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visit MIT OpenCourseWare at ocw.mit.edu. ANDREW LO: So what I want to do
in this lecture is to provide a quick overview of
the equity business, and then talk about a couple
of simple but rather powerful models to price equities-- we're
using the exact same tools that we've developed-- and then talk a bit about
growth opportunities and growth stocks. OK, so industry overview. What is equity? As I said, it's an
ownership in a corporation. And typically, when you own
a piece of a corporation, you're owning that
sequence of cash flows. There are two components
of possible cash flows for a piece of equity security. One is dividends. But, of course, we know
that there are companies that don't pay dividends. Typically, companies that are
early stage growth companies, they want to conserve
their cash, because they've got lots and lots
of investment ideas that they want to implement. And so any cash that's
generated internally, they're going to be plowing
back into current operations. So growth companies typically
don't pay dividends. But you still get value
from the security, because as the firm grows,
as the corporation becomes more valuable, that piece
of paper that you hold becomes more valuable. So in other words,
you get capital gains or price appreciation
of that piece of paper. And if you want to get value
out of that price appreciation, you could always sell it, right? So those are the two
ways of getting value. It's dividends-- and
by the way, there are two different
forms of dividends. Cash dividends or
stock dividends, both of which provide
additional value. But also the fact is
that you could sell it, and so you can get money
from capital gains. Now there are a couple of key
characteristics of common stock that are distinct from bonds. The cash flows we will
be able to analyze using the same tools, but
those tools will ultimately give us different answers,
because the legal structure for equities is
different than for bonds. And I have to say, that
whoever invented equities-- this is many, many
centuries ago-- really was a brilliant
financial innovator, because equities have just an
enormously powerful ability to provide proper motivation
and incentives for innovation, all sorts of innovation. And let me explain
what that means. First of all, one
aspect of equities that I think you
all probably know is that they are the residual
claimant to a corporation's assets after the bondholders. In other words,
bondholders have first dibs on the assets of the company,
but their claim on those assets is only equal to the face
value or promised payments of that debt, right? They don't have access
to any more than what the face value of that
bond is, as well as the coupons along the way. And to say that equity holders
are the residual claimant means that they get
everything else. Now you might say,
gee, that's not really all that interesting, because
you're second in line. Well, it's very interesting
if being second in line means that you get access to
all of the upside of a company's growth and success. I'm sure that you've all heard
of stories of entrepreneurs that have made many hundreds
of times what they put into a company, whereas the
bondholders may have gotten a handsome return
of 10, 15, 20%, but that's the upper bound
as to what they can get. As a bondholder, your upside
is capped, it's limited, OK? Whereas, as the residual
claimant, as the equity holder, you have no limit on
your upside, right? Because once the bondholders get
paid, you get everything else. Now the other aspect of
equity that's really important is something called
limited liability-- the fact that, as an equity
holder, the most you can lose is everything. Now that might not seem like
a good deal, but trust me, it's an amazing deal. By everything, we mean
everything that you put in, so it's not
literally everything. For example, you
don't lose your life. You don't lose your freedom. You don't lose your pinkie. You don't lose any other
body parts, or loved ones. All you are at risk of losing is
what you put in to the venture. So that's what limited
liability means. And the reason that
it's an innovation is, prior to the
modern-day corporation and limited liability,
it used to be the case that entrepreneurs
faced unlimited liability, or you could be put
in prison if you were to default on your obligations. The fact that there is a
downside limit to what you could possibly lose is a
tremendous boon to innovation, because now it means that
each and every one of you can go out and start
your own company and risk whatever money you
want to put into the company, but no more. And if it doesn't
work out, well, you can walk away and do it again. And I suspect many
of you know of so-called serial entrepreneurs
that just go from one company to another to another. Many years ago, when I
was at the Wharton School, I heard a talk by the person
who started up Domino's Pizza. I unfortunately don't
remember his name, but he was giving a talk
in one of these CEO series and he's a billionaire, because
of the incredible growth of Domino's Pizza
in the country. And somebody asked
this fellow, how did you know that having
a national pizza chain was going to succeed
as well as it did? And he's very honest. He said, you know,
I didn't know. You know, this was
my ninth company. The first eight went bankrupt. And if this one
had gone bankrupt, I probably would've
started a tenth. And I think that's just
a wonderful expression of the power of
modern capitalism and limited liability, because
here's an individual that just really wanted to do
something on his own and wanted to make
a success of it, and was willing to
work his heart out time after time after time
until he hit upon something that was really valuable. And that's the power
of limited liability. Think what innovation
would be if we decided that if your first company
fails, from that point on, you would never be allowed to
start a company ever again. Think how many people
would take the risk or take the plunge to do
something like starting up your own company. So the fact that we
have a security that limits your downside,
and that limits the downside of
other investors that want to join you in
your venture, really allows for capital
formation to occur at a rate and at a scale that would
be impossible without it. Now there's also voting
rights and the ability to access public markets. What that means is
that you can actually get other people, large
numbers of people, to co-invest with you. So that's particularly
important when you're thinking about taking on
very, very ambitious projects. For example, if you want to
start up a biotech company. Biotech companies require more
than a few hundred thousand dollars to get started. I think a few hundred
thousand dollars would maybe buy you a quarter of a
centrifuge these days. Doesn't really help for
starting up a biotech company. And so if we didn't
have the ability to access public markets, if
we didn't have the ability to bring the power
of the public to bear on a particular
investment opportunity, it wouldn't get done. So that combination of
limited liability and ability to access public markets,
and then voting rights that give investors some say
in how the company is run, is really the
secret to unlocking the power of the masses for
development of innovation and capital formation. Now there's another point
that I wanted to make here, which is short sales. I think that by
now you should have an appreciation for the
importance of short sales. Short sales allow information to
get into the market price that may not be positive
news, but is nevertheless important for people to have. And so the ability to
short sell a security is a method for
allowing investors to get information
into the market price as quickly and as
easily as possible. Those of you who participated
in the trading game that we did a couple of
weeks ago on that Friday-- you know, when we go over
the results towards the end of this course, when we talk
about efficient markets, I'm going to show you
that the prices that occurred in that marketplace
was not very efficient. Part of the reason that
it wasn't very efficient is because we didn't
allow you to short sell. And so those of you who had the
information that at one point the stock was worthless,
the most you could have done was to divest yourself of
shares that you already owned. But once you did that,
that was the end, and you're out of the market. You couldn't do anything more. If, on the other hand, we
allowed you to short sell, you would have driven that
price down to 0, where it belonged at that point. And so the ability to short
sell is a very, very important aspect of capital
market efficiency and for making prices as
informative as you can. Now there are two markets
for equities-- primary market and secondary market. Primary market means the
market where securities are issued for the very first time. Primary, that's
what primary means. Secondary you could think of as
the market for used securities. We have a market for used cars. You have a market
for used homes. And there's a market
for used securities. I know you don't really think
of the New York Stock Exchange as such, but, in fact, it is. It just turns out that
used securities are just as good as new securities,
and in many ways, better. And so the steps for getting
a primary security issued is very different than
the steps for dealing with secondary markets. For the most part,
what we're going to be talking about
in this course is secondary market
transactions and dynamics. However, there is
obviously a lot more to be said about
primary markets. I'm going to leave that to other
courses in the Finance group, including M&A and capital
budgeting and venture capital. Those are courses that
deal with the dynamics of the primary market. These are the markets
that you would care about if you're doing an IPO,
launching a new company, and issuing securities
for the very first time. So I won't spend too
much time on that. If you're interested,
you're welcome to read the relevant chapters
in the textbook. But what we're going
to do is to focus on the behavior of
secondary markets, in particular, in
the price formation mechanism for secondary
market securities. Here's a little bit
of a summary about how these markets have developed. You can see that
for primary markets, the IPO market goes
through cycles. There are periods where the
market's very, very active, and there are periods where
the market is pretty quiet and not a lot is going on. That has to do a lot
with the business cycle and with the credit cycle-- how
much money there is out there. And it's obviously very
important for those of you who are thinking
about doing startups, because when you do a
startup and you get funding from a venture capitalist,
the way the venture capitalist ultimately
gets paid is not by the satisfaction of being
part of your wonderful company, but rather by having
your company go public and having securities be
issued so that the venture capitalist can cash out at
those public market prices. So the venture capital
and technology industries are very much caught up in the
business cycle and credit cycle as well, and so this
gives you a little bit of a picture of how
that's changed over time. On the other hand,
the secondary market has a somewhat different
set of dynamics. It's related, but not
nearly as highly correlated as you might expect. This is an example
of the dynamics of public secondary
markets, the NYSE and NASDAQ over the last few years. What this displays is
the trading volume, both measured in terms
of shares as well as in composite fraction
on the NYSE volume. And you can see that
over time that the share volume, the amount
of shares traded, has just gone up year
on year, and this year will be no different. 2008 will be a tremendously
significant year for the amount of shares
traded on the exchange. Lots more participation in
public markets, and the volume, while there may be little bits
of a dip that are functions of business cycles,
not nearly as sensitive as the primary market is. Yeah. AUDIENCE: Is the internet
also, you know, more volume? ANDREW LO: Oh, absolutely. Well, there are a number of
technological innovations that have made this market
increase so quickly. So the internet is one. Now all of us can
trade on the internet. In fact, when I was teaching
Finance back in, let's see, was it 2000 or 2001? I remember during
the middle of the day one of the undergraduates
in the class looked at some kind of cell
phone device and then ran out. And he came back in shortly
before the end of class, and at the end of
class I asked him if everything was
all right, because he seemed really distressed. And then he said
that he just had to respond to a margin
call on his equity position that he'd put on the day before. This is an undergraduate. He's trading on his
little cell phone. That's a technological
innovation that has actually increased
the volume in these exchanges. But there are other
technological innovations as well. For example, something called
ECNs, electronic communications networks. These are-- essentially, they
started out as bulletin boards, where large buyers and
sellers of equities could come together
anonymously and transact with each other at relatively
inexpensive prices. They can cut out the middleman
and reduce the bid offer spread by hitting a transaction price
that was right in the middle. ECNs have grown tremendously
since the early, the mid 90s, when they started,
and now account for a pretty significant
fraction of the volume. Electronic order routing,
electronic trading, all of these technologies have
caused this kind of increase in the equity market trading
over the last several years. So today, as an
individual investor, you can trade much more quickly. You can trade much more cheaply. And you can trade much more
easily than ever before. So consumers have
benefited a great deal. Along the way, a number of
hedge funds and other investors have ended up going out of
business because they have not been able to compete
effectively with these kind of technological innovations. And this is what I mentioned
last time, that technology plays a very important role
in financial markets now, much more so than ever before. It used to be that it
mattered who you knew, rather than what you knew. That it was the old boys
network that mattered, instead of the computer network. And that the graduates
of Harvard and Yale had an advantage over the
graduates of MIT and Caltech. That's been flipped
on its head now over the last several years. It's what I call the revenge
of the nerds, which bodes well for all of you. [LAUGHTER] OK, so let me now turn to
the very first valuation model that was ever
developed for equities. It couldn't be simpler. It's a model that
I think all of you are going to
immediately understand, and yet the
implications are going to be really far-reaching
and profound. This is called the
Dividend Discount Model, and it starts with
the recognition that, when you invest in a
company, what you're getting for that piece of paper,
this common equity, you're getting the rights
to the flow of cash forever. And what kind of cash
are we talking about? Well, we're talking
about dividends. So it's true that not
all stocks pay dividends, but eventually you would figure
the stock will pay dividend at some point, right? For years, Microsoft
never paid a dividend. But about, was it five
years ago or six years ago? They announced that they're
starting to pay dividends. Why? Because they had
accumulated so much cash that they didn't have enough
things to invest that cash in, so they figured, let's give some
of it back to the investors. In their early days, they kept
every penny of their earnings to reinvest, because they had
so many different opportunities to take advantage of. But because they
became so mature and they had already a
number of investment projects that were quite
valuable, and yet were still generating
so much cash, they decided to return
some of it to investors. So at some point, you're
going to get dividends. And if a company never,
ever pays dividends, well, then, it should
be worth 0, right? If it pays you no cash
forever, then that seems like a very bad asset. Yeah. AUDIENCE: What stops the
board of directors [INAUDIBLE] really depends on [INAUDIBLE]
issuing dividends [INAUDIBLE].. ANDREW LO: Well, first of
all, if they issued dividends to pay themselves,
that's fine, as long as they pay all the other
shareholders at the same time. So the answer is, in
principle, nothing stops them, but what makes them
decide against that is if they have uses
for the cash other than paying themselves. If, as a company, you have no
idea what to do with the money you are generating,
well, first of all, that suggests that
maybe you're not doing your job,
because as a company, you're supposed to be coming up
with valuable ways of earning money for your investors. However, it may be that your
company is very mature, stable, there's no growth,
there's nothing going on, and all the cash that
you're generating you don't know what to do with. In that case, you may very
well return all of that money to investors. That's nothing wrong with that. The idea behind
having a vote though, is that you want to make sure
that the board of directors, who typically do own or are
responsible to shareholders that own large blocks of shares,
will be deciding in the best interests of the shareholders. And it could be that the best
interest of the shareholders is to give them
back their money, because we, the mature
company that we are, don't have any other
uses for the money. Yeah. AUDIENCE: [INAUDIBLE]
that, if the company never pays dividends, [INAUDIBLE]. What about the [INAUDIBLE]? Is there no value [INAUDIBLE]? ANDREW LO: Well,
but think about it. If a company keeps on
appreciating in value, but never pays out a dividend,
what's happening to the cash? You know, when I say
never, I mean never. So I don't just mean like
in 10 years or in 20 years. I mean never. So can you think
of a company that appreciates in
value all the time, but never, ever,
ever pays a dividend? There's no cash, so
you'll never get any cash. That's-- AUDIENCE: Well, then,
wouldn't you make a profit by selling [INAUDIBLE]? ANDREW LO: Oh, yes, you could
make a profit by selling, but if you sell a
security to somebody else and they know for a
fact that it never, ever, ever, ever pays any
money, well, then, that's called a
Ponzi scheme, right? In other words, you're
selling a piece of paper that's worthless to
somebody and hoping that they are a bigger fool than
you are for having bought it. So when I say it never pays
any cash, I really mean it. If it never-- if you know
for sure that it never, ever pays any cash, then it can't
be worth anything, right? If you don't believe that,
then I have a piece of paper that I would like you
to take a look at, and I would like
to sell you, OK? Yeah. AUDIENCE: Could it be like
coupons and, like, the company dissolves? ANDREW LO: What's that? AUDIENCE: Even if it
never pays dividends, you could still
get something back if the company
dissolves [INAUDIBLE].. ANDREW LO: Well, then
it does pay something. That's a liquidating dividend. Then that violates my
condition that it never, ever, ever pays anything, right? And that's the point. If the company is
growing and it has value, then you know for a
fact that either A, it will pay you a dividend
at some point, or B, if it doesn't and
it gets liquidated, then when it gets
liquidated, you'll get a pro rata
share of whatever's in the company, in which
case, that's a payment. So to say that a company
never, ever pays a dividend, I literally mean it will
never, ever pay anything, OK? And in that case, it
can't be worth anything if you know that. But if you can find somebody
who will buy it anyway, then that's an example
of an arbitrage. That's a free lunch. And so you can do that a lot if
you can find people like that. OK, so we're going to apply
the very basic principles of present value analysis to a
security that pays dividends. So let's let the
price of a stock, Pt, today, be given by that. Let Dt be the cash dividend
that gets paid at time t. And by the way, Dt could
be 0 for many, many years and at some point become
positive, all right? Dt can never be negative, right? We're not talking about
taking money from investors. It pays either a
positive amount or 0. And I'm going to let E
sub t be the expectation operator at time t. So now I'm going to
explicitly recognize that these dividends are
not known in advance. Unlike bonds, where you
know the coupons in advance, I don't know the
dividends in advance. So I'm going to have to guess. I'm going to have to make a
forecast as to what they are. And let me let r sub t be the
so-called risk-adjusted return that is commensurate with the
risks of the dividends that are there. I'm going to wave my
hands at this point as to how we get the
dividend discount return, the appropriate
risk-adjusted return, but I'll come back to that in
a few lectures, when we go over methods for determining the
appropriate risk adjustment, OK? But for now, let's
assume that we have it, and we get it from the
marketplace, right? Just like we got the yield
from the marketplace, it's a sum total of
everybody's fears, expectations, hopes, and so on. So with these
components defined, I'm now going to simply write
the price of my instrument as this value function of
the future cash flows, right? That's the most
general expression we started with on day one. And given what we now know about
present value and valuing cash flows that come in the future,
it's not a big leap of faith to put some structure on
this valuation operator, OK? The value of this sequence
of future cash flows is simply equal to the
expectation today, time t, of future dividends out
into the infinite future, discounted back by the
appropriate risk-adjusted rate of return. Now you'll notice that the
rate of return, this r, I put a subscript, t, plus
1, and t plus 2, and so on. I'm explicitly
recognizing the fact that the appropriate
risk-adjustment changes over time as market
conditions change and as the business changes, OK? So it could be that the
risk-adjusted return for a one-year
cash flow is this, but the risk-adjusted return
for a two-year cash flow is different. Just like we have a yield
curve for riskless bonds, we may have a yield curve
for risky cash flows, OK? And if I really wanted
to be a masochist when it comes to notation,
what I could do is to have a double
subscript that says that this is the
appropriate risk-adjusted return between years
t and t plus 1, and then this is between
years t and t plus 2, and so on, because these
discount rates may be completely different tomorrow. In other words,
tomorrow's discount rate for a one-year cash flow may be
different than today's discount rate for a one-year
cash flow, right? So I can have a whole string
of discount rates for today, and a completely different
string of discount rates for tomorrow and for
every day in the future. These things change
all the time. I think you'll see now why I
told you earlier equities is a lot more complicated than
fixed income instruments. It's because there are two
sources of uncertainty. One is the discount rate, and
the other is the cash flows. And moreover, the discount
rate that we're talking about, it's not the risk-free
discount rate, but it's the risk-adjusted
discount rate. And if risks change over
time, as certainly they have over the past
even few days, then the discount
rate should change. So in addition to
the term structure effect of different
yields, we also have the risk effect of looking
out into the future, given current market conditions. So while this
expression is tidy, and it looks nice
and clean, in order to turn this into
an actual number that you can look
at and decide, gee, do I want to invest
in this stock? Is it undervalued or overvalued? It's going to take
a lot of work. So before we get to
that work, I want to spend some time thinking
about simpler things, and try to come up with
relatively simple implications of this relatively robust model. Question? AUDIENCE: Yes, sir. Does rt take into
account the riskiness of the company itself, or
is it of the marketplace? ANDREW LO: The answer is yes. It's both. It's the riskiness
of the company, as well as the riskiness
of the aggregate set of market conditions. It's both. And so we have to figure
out how that factors into this equation. That's going to take us a
few lectures to get there. But the answer is both. Yeah. AUDIENCE: Would you
say it's related to the riskiness of the
expectation of the dividend being whatever it is at time t? ANDREW LO: Well-- AUDIENCE: If I were to know that
the first dividend is absolute certain, but after
that, not so much, then could I replace rt
with a risk-free rate, but rt plus 2 with something
else, and so forth? ANDREW LO: Yes, assuming
that that dividend really was risk-free. Yes, that's right. So the idea behind
the discount rate-- and, by the way, I'm going to
ask you to explain this to me. So I'm going to
make a statement, and then I'm going to ask
you to justify it, OK? The statement is this-- the discount rate that's used
in the denominator of each of these fractions,
that discount rate has to be risk-adjusted
in a way to reflect the risks of the numerator,
as well as general market conditions. It has to be commensurate
with the risks of that particular numerator. So if this numerator is much
less risky than this numerator, I would argue that
you would have to use a different
discount rate, one that's higher for the
more risky numerator than for the less risky. Now justify that for me. Why is that a reasonable
thing to want to do? Yeah. AUDIENCE: Because you're getting
more return on [INAUDIBLE].. ANDREW LO: That's right. AUDIENCE: Your discount
rate would be [INAUDIBLE].. ANDREW LO: That's right. You get more return
on your capital for something of
greater risk on average, because you've got to be
rewarded for bearing that risk. And if you're not
rewarded, you're not going to take on that risk. How do you know that? How do you know that you're
going to get rewarded for taking on that risk? Where did you get
that from, besides me? AUDIENCE: That's just the law
of the jungle, I don't know. [LAUGHTER] ANDREW LO: You're right. It's a law of the jungle. But in this case,
what is the jungle? AUDIENCE: [INAUDIBLE] ANDREW LO: Exactly, thank you. The market. Excellent. The market. The market is the
jungle from which you compete for scarce resources. And in order to get
your pet project funded, you've got to provide the
right incentives for people to buy into your project. So that's the logic
of the justification. Now let me go one
step farther and say, suppose that you want to
replicate these cash flows. Suppose that you want to create
a portfolio that gives you these kind of cash flows. Well, then, you've got
to go to the marketplace and figure out what the
appropriate opportunity cost is for each of those cash flows
and then discount them, because that's
what the market is charging for those cash flows. So that's why you have to
get the appropriate discount rate matched to the appropriate
cash flow, all right? It comes straight out of what
we learned about bond pricing, but now we're adding an
extra dimension-- risk. And I'm not going to be able
to talk about it in any more detail than this until we put
more quantitative structure on what we even mean by risk. I mean, you all take for
granted, when I say risk, you say, yes, you
understand what risk is. But in order for us to justify
a particular expression for how to make that kind
of adjustment, we have to be very specific
about how to measure risk. So in about three
or four lectures, I'm going to actually propose
a method for measuring risk. And once we have
that method in hand, we can then make that
risk adjustment extremely explicitly. I'm going to give you a
formula that you can actually compute in an Excel spreadsheet
that will tell you exactly whether the number should
be 6.5% or 7.3% or 8.9%. You're going to actually
see how to do that yourself. Yeah. AUDIENCE: The score
wasn't implying that those time structured
to when dividends paid out. Like, the time between
t plus 1 and t plus 2 doesn't have to be the same
as t plus 2 and t plus 3. ANDREW LO: Correct, correct. It doesn't have to be the same. And if it's not the same,
then the difference in horizon should be reflected by the
implicit size of that discount rate. Yeah. AUDIENCE: [INAUDIBLE]
the company's bond yield [INAUDIBLE]? ANDREW LO: Well, you tell me. Can we use the
company's bond yield to use as a discount
rate for the equity? Well, that depends. It depends on whether or
not the equity and the bond are of comparable risk, right? Remember, it's not
the company that determines the discount rate. It's not the company-- or rather, it's not
determined by fiat, or by announcement of a
company's particular policies. What determines the
yield is the riskiness of that yield and
the marketplace. The market determines
that particular price, not the individual, or not
the sources of those funds. AUDIENCE: Whenever [INAUDIBLE]
of the company's bonds do not reflect on
the company's equity? ANDREW LO: Oh, of
course, they do, but they reflect in
a very specific way, and we're going to
talk about that when we get into capital structure. Companies that have
very high leverage are going to have more
risky equity than companies with very low leverage. So the leverage does have
an impact on the equity. We're going to come to
that in a little while. There is a
relationship, all right? But for now, let's look at
these securities in isolation and not worry about it. And I'm going to keep
coming back to the idea that it's not the company that
gets to determine the discount rate, but rather it's
the company's riskiness-- or rather the riskiness of the
cash flows and the market's assessment of the cost
of that riskiness-- that determines
the interest rate. A few years ago, there
was a faculty member at Carnegie Mellon
who won a Nobel Prize, and it ended up that he
was one of the highest paid professors at the time. And so he was being interviewed
by the school newspaper, and they said,
Professor So and So, do you think it's appropriate
that even though you won a Nobel Prize,
that you should get paid twice as much as some
of the other faculty who are Nobel Prize-winning
physicists and fields medalists in the Mathematics
department, and so on? I mean, do you think it's
fair that your salary is twice as high as other
people in the school? And the faculty member, who is
an economist, said, listen son. The university does not
determine my equilibrium salary. They only determine
what city I work in. In other words, the
salary of an individual is not determined by that
particular institution. It's determined by
the marketplace. The marketplace bids
on that faculty member, and the highest
bidder, presumably, will be able to get
that faculty member. The same thing with
these cash flows. It's not the company's
debt, or the company's weighted average
cost of capital, which we don't know
what it is yet, but I'll define a
little later on. It's not the company
that gets to choose what the discount rate is. The question is, given the
riskiness of that cash flow, what does the market tell me
is the fair rate of return for that cash flow? That's the number I want to
plug into that denominator. Yeah, question. AUDIENCE: The market may
determine the discount rate, but the company determines the
growth rate on the dividend, right? They get to decide
what the dividend is. ANDREW LO: Well,
they get to decide what the dividend is
subject to their ability to pay that dividend. But if it turns out that
they make a bad decision, and they pay out
all the dividends, and they have no more
money, and they can't grow the company
anymore, then who determines what's worth what? Ultimately, the market. The market is the final arbiter
in all of these calculations. At least that's the
theory of finance. That's the basic, plain
vanilla, frictionless model, OK? It's the market that determines
these interest rates. Later on, after we
go through the basics and you understand the
frictionless model, I'm going to
introduce frictions, and then you'll see what
impact corporate policies have on these implications. In some cases,
corporate directors can actually do a lot of harm
by making suboptimal decisions that go against the market. In other cases, you could argue
that corporate decision-makers know more than
the market and are able to make bets that the
market is not capable of doing. That's certainly possible,
because who knows the company better than you do? Although a market
expert would say it's not knowing the
company that will determine the value of the company. It's knowing how
that company compares to all the other companies that
are out there that determines the value of the company. And you, as the
corporate insider, may know your
business very well, but you don't know
how you stack up against the 25 other
businesses in your industry, and we, the market, know better
than you, the individual. That's the argument that
would be made against that. AUDIENCE: In the case
of refinanced stocks, can I use the same formula? ANDREW LO: We're
going to get to that. We're going to talk
about preferred stocks. That's a separate issue. Preferred stocks have a
different priority of claim, and that's going to require
some slightly different modifications to this formula. Yeah. AUDIENCE: So I had a question
about the expected value. So yesterday in the example,
you discounted the 1,000 to 900 [INAUDIBLE] Et. So what else do you need
to discount in the r to account for the risk? ANDREW LO: Well,
I mean, you have to take into account the fact
that there are other competing opportunities for this
particular project in the marketplace. And so it's not just the
risk of this project, but rather how the
risk of this project stacks up against the risks
of all other possible projects that you would be competing
for in the open market. Let me put it to you this way. Let's do a simple
thought experiment. Suppose that instead of
these as being dividend streams for a given company,
let's do the following thought experiment. Let's imagine doing a strip, OK? You all know what
strips are now, right? So let's think about
stripping out dividends, OK? It's a very weird thought
experiment, granted, but just bear with me. Let's suppose that
instead of one company, I generate an
infinity of companies. Each company lives only
for one dividend payment, after which it gets liquidated. So each of these cash
flows, Dt plus 1, Dt plus 2, each one of these things is
a separate and independent company that gets
liquidated right after it pays the dividend, OK? Now how would you
value a portfolio of all of these companies? Well, you would do this, right? For each company,
you would figure out what the appropriate
discount rate is, and the appropriate
discount rate reflects not just the
time value of money, but the appropriate
riskiness of that cash flow. For example, if I took
that company-- let's actually do a thought
experiment of how we do that. Let's go through
the motions, OK. I've got a piece of
paper that is something that funds nanotechnology in
a very specific application. And this company
is going to require a certain amount of
investment, and then it'll pay off all of its
earnings in 2013, December, and then it'll liquidate
and be done with, OK? That's the company. How do I figure out the
price of the company today? Anybody? How do I figure out the price? I have this piece of
paper that says in 2013, the company will
liquidate, and I want to know what the price is. What's the first thing you
would do with that proposal if you got it in the mail? What would you want to know? Yeah. AUDIENCE: I would want
to know, like, if there's a security I can
buy in the market, is the company
going to pay for it? Because it's the same
risk return profile. And I look at the
marketplace for that. ANDREW LO: Why
would you do that? AUDIENCE: Because
there's no reason I would go through the hassle,
or friction, as you call it, of pricing a new
company if I could just go online and buy it. ANDREW LO: Right,
that's one logic, but another logic is that you
have money looking for a home. You can put it in
this new venture, or you can put it in
this existing company. And if they're
comparable, then at least you have some sense
of what it's worth. Exactly. In order to figure
out whether or not you can get a
comparable security, you need to know what the cash
flow is for that nanotechnology startup, right? So you might think first about
estimating the expected cash flow in the liquidating
dividend in 2013. OK, so you calculate the
numerator, all right? And you find a company
out there that has that same kind of cash flow. You have to find one that
has the same profile, so it does it in 2013, at
which point it gets liquidated. But let's even forget about-- suppose we didn't
have such a company. Suppose we didn't have
an existing security. So this is literally
a fresh start. You've got a piece of
paper that gives you the claim to a company that
liquidates in 2013 with one cash flow only. And now you've estimated
that cash flow to be approximately $27 million, OK? So now you've got the numerator. A piece of paper that
pays $27 million. How do you figure out its price? What would you do? Yeah. AUDIENCE: Calculate the risk
that it's going to [INAUDIBLE],, also you have the
time [INAUDIBLE].. ANDREW LO: OK, and
you've done that, and that's the $27 million. AUDIENCE: That's included
in the valuation. ANDREW LO: Right,
the $27 million includes the probability
that it actually is 0, so the expected
value is 27 million. How would you go about-- yeah. AUDIENCE: Wouldn't it
actually be two [INAUDIBLE],, so when the 27
million liquidates, you get the value of the assets? ANDREW LO: The liquidation value
is the 27 million on average. AUDIENCE: [INAUDIBLE]
two payments for that. ANDREW LO: No, no, no,
it's just one payment-- 27 million on expectation. Oh, it may be two possibilities. Maybe you either get 54
million with 50% probability, or nothing with 50%
probability, so the expectation is 27 million. What would you do? Yeah. AUDIENCE: I think
if you're already weighted in the probability
[INAUDIBLE] 0 [INAUDIBLE] ANDREW LO: Suppose you
don't know what to use. Suppose you want to figure
out what the price is. AUDIENCE: [INAUDIBLE] discount. ANDREW LO: Yeah, I
know what you mean. But suppose that you
didn't have that. What would you do? AUDIENCE: [INAUDIBLE]
at the yield curve just to get an idea of
what in 2010, at least either a risk-free
security or a security with that same credit risk. You know, what discount
rate that would go in there, discounting by that [INAUDIBLE]. ANDREW LO: You could
do that, but now we're getting more and
more complicated. Isn't there an easier way to
figure out what the price is? Exactly. You know, let's let
the market decide. Auction it off. Now when you auction it off, you
take the highest bidder, right? And you get a number. I don't know what
that number is, but let's just say the number
is, I don't know, 15 million. You've got somebody who's
willing to pay 15 million today for a cash flow that
gives them expected 27 million in 2013. With those two numbers, that
gives you r, doesn't it? That's how r is established. It's established
the exact same way that we establish r
for riskless bonds. The way that US
treasuries ended up being three basis points
on September 18th was, basically, tons of people
wanted to buy these securities, bidding down the yield
and bidding up the price. So if we had this piece of
paper that paid only one dividend in 2013 and
we auctioned it off, we would get a yield. The yield would be a
risk-adjusted yield. I don't know how the
risk adjustment got made. So you could be quite right that
you take the risk-free yield, and you add on top of
that a credit spread and who knows what. The point is, the market
did it for us, OK? So what I'm getting
after with this formula is I want to use those discount
rates that are determined by the marketplace. Because if ever I have
to sell my company, if ever I have to
take this company and break it apart
and get rid of it, and the market is
going to pay me for it, the way that the market
is going to evaluate the different pieces is just
the way that I described. It'll look at each cash flow,
look at how risky it is, look at the opportunity
cost of other investments that they can get the same
risk return profile for, and they'll pay that amount,
which will implicitly give me the appropriate yield. Yeah. AUDIENCE: So let's
say that me purchasing a stock with this
calculation, do I have to assume that
this calculation is wrong? Because why would I pay
out money for something that's going to be exactly the
same, kind of discounted, cash flow back to right now? ANDREW LO: So
that's a good point. Let me repeat the question. The question's why-- in order
for you to buy the stock, would you have to
assume that this is wrong, or rather, that
the market price is not equal to this? Well, the answer is
no, you don't have to. Although if you did, that would
provide a motivation for you to want to do that. But it could be that you
simply want the risk and reward of this particular cash flow. What's wrong with that? Suppose that the security
is fairly priced. So this equation
at the very bottom says that the price
of the security is equal to the present value
of all the future expected cash flows discounted at
the fair rate of return. That's a perfectly
reasonable thing for somebody to
want to invest in, if they like that kind of
risk/reward combination. So some people want to
put their money in Google, and some people want to
put their money in IBM, and some people want to put
their money in US Steel. Those are different
companies that have different rates
of return based upon their different
risks and cash flows, and even if those things
are fairly priced, it's not like you're
going to make no money. You're going to make money
based upon the fair market rate of return for that security. Now if you think you've
got a better mousetrap, and you can identify
mispriced securities, that gives you a whole
another reason for investing. But even without
any mistakes being made, even with if market
prices are perfectly fair, people want to
invest, because they want the return that
those kind of investments give them, right? OK, so let's consider
some simple cases. In order for us to really make
use of this formula, which at this level of generality
really is useless, let's try to simplify
and see what we get. And we're going to
simplify in the ways that we've done before. Let's assume that dividends
are fixed throughout time, and given by a number D, OK? And let's assume that the
risks don't change over time and are given by
a discount rate r. Well, if you fix D and you
fix r, magically, what you get is that the price
of the security is equal to our old friend, the
perpetuity formula, D over r, OK? Not that surprising. If you have a constant
stream of dividends, with a constant discount
rate, then the price is equal to D over r. Now, again, this may seem
totally trivial to you, but it does provide a very
interesting observation. Number one, the
price of common stock is an increasing function
of the expected cash flows in the form
of future dividends. So if you expect there to be
higher dividends going forward, the price should
go up, and if you expect lower dividends
going forward, the price should go down. So that's a nice insight. Another insight, though, is
that the price of a stock is inversely proportional
to its discount rate. If interest rates
go up in general, if interest rates
go up, what should happen to the stock price? AUDIENCE: [INAUDIBLE] ANDREW LO: Exactly,
it should go down. There are two ways
of thinking about it. One is that future
cash flows are going to have to be
discounted at a higher price. Or two, the demand
for stocks will not be as great, because now the
opportunity for earning higher return exists in other
securities like bonds, and so that will reduce
the demand for stocks and the price will
come down, right? So that's a very
nice model, but we can make it a little
bit nicer by allowing the dividends to grow. So now suppose you have a
growth company, a company where the dividends are
expected to grow at a rate of g every period. Well, then, once again, we have
our old friend, the perpetuity, with growing coupons, right? D over r minus g. And now, as I think I
alluded to early on when we went through this formula, we
have in this very, very simple expression one explanation
for the technology bubble, both how it got so big,
and secondly, how it burst. If r is close to g, if the
growth rate is very large, you're going to get
a very big price. And if there are rapid changes
in what people expect g to be, or what people
estimate g to be, you can get very rapid shocks
in the level of prices, including price one-ups
and then crashes, right? Yeah. AUDIENCE: What kind of confuses
me is that, I mean, yeah, so is r greater than g? And r greater than
g is necessary in order to get that
[INAUDIBLE] efficient. But is there any
more meaning to that, or is this just a
mathematical thing? ANDREW LO: There
is meaning to that. The meaning is
actually quite simple, and we alluded to
it when we first went through this formula. Suppose that r were
not greater than g. Suppose r were less than g. What that's telling you
is that the rate of growth of this security, or this
cash flow, or this dividend, the rate of growth is much
faster than the interest rate, all right? So you've got wealth that's
growing over time faster than the interest rate, which
means that if it really is true that it'll last out
into perpetuity, then in very short order you
should become bigger than the entire
planet's GDP, right? Because you're going to be
bigger than the interest rate. So the rate at which
assets in the future are being deflated
to the present is actually less
than the rate of what you're growing your wealth. Pretty soon, you're going to
become richer than God himself, and we know that
that can't happen. AUDIENCE: But isn't it that-- I mean, so right now,
the inflation rate is greater than the interest
rate, for example, right? ANDREW LO: That's right now. That's right now, but this
is out of the perpetuity. Do you believe that
that's sustainable out of the perpetuity? AUDIENCE: No. ANDREW LO: Well, then,
this formula doesn't work. This formula is a formula
that's predicated on infinity, not 10 years, not 20 years. As we mentioned, when we
went over the formula, China has been growing at a rate
of 10% for the last 15 years. Do you think 10% growth
rate is sustainable? If China continues
to grow at 10%, pretty soon we're all going
to be speaking Mandarin. I mean, it's just not
possible for a country to both be reasonably-sized
and not totally dominant, and to have a rate
of growth so much larger than what
can be sustained over a long period of time. And so that's the key. This is a formula
that's about infinity. It's not about five
years or 10 years. OK, another question. No. OK, so in this case,
the Gordon growth model allows us to get an
expression that tells us if there are very,
very significant growth opportunities that
can actually push up the price of a
stock dramatically. If somehow all of us decide that
those growth opportunities no longer exist because we have
new information, then boom, it disappears, OK? A good example of
this is cold fusion. I don't know how many of you
remember, 15 or 20 years ago, there was a big controversy
about the Pons and Fleischmann experiment, where they did
an experiment where it seemed like they generated heat,
but heat not from a chemical reaction, but from
a nuclear reaction in a standard
laboratory setting. And typically, you need
very, very unusual conditions to generate thermonuclear
reactions that can create that kind of heat. Now in the end, they were
discredited and, apparently, although there's still
controversy out there, it doesn't seem like it
was a nuclear reaction. But if it were, if it
was possible to generate a nuclear reaction at room
temperature, what that could have meant is that
it would eliminate all of the energy
problems of the world, because you'd be able to
run your car on tap water. And the amount of energy
in an ounce of tap water is enough to fuel your
car for about a year. So think about it. If that technology really
worked to have worked out, what do you think the
value of that would be? What's the g in that case? And you can
understand why people would have invested hundreds
of billions of dollars into that kind of
an opportunity, if it were, in fact,
a real opportunity. There was a short time
where we didn't know, and during that time, r
minus g looked pretty small. g looked big relative
to r, all right. And so that created
very, very large swings in prices of both
traditional energy companies like oil companies. You can imagine what oil
companies would be worth if we figured out how to
run cars on water, right? That would maybe be justifiable
in light of how much they've made over the years. But the point is that it
creates enormous opportunity and potential dislocation
so that the expectations of the market matter a
great deal, and this is why. This is how it actually
gets incorporated. Now I'm going to
take that equation and turn it around,
turn it on its head, and it'll give us
another insight into how to think about the discount rate
and the value of corporations. If the price of a stock today
is given by D over r minus g, then I can flip things
around and say that r minus g is equal to D over P, right? The dividend price ratio is
equal to r minus g, or r-- the discount rate that I'm
using for the cash flows-- is given by the dividend
yield plus the rate of growth implicit in that company's
investment opportunity set. Now why is this interesting? Well, in order for
you to understand the importance of
this expression, you have to realize
that, for many years, stock analysts would look
at a company's discount rate or cost of capital by simply
using the dividend yield. So in the exact same way
that if you have a bond, and you see what the coupons
are, and you take the coupon and divide it by the
price, that gives you a sense of what your rate of
return is over a given period. When you look at a stock, and
you want to ask the question, how much am I earning
on that stock? What is the rate of return
on that stock for me, the investor? You take the dividends that
you get paid every quarter, and you take that
dividend and you divide it by the stock price,
and that gives you a sort of rate of return, right? Because if you
think about buying the stock for a price, P, and
then getting cash flows of D every quarter, or every
period, then your yield, your rate of
return, is D over P. That's called the dividend
price ratio, or dividend yield. What this expression
says is something that every MIT graduate knows
in his or her heart, which is that technology
adds value above and beyond what you observe
in current cash flows. It's not just the dividend
that gives a company value, it's the ability for
companies to grow over time. It's not just the company's
current plant and equipment and operations
that give it value, it is all of the interesting,
wonderful, innovative, creative ideas that are locked
up in that company that may one day be
implemented and allow it to grow far beyond the
founders' wildest dreams. That also has to be factored
into the rate of return of the company. And this simple little dividend
yield model tells us this. It says that the
required rate of return, the risk-adjusted discount rate,
the cost of capital, the user cost, whatever you want
to call it, this r, has two pieces to it. One is the cash that you get on
a regular basis, the dividends that the current
operations generate, plus the growth opportunities
of those dividends out into the
infinite future, OK? Now remember, the way that
we structured this dividend payment, the way that we
had our formula set up, the dividends are the
dividends that get paid next period, right? If you go back and
look at the formula, this is the price
today, and it's given by the dividends
paid at time t plus 1. So this price that I'm
using in my notation is the current
ex-dividend price, meaning this period's dividend
has been paid already, and now the value to
this piece of paper is the future dividend,
starting next period, t plus 1. So when I say D is
fixed, it's fixed, but it's getting
paid next period, OK? So in this expression,
this D is actually next period's dividend. But remember that
when I'm trying to value the company today,
I don't observe next period's dividend, which is random,
but I know how much was just paid in the most recent period. So if I want to use
D, and there's growth, I actually have to take the most
recent dividend, the one that just got paid, and
multiply that by 1 plus g to get the value of
next period's dividend. So that's why this
expression I've corrected-- not corrected,
it's not that it's wrong-- it's just I've changed
the expression so that it is D sub 0, which is the most
recent dividend that was just paid multiplied by 1
plus g divided by P. So I just do that-- if you want to use this
formula, and by the way, you can actually go
out and use this now. I would actually
encourage you to use it. Go out and take a look
at your favorite stock, and take a look at
its dividend yield. You can find it on
yahoofinance.com as well as other web sites. And then you make a guess as
to what the appropriate growth rate is, and try to
figure out whether it fits this equation, OK? You can observe dividends. You can observe today's price. And you have to make an
assumption about what you think the growth rate is. And when you plug that
in, that will give you an estimate of what
the cost of capital is for that particular company. Yeah. AUDIENCE: So like this exercise
without the [INAUDIBLE],, with just the perpetuity
formula, D over r, incurs-- I mean, every stock
that I look at seems to be more than the
dividends divided by-- ANDREW LO: That's right. Exactly. That's because why? Why is it, if you
just use D over P, every single stock looks
like it's overvalued. What are you missing? AUDIENCE: g. ANDREW LO: Yeah, exactly. Right, you're missing g. AUDIENCE: But then g turns out
to be higher than r, right? ANDREW LO: Well, no, no, no. How did you get r? AUDIENCE: OK, OK. We don't know r ANDREW LO: We don't know r. That's what we're trying
to figure out, right? So you just said you're
looking at D over P, and you're trying to
figure out implicitly what that implies for the
growth rate of stocks. Take a look at this expression
in light of future growth opportunities and you'll see
that dividend yield is not the only story. You've got to use
other expressions. Yeah. AUDIENCE: So looking at
that [INAUDIBLE] about it on an annualized basis or
between dividend payment? ANDREW LO: Well it should
be on an annualized-- well, it should be on whatever
cycle the dividends get paid. So if dividends
get paid quarterly, then it's a quarterly
growth rate. If it's an annual payment, then
it's an annual growth rate. So the benefit of
this expression is that there is no timing
that's been assumed. It's just whatever
the periods are. So if it's quarterly dividends,
use quarterly growth rate. Yeah, question. AUDIENCE: We can't just
go out and use this model on just about any
company, right? Doesn't the company
have to, I guess, pay dividends and use
dividends as, perhaps, a way to represent the
[INAUDIBLE] of the company? ANDREW LO: Well, yes. So if it doesn't have
dividends, then this formula is not going to be all
that interesting, right? D's going to be 0. But remember, this
is not the current D. This is the steady state
D. And if companies are in the early part
of their growth phase, it's going to be hard to
estimate what that steady state D is. So there'll be other
expressions that we're going to derive
in a few minutes, where we use accounting
identities to relate dividends to earnings or to cash flows. It used to be the case that
instead of using dividends, you would use
earnings, because even though companies that
don't pay out dividends, they still have earnings. Well, that is until the
internet came about, right? Then you had companies that
actually had no earnings. So how do you valuate a
company that has no dividends and has no earnings, and
has negative cash flows? In fact, if you use those
models, the more negative the cash flow, the
higher the value. So something weird is going on. It has to do with
the fact that these are meant to be steady
state formulas, and not formulas for individual
time periods. If there are individual
time periods where you have zero cash flows or
negative cash flows because of growth, you'll have to make
adjustments in the formulas, and I'll show you how to
do that in a few minutes. Yeah. AUDIENCE: Do you have
to change the formula if, let's say, the board decides
to change dividend [INAUDIBLE]?? ANDREW LO: Well,
again, this formula is really meant to be steady
state dividends, right. So if they change the dividends,
what you should not use is this. What you should go
back and use, which is going to be a bit
more complicated, is this, the bottom
equation, right? So this equation
is always correct, because this is
completely general. Dividends at time t plus
k out into the future. And so if you know the
future path of dividends, or if you have an expectation
of what that future path is, you can use this formula. But look how difficult this is. I mean, think about
how an equity analyst has to make his living. They've got to figure
out, not only what the appropriate discount rate
is, which is hard enough, but they've going
to figure out what the appropriate path
of dividends are, not just what the dividends
will be in steady state, because they may not
be able to do that. They may want to figure
out what the dividends are going to be next year, the year
after, the year after that. So there's a lot
of work to be done. It's hard. It's hard work. But more importantly,
it's not just hard work, it's actually very
inaccurate work. In other words, it's
really hard to estimate this thing with any degree of
accuracy, so what do you know? You know you're going to
be wrong most of the time. Imagine a job where you go into
the job knowing that if you do really well, you're a genius. You're at the top of your class. You're the best that's
ever done this thing. And in that case, you're going
to be right 52% of the time. 52% of the time. That means you're
wrong 48% of the time. That's pretty discouraging. But that's really the
nature of this task. It's really hard. You know, it's like trying
to do weather forecasting, but weather forecasting
over the next 30 years, and then taking the sum total
of all of those decisions, putting it into a portfolio,
and then investing your life savings in that. That's kind of tough, right? But it's also exciting. Yeah, question? OK, oh yes. AUDIENCE: [INAUDIBLE]
If dividend is going to change
in the future, wouldn't this formula be
likened to the annuity equation? So that point in time when
it changes, for which-- [INTERPOSING VOICES] ANDREW LO: You would use
the annuity discount formula in pieces. So for example, if the cash
flows for the first 10 years look like one thing, and
then the next 20 years look like another
thing, and then the next 30 years look like
something else, what you could do is apply the annuity discount
formula to the first 10 years, and then apply the
annuity discount formula with a different discount
rate and a different cash flow to the next 20, and then
discount that back and then discount that back
10 more years, and then do that to the next
30, and then discount it back to the very beginning. So exactly. That's the way to do it,
which is effectively doing it like this, but it's hard. I mean, it's hard enough to
estimate cash flows next year. And I can tell you
there are a lot of firms that have forecasted this
year's cash flows last year are scratching their
heads, wondering how they can be so far off. Now imagine doing
it 30 years hence. I mean, it's an impossible task. But at the end of the
day, it has to be done. In other words, whether you want
to make those forecasts or not, people are going to
trade your stock. And so if you're not
making those forecasts, well, somebody else is
going to, because they've got to trade the stock. So what we want to
do is to figure out a slightly better mousetrap
of understanding what those forecasts are telling us. And if we can literally
get 52% correct rates, we're going to be rich beyond
our wildest expectations. That's really hard to do. And it's just the nature of
this particular endeavor. It's very difficult to estimate
cash flows, discount rates, and risk conditions so
far out into the future. Question, yes. AUDIENCE: You said we could
use this formula to calculate the firm's cost of capital. I'm wondering why
would we do that? Why do I care about
the firm's cost? I think it's much more
interesting to calculate the growth rate [INAUDIBLE]. ANDREW LO: Well, in order to
calculate the cost of capital, you need the growth rate. AUDIENCE: OK but,
I mean, I think it's easier to get
the cost of capital and guess the growth rate. I just don't understand why I
would be interested in getting to know this firm's cost-- ANDREW LO: In the
cost of capital, OK. Well, you would have to wait
about another seven lectures for that, because there
is a reason why you care about the cost of
capital, and that is that if you're trying to
decide how to spend your firm's money, if you're a CFO
and you're allocating cash across different
activities, you need to know what your
firm's cost of capital is so that you get a sense
of what the opportunity cost versus taking that
money and investing it in other opportunities
outside the firm. So in order to make decisions,
you need that number. AUDIENCE: If I'm in [INAUDIBLE],,
as an investor outside, like, looking at the
stock market, [INAUDIBLE]?? ANDREW LO: Well,
you do, in the sense that you want to know
whether you're going to get your money's worth. I mean, if you're investing
in one company versus another, in order to make
that decision, you need to know what the
rate of return is, right? So it's actually
quite important. It's very important
for decision-making what that number is. AUDIENCE: Right after return. It's not cost of capital. If I look it that way. ANDREW LO: So let's call
it the rate of return. That's right, yeah. Well, and by the way,
the reason that I always use four or five names
for the same quantity is to sensitize you to
the fact that people look at these numbers from
different perspectives. So when I use the
term cost of capital, I'm thinking about it as
a corporate manager who has internal funds that
are going to be deployed in different activities. And the cost of that capital
as a CFO is given by r. Now as an investor
external to the company, I'm thinking about how
to invest my money. I want to know what
my rate of return is. And as a regulator that
wants to understand what the appropriate
capital charge is for different kinds of
activities that are going to be appropriate for
borrowing and lending, I also need to know what the
appropriate risk adjustments are to that particular number. Yeah. AUDIENCE: I was
wondering how frequently the companies actually
change their dividend policy. Is it every year,
every few years? And also are there exceptions? Like is there a
reason sometimes where a company who is, like,
growing to issue dividends, or for a company that's got
a lot of cash to not do so? ANDREW LO: So that's
a great question. The question is how companies
set their dividend policy. The short answer
is that companies don't like to pay dividends
unless they know for a fact that they can maintain the level
for a good long period of time. And the reason is simple. When a company cuts dividends,
that's considered bad news. No matter how you slice
it, when a company decides to reduce its dividends, the
typical response is uh oh, it's cash-strapped, or it's in
trouble, there's a problem. So once you know that, then
as a corporate financial-- chief financial officer-- you will not
recommend to the board to cut dividends unless there's
a really significant issue with the firm. And therefore, as
a result, you're not going to either
pay or raise dividends unless you think you
can support that level for a good long time. So because of that
reason, you're right, dividends don't get
changed very often. And actually, it's quite
costly in some senses to change that dividend
policy, not just from the corporate perspective,
but from shareholder perception. AUDIENCE: What about exceptions? Like why would a
company currently do something that
is different from-- ANDREW LO: There are
exceptions because of certain circumstances that
are unique to the company. For example, a company
could be in a cash crunch, like, right now, because of
some kind of capital charge due to a certain underperforming
securities, in which case they may declare a temporary
suspension of dividends. The other side of the
equation is that a company may have gotten a big windfall. They just decided
to sell a division, and they've got a
large amount of cash. They don't know what to
do with all the cash, so what they'll do is
that they'll pay out an extraordinary dividend. Extra ordinary
dividend, which means that it's a one-time thing,
and then from that point on, they'll go back to a
regular dividend policy. Yeah. AUDIENCE: What
does a [INAUDIBLE].. How you want to invest
in billions of dollars. Do you borrow money to invest
versus [INAUDIBLE] dividend [INAUDIBLE]? ANDREW LO: Well, it depends
on how much money you have. It depends upon what your
shareholders want to have done. I mean, that's
certainly a decision that a corporate
financial manager would have to make in concert
with the shareholders, as well as the CEO. And that's a strategic decision. But in order to
make that decision, you've got to have a few
things at your fingertips. You've got to have the
opportunity cost of capital. You've got to figure out
what your borrowing cost is. And in order to figure
out your borrowing cost, what do you need
to know about your debt? AUDIENCE: [INAUDIBLE] ANDREW LO: How risky. And how do we measure
risk with corporate debt? We just talked
about it last class. Hint, hint. AUDIENCE: You got to rate it. ANDREW LO: Yeah, you
need a rate, right. So you have to figure
out whether or not the cost of funds from
internally-generated sources is cheaper or more
expensive than going to the external capital markets. Right now, I would say that
it's extremely expensive to go out into capital markets,
if you could do it at all. If you're going to
raise money, you're going to be paying
up through the nose. General Electric credit
default swap today was priced at 700 basis points. This is AAA-rated security,
at 700 basis points credit. It's crazy! But people don't want
to lend right now. So if you want to borrow
in capital markets today, good luck.
