So let’s begin.  We’re going to
go into business together.  We’re going
to start a company and we’re going to
start a lemonade stand
and now I don’t have any money today, so
I’m going to have to raise money from investors
to launch the business.  So how am I going
to do that?  Well I’m going to form a corporation.
 That is a little filing that you make with
the State and you come up with a name for
a business.  We’ll call it Bill’s Lemonade
Stand and we’re going to raise money from
outside investors.  We need a little money
to get started, so we’re going to start
our business with 1,000 shares of stock.  We
just made up that number and we’re going
to sell 500 shares more for a $1 each to an
investor.  The investor is going to put up
$500.  We’re going to put up the name and
the idea.  We’re going to have 1,000 shares.
 He is going to have 500 shares.  He is
going to own a third of the business for his

So what is our business worth at
the start?  Well it’s worth $1,500.  We
have $500 in the bank plus $1,000 because
I came up with the idea for the company.  Now
I’m going to need a little more than $500,
so what am I going to do?  I’m going to borrow
some money.  I’m going to borrow from a friend
and he’s going to lend me $250 and we’re
going to pay him 10% interest a year for that

Now why do we borrow money instead
of just selling more stock?  Well by borrowing
money we keep more of the stock for ourselves,
so if the business is successful we’re going
to end up with a bigger percentage of the

So now we’re going to take
a look at what the business looks like on
a piece of paper.  We’re going to look
at something called a balance sheet and a
balance sheet tells you where the company
stands, what your assets are, what your liabilities
are and what your net worth or shareholder
equity is.  If you take your assets, in this
case we’ve raised $500.  We also have what
is called goodwill because we’ve said the
business—in exchange for the $500 the person
who put up the money only got a third of the
business.  The other two-thirds is owned
by us for starting the company.  That is
$1,000 of goodwill for the business.  We
borrowed $250.  We’re going to owe $250.
 That is a liability.  So we have $500 in
cash from selling stock, $250 from raising
debt and we owe a $250 loan and we have a
corporation that has, and you’ll see on
the chart, shareholders’ equity of $1,500,
so that’s our starting point.

Now let’s
keep moving.  What do we need to do to start
our company?  We need a lemonade stand.  That’s
going to cost us about $300.  That is called
a fixed asset.  Unlike lemon or sugar or
water this is something like a building that
you buy and you build it.  It wears out over
time, but it’s a fixed asset.  And then
you need some inventory.  What do you need
to make lemonade?  You need sugar.  You
need water.  You need lemons.  You need
cups.  You need little containers and perhaps
some napkins and you need enough supplies
to let’s say have 50 gallons of lemonade
in our start of our business.  Now 50 gallons
gets us about 800 cups of lemonade and we’re
ready to begin.

Let’s take a new look
at the balance sheet.  So now we’ve spent
$500 on supplies.  We only have $250 left
in the bank, but our fixed assets are now
$300.  That is our lemonade stand.  Our
inventory is $200.  Those are the supplies
and things, the lemons that we need to make
the lemonade.  Goodwill hasn’t changed
at 1,000, so our total assets are $1,750 and
we still owe $250 to the person who lent us
the money.  Shareholder equity hasn’t changed,
so we haven’t made any money.  All we’ve
done is we’ve taken cash and we’ve turned
it into other assets that we’re going to
need to succeed in our lemon stand business.

So let’s make some assumptions about
how our business is going to do over time.
 We’re going to assume we’re going to
sell 800 cups of lemonade a year.  That’s
not a particularly ambitious assumption, but
we should assume the lemonade business is
fairly seasonal.  Most of the lemonade sells
will happen over the summer.  We’re going
to assume that each cup we can sell for $1
and it’s going to cost us about $530 per
year to staff our lemonade stand.  

now let’s take a look at the income statement,
so the income statement talks about the profitability,
about the revenues that the business generated,
what the expenses are and what is left over
for the owner of the company.  So we’ve
got one lemonade stand.  We’re selling
800 cups of lemonade at our stand.  We’re
charging $1, so we’re generating about $800
a year in revenue and we’re spending $200
on inventory.  There is a line item here
called COGS.  That stands for cost of goods
sold.  We have depreciation because our lemonade
stand gets a bit beat up over time and it
wear out over five years, so it depreciates
over 5 years.  We’ve got our labor expense
for people to actually pour the lemonade and
collect cash from customers and we have a
profit.  We have EBIT and that is earnings
before interest and taxes, of $10.  That
is kind of our pretax profit for the business.
 We didn’t make very much money because
you take that pretax profit of $10 and you
compare it to our revenues.  It’s about
a 1.3% margin.  That is not a particularly
high profit.  Now we’ve got to pay interest
on our debts and we have a loss of $15 and
then we don’t have any taxes, but at the
end of the day we still lose money.  

the question is, is this a particularly good
business?  Well we’re losing money and
our cash is basically going down over time.
 Is this a business we want to stay in?  Now
the cash flow statement takes the income statement
and figures out what happens to the cash in
the company’s till, so when you put up $750,
some money goes to pay for a lemonade stand.
 Some money is lost selling the product and
at the end of the day we started with $750
and now we only have $500.  Let’s look
at the balance sheet.  What has happened?
 Our cash has gone down from 750 to 500.
 Our fixed assets have gone from 300 to 240.
 That means our lemonade stand is starting
to wear out.  Goodwill hasn’t changed.
 We still owe $250 and our shareholder’s
equity is now down to $1,490, so it was the
1,500 we started with minus the $10 we lost
over the course of the year.  

So should
we continue to invest in the business?  We’ve
lost money in the first year.  Is it time
to give up?  Well let’s think about it.
 Let’s make some projections about what
the company is going to look like over the
next several years.  Let’s assume that
we take all the cash the business generates
and we’re going to use it to buy more lemonade
stands so we can grow.  Let’s assume we’re
not going to take any money out of the company
and we’re not going to pay a dividend.  We’re
going to keep all the money in the company
and reinvest it.  Let’s assume that we’re
going to—as we build our brand we can charge
a little more each year, so we’re going
to raise our prices about a nickel, five cents
more for each cup of lemonade each year and
then we’re going to assume we can sell 5%
more cups per stand per year.  So we’ve
got built in growth assumptions. 

let’s take a look at the company.  So if
you take a look at this chart you’ll see
in year one we started out with one lemonade
stand.  We add one a year and then by year
five we’re up to seven because we’ve got
a big expansion plan.  Our price per cup
goes up a nickel a year and our revenue goes
from $800 and starts to grow fairly quickly
and the growth comes from increased prices
for cups of lemonade and it also comes from
opening more stands.  So by year five we
have almost $8,000 in revenue.  Our costs
are relatively constant, which is the lemonade
and the sugar.  That’s about $1,702.  We
have depreciation as more and more stands
start to wear out over time.  We’ve got
labor expense, but by year five the business
is actually doing pretty well.  We went from
a 1.3% margin to over a 28% margin.  The
business is now up to scale.  We’re starting
to cover some of our costs.  We’re growing.
 We’re still paying $25 a year in interest
for our loan and we have earnings before taxes,
after interest of $2,300 by the end of year
5.  So we put $500 into the business.  We
borrowed 250 and by year five we’re making
a profit of $2,300.  That sounds pretty good.
 Now we have to pay taxes to the government.
 That is about 35% and we generate net income
or another word for profits of $1,500 by the
fifth year and about a dollar a share.  

if you think about this our friend put up
$500 to buy 500 shares of stock.  He paid
a dollar and after five years if our business
goes as we expect he is actually making a
dollar a share in profit.  That sounds like
a pretty good deal.  So what has been the
growth?  The growth has been fairly dramatic
over the period and that is what has enabled
us to become a successful business.  Now
these are just projections, but if they’re
reasonable projections this might be a business
that we want to start or invest in.

let’s look at the cash flow statement.  So
as the business becomes more and more profitable
we generate more and more cash and the cash
builds up in the company.  We go from $500
of cash in the company to over $2,000 of cash
over the period.  The balance sheet, again,
the starting balance sheet had shareholder’s
equity of $1,490, but as the business becomes
more profitable the profits add to the cash.
 They add to the assets of the company.  Our
liabilities have not changed and the business
continues to build value over time.  So again
by the end of year five we’ve got $4,000
of shareholder equity and that’s almost
three times what it was when we started.

Now is this a good business or a bad business?
 How do we think about whether it’s good
or bad?  One thing to think about is what
kind of earnings are we achieving compared
to how much money went into the company.  Now
this is a business that we valued at $1,500
when we started.  Someone put up $500 for
a third of the company.  We gave it a $1,500
value.  By the end of year five it’s earning
over $1,500 in earnings, so that’s over
a 100% return on the money that we put into
the company.  That’s actually quite a high
number.  We spent—let’s talk about return
on capital.  We’ve spent $2,100 in capital
building lemonade stands and we earned $2,336
in year five on the capital we invested.  That’s
over 100% return on capital.  That is a very
attractive return.  Earnings have grown at
a very rapid rate, 155% per annum.  This
is really a growth company and our profitability
has gone from 1.3% to 28.6% by year five and
that sounds pretty attractive and it is.  

let’s look at the person who put up the
loan.  Well that person put up $250 and the
business has been profitable.  We’ve been
able to pay them their interest of 10% a year,
$25 a year and they’re happy because they
put up $250.  They’re getting a 10% return
on their loan and the business is worth well
more than $250.  We’ve got more than that
in cash.  As a result, they’re in a safe
position, but they’ve only made 10% on their

Now let’s compare that with
the equity investor, the person who bought
the stock in the company.  That person earned
a dollar a share in year five versus an investment
of a dollar a share, so he is earning over
100% or about 100% return on his investment
versus only 10% for the lender.  So who got
the better deal?  Well obviously the equity
investor.  Now why did the equity investor,
why do they have the right to earn so much
more than the lender?  The answer is they
took more risk.  If the business failed the
lender is entitled to the first $250 of value
that comes from liquidating the company, so
if you sell off the lemonade stands and you
only get $250 the lender gets back all their
money.  They’re safe.  They got their
10% return while the business was going.  They
got back their $250, but the equity investor,
the person who bought the stock is wiped out
because they come after the lender.

what is the difference between debt and equity?
 Debt tends to be a safer investment because
you have a senior claim on the assets of a
company and it comes in lots of different
forms.  You’ve heard of mortgage debt on
a home.  That’s a secured loan secured
by a house, but you could have mortgage debt
on a building for a company.  There is senior
debt.  There is junior debt.  There is mezzanine
debt.  There is convertible debt, but the
bottom line, it’s all debt.  It comes in
different orders of priority in a company
and the rate your charge is inversely related
to your security, so the better the security
and the less risk the lower the interest rate
you’re entitled to receive.  The more junior
the loan the higher the interest rate you’re
entitled to receive, but you can avoid the
complexity.  All you need to think about
is debt comes first.  It’s a safer loan,
but you’re profit opportunity is limited.

the equity also has their varying forms.  There
is something called preferred equity or preferred
stock.  There is common equity or common
stock and again stock and equity are basically
synonyms.  They’re options, but really
not worth talking about today.  The important
point is that equity gets everything that
is left over after the debt is paid off, so
it’s called a residual claim.  Now the
good thing about the residual claim is that
business grows in value if you don’t owe
your lender anymore, but all that value goes
to the stock holder.  So the question is
why was the lender willing to take only a
10% return when the equity earned a much higher
rate of return and the answer is when the
business started there was no way of knowing
whether it would be successful or not and
the lender made a bet that if the business
failed they could sell off the lemonade stand.
 It cost $300 to make it.  They would have
some lemons, some lemonade.  Even if they
sold it at a much lower price than the dollar
they originally projected the lender felt
pretty comfortable that they would get their
money back, whereas the stockholder is really
taking a risk.  They were betting on the
profitability of the company and they were
taking a risk that if it failed they would
lose their entire investment, so they were
entitled to get a higher return or have the
potential to have a higher return in the event
the business we successful.

So let’s
talk about risk.  Lots of different ways
people think about risk, but the one that
we think is the most important—you know
a lot of people talk about risk in the stock
market as the risk of stock prices moving
up and down every day.  We don’t think
that’s the risk that you should be focused
on.  The risk you should be focused on is
if you invest in a business what are the chances
that you’re going to lose your money, that
there is going to be a permanent loss.  When
you’re thinking about investing your own
money, when you’re thinking about one investment
versus another don’t worry so much about
whether the price moves up and down a lot
in the short term.  What matters is ultimately
when you get your money back will you earn
a return on your investment.  

How do
you think about risk?  Well one way to think
about risk is to compare your risk to other
alternatives, so you could buy government
bonds and government bonds are considered
today the lowest risk form of investment and
the US Treasury issues 10 year, 3 year, 5
year debt.  There is a stated interest rate
and today a 10 year Treasury you earn about
a 3% return.  So you give your government
$1,000 and you get $30 a year in interest.
 At the end of 10 years you get your $1,000
back, so that’s very, very safe and that
sort of provides a floor.  Now obviously
if you’re going to make a loan you can lend
money to the government and earn 3%.  Well
if you can lend money to a lemonade stand
you want to earn meaningfully more, so in
this case the lender is charging a 10% rate
of interest.  Why 10%?  Because they want
to earn a nice fat spread over what they can
make lending to the government because a startup
lemonade stand business is a higher risk business.

investors sort of think about things similarly,
so the higher the valuation—the more risky
the business the higher the rate of return
the equity investor is going to expect and
the lower the risk business the lower the
return the equity investor is going to expect
and equity investors don’t get interest
the same way a lender does.  What equity
investors get is they get the potential to
received dividends over the life of a company.

Let’s talk about raising capital.
 You started this lemonade business.  Now
the point of this was to make money in the
first place.  The business is doing very
well yet I, having started the business coming
up with a name and the concept, hired all
the people, I’ve made nothing, right.  So
the business has grown in value, but where
is my money?  I need money to buy a car for
example, so I want to buy a car for $4,000.
 What are my choices?  What can I do?  Well
we’ve taken all the cash the business has
generated.  We’ve reinvested it in the
business.  Now the good news is we’ve taken
all that money.  We’ve been able to use
it to buy more lemonade stands and these lemonade
stands are more and more productive and it’s
grown the value of the business faster and
faster.  Now my alternatives could included
instead of growing the business so quickly,
instead of investing in more lemonade stands
I could simply have paid dividends to myself.
 Now the good news about that is I get money
along the way, but the bad news about that
is the business wouldn’t grow as quickly
and if you have a business as profitable as
this lemonade stand company and you just open
a new lemonade stand and people earn—we
can earn hundreds of dollars in each new stand
it makes sense to keep investing.  

how do I keep my business going and growing,
taking advantage of the opportunities, but
take some money off the table?  How do I
do that?  Well I could sell the company,
so I could sell my lemonade stand business.
 I started this one in New York.  Maybe
there is someone in New Jersey who wants to
buy me, consolidate with my lemonade stand
company.  Well the problem with that is once
I sell it I can no longer participate in the
opportunity going forward and I believe in
this business.  I think it’s going to be
very successful over time.  So that’s one

The other alternative is
I could pay a dividend.  We have by year
five, over $2,000 sitting in the bank, so
I could pay that money out to the shareholders
of the company, but that would really slow
my rate of growth going forward because I
couldn’t afford to build and buy more lemonade
stands and it’s not the $4,000 that I need
in order to raise money.  So I’m going to
look at taking a business public.  What does
that mean?  Well first of all, before we
take our business public we want to think
about what it’s worth.

It’s year
five.  We’ve been doing a good job.  We’ve
got a business that is profitable.  Everything
seems to be going well.  Well the problem
is I’ve got some personal needs.  I’ve started
this company.  I’ve taken all the cash the
business generates.  I’ve reinvested the
cash in the business.  I bought more and
more lemonade stands.  The growth is accelerating.
 I feel great about it, but I need money.
 How do I get money?  What do I do?  Well
I’ve got a company that generates a lot of
cash each year, but I’ve been reinvesting
the cash, so one alternative is perhaps I
don’t grow as quickly.  I don’t buy as
many lemonade stands and I start sending that
money back to me in the form of a dividend.
 So each year I pay out some amount of cash
in the company.  My need is really greater
than that.  There is only about $2,000 in
the company today.  If I sent that out that
is half of what I need to by a car.  So how
do I get the rest of the money or how do I
get more money?  Well I could sell the company,
so that’s one alternative, but the problem
there is I’ve got this really good business.
 It’s growing really quickly.  Why would
I want to get rid of it at this point?  So
what should I do?  

The other alternatives,
other than selling 100% of the business is
to sell a piece of the business and I can
do that privately.  I can find an investor
who wants to buy a private interest in the
company and if the business is worth enough
I can sell them a piece of the business and
we can be successful.  The other alternative
is I can take the business public.  Everyone
has probably heard of an IPO, an internet
company is going public, people getting rich
on an IPO.  What is interesting is an IPO
doesn’t make someone rich.  All it really
does is it takes a business that they already
own and it sells a piece of it to the public
and it gets listed on an exchange like the
New York Stock Exchange. 

An IPO, the
abbreviation stands for initial public offering
and it’s initial because it’s the first
time a company is going public.  Going public
means you’re selling stock to the broad
general public as opposed to finding one investor
buying interest in the company and its offering
because you’re offering people the opportunity
to participate and the way to do that actually
is you get a good lawyer.  You get a good
bank, investment bank.  It’s going to be
your underwriter and you’re going to put
together a document called a prospectus, which
is going to talk about all the risks and the
opportunities associated with investing in
your company.  It’s going to have history
of how the business is done over time.  It’s
going to have the balance sheet that we talked
about.  It’s going to have income statements
from the previous several years.  It’s
going to have cash flow statements and investors
are going to read that document and they’re
going to learn about whether this is a business
they want to invest in and how to think about
what price they want to pay for it. 

you decide you want to take your business
public you’re going to have to reveal a
lot of information to the public in order
to attract investors to participate and the
Securities and Exchange Commission they’re
going to study this prospectus very carefully.
 They’re going to make sure that you disclose
all the various risks associated with investing
in the company and you’re also going to
have an opportunity to talk about the business.
 It’s some combination of a marketing document
as well as a list of the appropriate risks
that people should consider before buying
stock in the company.  That takes time to
prepare.  It costs money to prepare.  You’re
going to need good lawyers.  You’re going
to need a good investment bank and you’re
going to go through a process where you’re
going to make a filing with the FCC with a
copy of the initial what’s called registration
statement for the offering or the prospectus.
 The FCC is going to comment on it and eventually
you’re going to have a document that you
can then sell shares to the public.

is kind of an exciting time for you because
when you sell shares to the public that’s
really, in most cases, the way to get the
optimally high price for the company, but
you don’t have to sell 100% of the business
to the public.  In fact, typically you only
sell a small percentage.  You get to keep
the rest.  You get to keep control of the
company, but you get to raise money in the
offering and you can use that money to buy
the car that we were talking about before.

before you decided to go public or even to
sell it at all it’s probably a good idea
to figure out what the business is worth.
 So let’s talk about valuation or how to
value a business.  One way to think about
the value of your business is to compare it
to other similar businesses.  Now the stock
market is actually a pretty interesting place
to look.  Now the stock market is a list
of companies that have sold shares to the
public and you can look in the New York Times
or the Wall Street Journal or online, on Yahoo
Finance or Google or other sites and look
at stock prices for Coke, for MacDonald’s
and what those stock prices tell you is what
the value of the company is.  And how do
you figure out the value of the company?  Well
you look at where the stock price is.  You
count how many shares are outstanding.  The
shares outstanding will be listed in various
filings with the FCC.  You multiply the shares
outstanding times the stock price.  That
tells you the price you’re paying for the
equity of the company, so if you go back to
our example of our little lemonade stand we
have 1,500 shares of stock outstanding.  We
sold them for a dollar initially, one-third
of them to an investor and the business initially
had a value of $1,500.

So what is the
business worth today?  Well one way to look
at it; let’s look at other lemonade stand
companies.  Let’s assume other lemonade
stand companies have sold either in the private
market, the public market for a price of 10
times earnings or 10 times profit, so that
will give you a sense of value.  You could
look at the stock market if there are other
examples of a business similar to a lemonade
stand company.  Perhaps a company that sold
soda every month would be a good example,
but let’s use a comparable example.  So
let’s assume another lemonade stand company
is trading at 20 times earnings in the stock
market.  Well we earned a dollar per share
in year five.  If we put a 20 multiple on
that dollar the business is worth, according
to the comparable about $20 per share.  We’ve
got 1,500 shares outstanding.  We multiply
1,500 times 20.  Now our business is worth
$30,000.  So we had a company that started
out at 1,500, five years later it’s worth
$30,000.  That’s actually quite good.

how do we raise $4,000 if that’s the appropriate
value for our business?  Well if we sold
200 of our shares, 200 of our shares that
are today now worth $20 a share we could raise
the $4,000 that we are talking about.  Now
what would that do?  What would happen if
we sold 200 of our shares in the market?  Well
our interest in the business would go down
because today we own 66 and 2/3 percent or
2/3 of the company.  A third is owned by
our private investors.  Well if we sold stock
in the market, if we sold 200 of the shares
that we would own our ownership would go from
67% to 53%, so the good news there is we’d
still have control of the business because
in most public companies owning a majority
allows you to control the business going forward,
but because the company is now owned by public
shareholders you have to make sure their interests
are properly represented, so you have to have
a board of directors, a group of individuals
who represent the interests of the shareholders
who have a duty to make sure that their shareholders
are treated properly and you wouldn’t have
the same degree of flexibility you had when
you were a private company because you have
other constituencies that you need to think

Now the benefit of the IPO is
the stock would now be liquid.  There would
be a market where it would trade in the public
markets and then over time if I wanted to
sell more stock I could do so or if new investors
wanted to come in they could buy stock and
our stock would now be liquid.  It would
make me feel better about this business in
terms of my ability to at some point exit
or if a I wanted to raise more money I could
sell stock fairly easily in the market because
each day you could look up the price either
on the web or in the New York Times or otherwise
and you could figure out what your business
is worth.

Okay, now how does this matter
to you?  Now the purpose of the example of
our lemonade stand is just going to give you
a primer on what companies are, what they
do, how they earn profits, what the various
reports they provide to investors so investors
can figure out what they’re worth and the
purpose of this lecture is to give you a sense
of some of the things you need to think about
when you’re thinking about investing perhaps
some of your own money whether you want to
invest in a lemonade stand or you want to
invest in a company on the market, so a few
basic points to think about.  One of the
most important is if you’re going to be
a successful investor it makes a lot of sense
to start early.  Now that’s kind of a hard
thing.  Today you’re probably a student.
 You don’t have a lot of spare money.  
Well let’s assume at 22 you have a pretty
good job.  Instead of spending your money
on gadgets or a fancy apartment or not so
fancy apartment or going out and drinking
a fair amount you put some money aside and
you start investing money.  Let’s say you
could save $10,000 at 22 and you can earn
a 10% return on that money between now and
the time you retire.  What would you have
in 43 years?  The answer, if you put aside
$10,000, you don’t save another penny and
you invested it in your and you earned 10%
on your money each year you’d have $600,000
in year 43 and the reason for that is well
in year 1 your $10,000 will become 11, in
year 2 your $11,000 would grow by 10% and
so you would be earning interest not just
on your original principle, but you’d earn
interest on the interest you had earned the
previous year and that compounding effect
allows money to grow in an almost exponential
fashion.  Now obviously if you earn more
than 10% you can earn even higher returns.

that’s if you put $10,000 aside at 22 you’d
have $600,000 in 43 years.  That’s pretty
good.  What is you had to wait until you
were 32 when you earn the same 10% per annum?
 The problem there is by year 33 you’d
only have $232,000.  Maybe that is not enough
to retire, so the key thing here is if you’re
going to be an investor one of the most valuable
assets you have today as someone who is 18
or 19 years-old is your youth.  You want
to start early so that your money can grow
over time.

Now what if you could earn
15%?  I’ll give a you better sense of how
powerful compounding is because remember at
10% for 43 years you’d have $600,000.  That’s
pretty good, but if you earned 15% you’d
have over 4 million.  Now you’re in a pretty
good position and so obviously making smart
decisions about where you put your money has
a huge difference in what you’re retirement
assets are.  Now obviously if could put aside
more than $10,000, if you could put aside
$10,000 each year then you’re wealth would
be quite enormous.

Now just for fun if
you were one of the world’s great investors,
Warren Buffet being a good example, if you
could earn 20% per year for 43 years you’d
have 25 million dollars.  Again the original
$10,000 investment would increase about 2,500
times over that period of time just by earning
a 20% return.  Albert Einstein said the most
powerful force in the universe is compound
interest, so the key is start early, earn
an attractive return and avoid losing money
and you’re going to have a very nice retirement.

now let’s talk about the risk of losing
money.  Now let’s assume that in order
to try to get a 20% return you took a lot
of risk and it turns out that every 12 years
you lost half your money because you just
made—you hit a bad patch in the market or
you made dumb decisions.  Well your 25 million
dollars at 20% would now only be worth a million
eight in 43 years, so a key success factor
here is not just shooting for the fences,
trying to get the highest return.  It’s
avoiding significant loses over the period.

Okay, so as Warren Buffet says rule
number one in investing is never lose money
and rule number two is never forget rule number
one, so if you can avoid loses and earn an
attractive return over time you’re going
to have a lot of money if you can stick at
it for a long period of time.

So how
do you be a successful investor?  Now I’m
assuming that you’re not going to go into
the business of investing.  I’m assuming
that you’re going to be a doctor or a lawyer.
 You’re going to pursue your passion, but
you’re going to have some money that you’re
going to save over time and I’m going to give
you my advice on the topic.  It’s not necessarily
definitive advice, but it’s the advice I
would give my sister, my grandmother on what
she should do if she were in the same position.
 I think that’s probably the right way
to think about it.  

So number one,
how do you avoid losing money?  What are
the good places to invest?  My first piece
of advice is despite the story about the lemonade
stand I’d avoid investing in lemonade stands.
 I’d avoid investing in startup businesses
where the prospects are not very well known
because again you don’t need to make 100%
a year to have a fortune.  You just need
to invest at an attractive return 10, 15 percent
over a long period of time.  Your money grows
very significantly.  So how do you avoid
the riskiest investments?  My advice would
be to invest in public securities, invest
in listed companies, companies that trade
on the stock market.  Why, because those
businesses tend to be more established.  They
have to meet certain hurdles before they go
public.  The stocks are liquid, so you can
change your mind if you want to sell.  If
you invest in a private lemonade stand it’s
hard to find someone to take you out of that
investment unless that business becomes fabulously
profitable.  So that’s piece of advice
number one, invest in public companies.  

two, you want to invest in businesses that
you can understand.  What I mean by that
is there are lots of businesses that you come
in that you deal with in the course of your
day in your personal life, whether it’s
a retail store that you know because you like
shopping there or it’s a product, your iPad
that you think is a great product, but you
have to understand how the company makes money.
 If the business is just too complicated,
you don’t understand how they make money,
even if they’ve had a great track record
I would avoid it and a lot of people thought
Enron was an incredible business because it
appeared to have a good track record, but
very few people understood how they made money.
 It was good to avoid it.  

very important criterion is you want to invest
at a reasonable price.  It could be a fabulous
business that is done very well over a long
period of time, but if you pay too much for
it you’re not going to earn a very good
return investing in that company.  The last
bit is that you want to invest in a business
that you could theoretically own forever.
 If the stock market were to close for 10
years you wouldn’t be unhappy.  What do
I mean by that?  Again if you’re going
to compound your money at a 10 or 15 percent
return over a 43 year period of time you really
want a business that you can own forever.
 You don’t want to constantly have to be
shifting from one business to the next.  And
what are businesses that you can own forever?
 Well there are very few that sort of meet
that standard.  Maybe a good example is Coca
Cola.  What is good about Coca Cola?  It’s
a relatively easy business to understand.
 You understand how Coke makes money.  They
sell a formula or syrup to bottlers and to
retail establishments and they make a profit
every time they serve a Coca Cola.  People
drank a lot of Coca Cola for a very long period
of time.  The world’s population is growing.
 They sell it in almost every country in
the world and each year people drink a little
bit more Coca Cola, so it’s a pretty easy
business to understand and it’s also a business
that I think is unlikely to be competed away
as a result of technology or some other new
product.  It’s been around long enough.
 People have grown used to the taste.  Parents
give it to their children and you can expect
it will be around a long period of time.  I
think that’s one good example.

good example might be MacDonald’s.  You
may not love MacDonald’s hamburgers.  You
may or you may not, but it’s a business
that it has been around for 50 years.  You
understand how they make money.  They open
up these little—build these little boxes.
 They rent them to the franchisees.  They
charge them royalties in exchange for the
name and they sell hamburgers and French fries
and you know what?  People have to eat.  It’s
relatively low cost food.  The quality is
pretty good and they continue to grow every
year.  So I think the consistent message
here is try to find a business that you can
understand that’s not particularly complicated
that has a successful long term track record
that makes an attractive profit and can grow
over time.

So what are the key things
to look for in a business as I say that lasts
forever?  Well you want a business that sells
a product or a service that people need and
that is somewhat unique and they have a loyalty
to this particular brand or product and that
people are willing to pay a premium for that.
 Another good example might be a candy business.
 While people are going to buy generic versions
of many kind of food products, flour, sugar,
they don’t need to have the branded product.
 When it comes to candy people don’t tend
to like the Walmart version or the Kmart version.
 They want the Hershey chocolate bar or the
Cadbury chocolate bar or the See’s Candy.
 They want the brand and they’re willing
to pay a premium for that and so that’s
I think a key thing.  You want the product
to be unique.  You don’t want it to be
a commodity that everyone else can sell because
when you sell a commodity anyone can sell
it and they can sell it at a better price
and it’s very hard to make a profit doing

If you’re investing for the long
term you want to invest in businesses that
have very little debt.  In our little example
before we talked about our lemonade stand.
 There is $250 worth of debt.  That didn’t
put too much pressure on the lemonade stand
company, but if it had been $1,000 and we
hit a rough patch the business could have
gone out of business for failure to pay its
debts.  The shareholders could have been
wiped out.  So if you can find a company
that can earn attractive profits, that doesn’t
have a lot of debt or they generate vastly
more profits than they need to pay the interest
on their debt that is a safe place to put
your money over a long period of time.

want businesses that have what people call
barriers to entry.  You want a business where
it’s hard for someone tomorrow to set up
a new company to compete with you and put
you out of business.  I mean going back to
the Coca Cola example.  Coca Cola has such
a strong market presence.  People have come
to expect when they go to a restaurant they
can ask for a Coke and get a Coke.  It’s
very hard for someone else to break in.  Of
course there is Pepsi and there are other
soda brands, but Pepsi has been around a long
time and Coca Cola and Pepsi have continued
to exist side by side over long periods of
time.  It’s going to be very hard for someone
to come in and come up with a new soft drink
that is just going to put Coca Cola out of
business, so when you’re thinking about
choosing a company make sure that they sell
a product or a service that is hard for someone
else to make a better one that you’ll switch
to tomorrow.  Look for something where people
have real loyalty and they won’t switch
and it doesn’t—even if someone offers
the same, similar product for 20% less they
still want the branded, high quality product.

You also want businesses that are
not particularly sensitive to outside factors,
so-called extrinsic factors that you can’t
control.  So if a business will be affected
dramatically if the price of a particular
commodity goes up or if interest rates move
up and down or if currency prices change.
 You want a company that is fairly immune
to what is going on in the world and I’ll
use my Coca Cola example.  I mean if you
think about Coca Cola it’s a product that
has been around probably 120 years.  Over
that period of time there have been multiple
world wars.  There has been all kinds of
you know, development of nuclear weapons,
all kinds of unfortunate events and tragedies
and so on and so forth, but each year the
company pretty much makes a little bit more
money than they made before and they’re
going to be around and you can be confident
based on the history that this is a business
that is going to be around almost regardless
of whether interest rates are at 14%, whether
the US dollar is not worth very much or the
price of gold is up or down.  Those are the
kind of companies you want to invest in, in
the long term, businesses that are extremely
immune to the events that are going on in
the world.

Another criteria, if you think
back to our lemonade stand company, as we
grew we had to buy more and more lemonade
stands.  Now those lemonade stands only cost
$300 each, but imagine a business where every
time you grew you had to build a new factory
to produce more and more product and those
factories were really expensive.  Well that
company might generate a lot of cash from
the business, but in order to grow you’re
going to have to just reinvest more and more
cash into the business.  The best businesses
are the ones where they don’t require a
lot of capital to be reinvested in the company.
 They generate lots of cash that you can
use to pay dividends to your shareholders
or you can invest in new high-return, attractive

So the key here is low capital
intensity, so let’s talk about a low capital
intensity business.  Maybe the best way to
think about a low capital intensity business
is to think about a high capital intensity
business.  If you think about the auto industry
before you produce your first car you have
to build a huge factory.  You’ve got buy
a lot of machine tools.  You have to make
an enormous investment before you can send
your first car out the door and those machine
tools wear out over time and as you make more
and more cars you have to invest more and
more in the factories, so it’s a business
that historically has not been very attractive
for the owners of the business.  If you looked
at the price of General Motors’ stock 50
years ago it actually hasn’t changed meaningfully
even up until the last several years before
it went bankrupt.  If you ignored the most
recent period up through the bankruptcy of
GM very few people made money investing in
GM over a 40 or 50 year period of time and
the reason for that is that GM constantly
had to reinvest every dollar that they generated
to build better and better factories so they
can be competitive.  

If you compare
that to Coca Cola while Coca Cola there are
bottling companies around the world a lot
of those bottling companies aren’t even
owned by Coca Cola.  What they’re really
doing is they’re selling a formula and in
exchange for that formula they get a royalty
on every dollar that is spent on Coca Cola.
 Those are the better businesses. 

good example might be American Express.  If
you think about the American Express card
when you take your American Express card and
you buy something American Express card gets
a few percent of every dollar that you spend.
 So you put up the capital and they get a
several percentage point return on that.  They
get 3% of so of what you spent.  So businesses
where you own a royalty on other people’s
capital are the best businesses in the world
to invest in.

I guess the last point
I would make is that if you’re going to
invest in public companies it’s probably
safest to invest in businesses that are not
controlled.  A controlled company is kind
of like our lemonade stand business that we
took public.  The problem with a controlled
company unless the controlling shareholder
is someone you completely trust, unless there
is someone that has a great track record for
taking care of so-called minority investors,
the non-controlling shareholders it can be
a risk of proposition to invest in that business
because you’re at the whim of the controlling
shareholder and even if the controlling shareholder
today is someone that you feel comfortable
with there is no assurance that in the future
they might sell control to someone else who
is not going to be as supportive of the shareholders
of the business.  So it’s not that you
just—you can simply have a profitable business
and a business that has done well.  You have
to make sure that the management and the people
that control the business think about you
as an owner and are going to protect your
interests.  So these are some of the key
criteria to think about.
Now when are you ready to start investing
money?  My guess is you’re a student.  You
probably have student loans.  Perhaps you
even have some credit card debt.  You’re
going to graduate.  You’re going to get
a job.  So you don’t want to jump right
in and while you have a lot of debt outstanding
start investing in the stock market.  The
stock market is a place to invest when you’ve
got a good—you have money you can put away
that you won’t need for 5 years, maybe 10
years.  So if you’re paying relatively
high interest rates on your credit cards you
definitely want to pay off your credit cards
first before you think about investing in
the stock market.

You student loans are
probably lower cost than your credit cards,
but again here my best advice would be if
your student loans are costing you six or
seven percent well if you pay them off it’s
as if you earned a guaranteed six or seven
percent return and you’re just better off
getting rid of your credit card debt and even
your student loan debt before you commit a
lot of material amount of money to the stock

So what do you do with your money
while you’re waiting to invest?  The answer
is you pay down your debt and you want to
have—even once you’ve paid off your credit
card debts, perhaps you paid down your student
loans, you want to have enough money in the
bank so that even if you were to lose your
job tomorrow you’ve got a good 6 months,
maybe even 12 months of money set aside.  So
these are some pretty high standards and obviously
therefore these make it harder to start investing
earlier, but the safest course of action in
order to be a successful investor is be as—have
as little debt as possible.  Be comfortable
having some money in the bank, so if you lose
your job tomorrow you can live until to find
your next opportunity and once you’ve achieved
those goals then put aside money that you
don’t need to touch.  If you can do that
then you can be a successful investor. 

let’s talk a little bit about the psychology
of investing, so we’ve talked about some
of the technical factors, how to think about
what a business is worth.  You want to buy
a business at a reasonable price.  You want
to buy a business that is going to exist forever,
that has barriers to entry, where it’s going
to be difficult for people to compete with
you, but all those things are important, but
even—and a lot of investors follow those
principles.  The problem is that when they
put them into practice and there is a panic
in the world and the stock market is heading
down every day and they’re watching the
value of their IRA or their investment account
decline the natural tendency is sort of to
do the opposite of what makes sense.  Generally
it makes sense to be a buyer when everyone
else is selling and probably be a seller when
everyone else is buying, but just human tendencies,
the tendency of the natural lemming-like tendency
when everyone else is selling you want to
be doing the same thing encourages you as
an investor to make mistakes, so a lot of
people sold into the crash of ’87 when in
fact they should have been a buyer in that
kind of environment.  

So that’s why
I talked before a little bit about why it’s
very important to be comfortable.  You want
to be financially comfortable.  If you have
student loans you want to have a manageable
amount of debt.  You probably don’t want
to be paying any—you don’t want to have
any revolving credit card debt outstanding.
 You want to have some money in the bank
because if you’re comfortable then the money
that you’re risking in the stock market
is not going to affect your lifestyle in the
short term.  As long as you don’t need
that money tomorrow you can afford to deal
with the fluctuations of the stock market
and the fluctuations, depending on who you
are can have a big impact on you.  People
tend to feel rich when the stocks are going
up.  They tend to feel poor when the stocks
are going down and the reality is the stock
market in the short term is what Ben Graham
or even Warren Buffet called a voting machine.
 Really stock prices reflect what people
think in the very short term.  If affects
the supply and demand for investors, buying
and selling stocks in the short term.  Over
the long term however, stocks tend to reflect
the value of the businesses they own.  So
if you’re buying businesses at attractive
prices and you’re owning them over long
periods of time and those businesses are growing
in value you’re going to make money over
a long period of time as long as you’re
not forced to sell at any one period of time.

be a successful investor you have to be able
to avoid some natural human tendencies to
follow the herd.  When the stock market is
going down every day you’re natural tendency
is to want to sell.  When the stock market
is actually going up every day your natural
tendency is to want to buy, so in bubbles
you probably should be a seller.  In busts
you should probably be a buyer and you have
to have that kind of a discipline.  You have
to have a stomach to withstand the volatility
of the stock markets.  

The key way
to have a stomach to withstand the volatility
of the stock market is to be secure yourself.
 You’ve got to feel comfortable that you’ve
got enough money in the bank that you don’t
need what you have invested unless—for many
years.  That’s a key factor.  

two, you have to recognize that the stock
market in the short term is what we call a
voting machine.  It really represents the
whims of people in the short term.  Stock
prices are affected by many things, by events
going on in the world that really have nothing
to do with the value of certain companies
that you’re investing in, so you’ve got
to just accept the fact that what you own
can go down meaningfully in value after you
buy it.  That doesn’t necessarily mean
you’ve made an investment mistake.  It’s
just the nature of the volatility of the stock

How do you get comfortable?  Well
the way you get comfortable with the volatility
is you do a lot of the work yourself.  You
don’t just buy a stock because you like
the name of the company.  You do your own
research.  You get a good understanding of
the business.  You make sure it’s a business
that you understand.  You make sure the price
you’re paying is reasonable relative to
the earnings of the company and we talked
before a little bit about earnings and how
to look at a value of a business by putting
a multiple on earnings.  A more sophisticated
way to think about a business is to—the
value of anything is actually the amount of
cash you can take out of it over a very long
period of time and people do build models
to predict how much cash a business will generate
over a long period.  That is probably something
a little bit more complicated than we’re
going to get into for the purpose of this
lecture, but maybe another way to think about
it would be helpful.

So when you by a
bond and you get an interest rate, so today
the 10 year Treasury pays about 3%.  You’re
earning 3% on your investment.  When you
buy a stock that’s trading at a multiple
of its profits or a so-called PE ratio or
a price to earnings ratio let’s say of 10
times it’s very similar to a bond.  In
fact, if you flip over the PE ratio, you put
the E on top, what the business is earning
and you put the price that you’re paying
for the stock on the bottom it’s what the
earnings are per share over the price you
get what’s called an earnings yield and
you can compare that earnings yield to for
example the 10 year Treasury, so a company
trading at a 10 PE is actually trading at
a 10% earning yield, so you can actually think
about stocks or buying equity in a business
as very similar to buying an interest in a
bond.  The difference is in the bond you
know what the coupon is going to be.  You
know that 3% interest rate every year for
the next 10 years.  With stock you don’t
know what the coupon is going to be.  The
coupon in the stock is how much profit it
earns and you can try to project that profit
based on the history of the business and what
the prospects are, but that profit is going
to move up and down every year.  Now hopefully
the long term trend is up and so the way I
think about the decision between buying a
bond or buying a stock is I want to make sure
that the earnings yield, that earnings per
share over the price I’m paying for the stock
is higher than what I could get owning a Treasury
and that earnings yield is something that’s
going to grow over a long period of time.

if you had a business that was growing at
a very, very high rate very often—or growing
its profits at a very high rate, very often
people are prepared to pay a pretty high multiple
of those profits.  Why, because they expect
that earnings yield to grow, so if you had
a business you might even pay—it might be
cheap some day to buy a business at 30 times
its profits or a 3% or a 3.3% earnings yield
if you think that 3.3% is going to grow at
a high rate and eventually get meaningfully
higher to a 5, a 6, a 7, a 8 or 10 percent
rate.  Those kinds of investments are much
riskier.  The higher the multiple generally
the higher the risk you take because you’re
betting more on the future of the business.
 You’re betting more on the future profitability.

my basic piece of advice in recommending the
MacDonald’s and the Coca Cola’s of the
world are to find businesses that where you’re
going in yield your earnings yield is high
enough that you don’t need to be right about
a very high rate of growth into the future
in order to earn attractive rate of return.

Okay, so the few key success factors
for being an investor in the stock market
are one, do the homework yourself.  Make
sure you understand the companies that you’re
investing in.  Two, invest money that you
won’t need for many years and three, limit
the amount of—don’t borrow money certainly
to invest in the stock market and limit that
amount of leverage, if any, that you have
as an investor.

Okay, so after this brief
40 minute lecture I wouldn’t just jump in
immediately and start investing in the stock
market.  You have some work to do.  There
is some books you can read and we’re going
to provide you with a list of recommended
books at the end of the lecture that will
help you learn more about investing.  Almost
everything you need to know about investing
you can actually read in a book.  I learned
the business from reading books as opposed
to reading books and the experience associated
with starting small and investing in the stock

Let’s say this is just not
for you.  I don’t want to invest, buy individual
stocks.  It just seems too risky.  I don’t
have the time to do my own research.  What
are your alternatives?  Well you alternatives
are to outsource your investing to others.
 You can hire a money manager or you can
hire a group of money managers and there are
a couple of different alternatives for a startup
investor.  The most common alternative is
mutual fund companies.  So what is a mutual

A mutual fund is I guess technically
it’s a corporation, but where you buy stock
in this corporation and the manager selects
a portfolio of stocks.  So what they do is
they pool together capital, money from a large
group of investors.  So say they raise a
billion dollars and they take that money and
they invest in a diversified collection of
securities.  Now the benefit of this approach
is that with a tiny amount of money, even
less than $1,000 you can buy into a diversified
portfolio managed by a professional manager
who is compensated to do a good job for you
investing in the market.  So mutual funds
are a good potential area for investment.
 The problem is there are probably 7, 8,000,
maybe 10,000 different mutual funds and some
are fantastic and some are not particularly
good, so you need to do research to find a
good mutual fund manager in the same way that
you need to find individual stocks, so it’s
not just the easy thing of just invest in
mutual funds.

So here are a few key success
factors in identifying a mutual fund or a
money manager of any kind to select.  Number
one, you want someone who has an investment
strategy that makes sense to you; you understand
what they do and how they do it.  They’re
not appealing to your insecurity by using
complicated words and expressions that you
don’t understand.  If they can’t explain
to you in two minutes what they do and how
they do it and why it makes sense then it’s
a strategy you shouldn’t invest in.  Number
two and this is not necessarily in this order.
 This probably should be number one, is you
want someone with a reputation for integrity.
 Again if you’re starting out you probably
want to invest in some of—a mutual fund
that is sponsored by some of the larger mutual
fund complexes as opposed to a tiny little
mutual fund that is privately—by a mutual
fund company that you’ve never heard of.
 There is some benefit in the larger institutions
that have—you can be more confident that
they’re not going to steal your money.  You
want someone, an approach where the investor
invests money on the basis of value.  Now
this sounds kind of obvious, but value investing
has a very long term track record and there
are other kinds of investing including technical
investing where people are betting on stocks
based on price movements, but I highly recommend
against those kind of approaches.  So you
want someone making investments where they’re
buying companies based on their belief that
the prospects of the business will be good
and that the price paid relative to what the
business is worth represents a significant

You want to invest with someone
that a long term track record and I would
say 5 years is the absolute minimum and ideally
you want someone who has 10, 15, 20 years
of experience investing in the markets because
there is a lot that you can learn being a
long term investor in the market.  You want
someone who has a consistent approach, where
they haven’t changed what they do materially
year by year, that they have a stated strategy
that they’ve kept to thick and thin that
has enabled them to earn an attractive return
over their lifetime as an investor and I always
say in some way most importantly you want
someone who is investing the substantial majority
of their own money alongside yours.  Obviously
it shouldn’t be that they’re investing
your money.  This is what they do for you,
but for their money they do something meaningfully
different.  You want someone whose interests
are aligned with yours.  If it’s a mutual
fund you want them to have a lot of money
in their own mutual fund.  If it’s a hedge
fund, which is a privately sold fund for investors
who have higher net worth you want a manager
who is investing alongside you as well.  

have a strong aversion to strategies that
require the use of leverage, so in the same
way you want to invest in companies that use
very little debt you want to invest in investment
strategies that you very little leverage.
 If you can avoid leverage and invest in
high quality businesses or invest with high
quality managers it’s hard to lose a lot
of money versus the use of leverage.  Lots
of money can be lost.

Now in the same
way when you’re building a portfolio of
stocks where you don’t want to put all of
your eggs in one basket and you want a reasonable
degree of diversification and the more sophisticated,
the more work you do, the higher the quality
the business is you invest in the more concentrated
your portfolio can be, but I would say for
an individual investor you want to own at
least 10 and probably 15 and as many as 20
different securities.  Many people would
consider that to be a relatively highly concentrated
portfolio.  In our view you want to own the
best 10 or 15 businesses you can find and
if you invest in low leverage, high quality
companies that’s a comfortable degree of
diversification.  If you invest with money
managers you probably don’t want to put
all your eggs in one basket there either and
here you probably want to have two or three
different, perhaps four different alternative,
mutual funds or money managers, so again there
you have some degree of diversification in
your holdings.
So we spent the hour.  We started with a
little lemonade stand company and the purpose
of that was to give you some of the basics
on how to think about a business, where the
profits comes from, what revenues are, what
expenses are, what a balance sheet is, what
an income statement is, how to think about
what a business is worth, how to think about
what the difference between what a good business
is versus a bad business, how debt offered
is generally higher, actually lower risk,
but lower return, how equity investors or
investors who buy the stock or the ownership
of a business have the potential to earn more
or lose more and we use that background as
a way to think about-

We use that as
the—just as the basics to get someone of
the vocabulary to think about investing and
we talked about investing in the stock market.
 We talked about ways to think about how
to select investments, how to deal with some
of the psychological issues of investing.
 We covered a fair amount of ground in a
relatively short period of time. 

I entitled the lecture Everything you Need
to Know about Finance and Investing in Less
Than an Hour.  Well it really isn’t everything
you need to know.  It’s really just an
introduction and hopefully I didn’t mislead
you, induce you to watch this for an hour,
but there is a lot more that can be learned
and there is wonderful books that can teach
you on the topic, so I think what is interesting
about investing whether you choose this as
a fulltime career or not if you’re going
to be successful in your career you’re going
to make some money and how you invest that
money is going to make a big difference in
the quality of life that you have and perhaps
that your children have or the kind of house
you’re able to buy or the retirement that
you’re going to be able to enjoy and we
talked about the difference between a 10%
return and a 15 and a 20% return over a very
long lifetime and what impact that has in
terms of how much wealth you create over the
period, so investing is going to be important
to you whether you like it or not and learning
more about investing is going to have a big
impact on your quality of life if money is
something that you need in order to meet some
of your goals.  

So I recommend this
as an area worthy of exploration and the more
you learn about investing the more—these
same concepts while they’re useful in deciding
how to invest your portfolio they’re also
useful to you in thinking about decisions
like buying a home, making decisions in your
line of work, if you’re a lawyer whether
to hire additional people, these kinds of
calculations and thought processes are helpful
and they’re helpful in life and I recommend
that you learn more.  So take a look at the
reading list and good luck.