borrowmoney for a restaurant is 15%. And we said that this isnot a good investment. Because our cost of capitalis higher than our return on capital. And you could do the mathand figure it out. But what if there was some kindof government program? They just felt that thereweren't enough beauty parlors in the country. And they were willing to giveyou a really cheap loan to buy a beauty parlor. And the government program, theysaid, we're going to give you a low-interest loan of 2%. So my question to you is,now, which project would you rather do? Superficially, it looks likethe restaurant was better. You get a 10% return,as opposed to 5%. But your cost of capital, theinterest rate you would have to pay on a loan for the beautyparlor, all of a sudden looks a little bit better. In fact, this is actuallya good investment. Because your cost of capitalis less than your return on capital. We can even do the math. Every year the beauty parlorwill generate $50,000. And you'll be paying $20,000in interest. So you'll be netting $30,000 without havingto put any money for yourself. You'll be borrowingall the money. So clearly this is agood investment. So that's it, now, for the introon return on capital and cost of capital. And in my next presentations,I'll go into a little bit more detail and do a few morenuanced examples.
