Learn about accounting basics and accounting principles that will help boost your bank account with Dr. Patrick Badolato of UT Austin McCombs School of Business. We had the pleasure of inviting him to our headquarters to share timeless accounting principles with us!
Patrick Badolato: What we’re going to do…. I thought this would be a great place to start, but this is what happens when marketers who are good at marketing come up with a good title—and this is the accountant’s version. It’s really what I started at, and realistically it’ll be a combination of the two of them. I don’t want to oversell this, and here’s my general idea here, is I want to discuss accounting—the idea of it. I want to do a lot of tying this into personal finance, but for a couple of reasons. And, one is really that I hope to show you that although you may not find it to be exciting, or even enjoyable, accounting should be, in many ways, relevant.
You may not want to be an accountant, or like accountants, or have any time for accountants. But many of us still have to do things and build off of the skill sets that accountants have. So, in many ways, you are already accountants. You do things that we have to think about in our daily lives. So, when bringing the personal finance element to this discussion, it still is through the lens of how does this relate back to accounting, how does accounting relate to personal finance and vice versa.
[Shows slide] At the end of all this, though, what I want to do is similar to what I do in the classroom, which is emphasize that accounting is one of those disciplines that seems extremely complicated, extremely difficult, full of jargon—but I want to strip all that away. So I want to strip away the things that make it harder to understand, things that make it harder to be enjoyable, things that make it harder to process, and focus on some things that I hope—or I’ll do my best; I’m still an accountant—to entertain you with. We will cover during today’s discussion movies, cartoons, online games, and even charades. You’re ready?
I won’t make, I cannot make, this super exciting. I’ll do my best; hopefully it’ll work out. But I really want to make this, the idea of accounting, what you can learn from that. And we’ll eventually end up with the idea of analysis, emphasize its relevance, how relevant it is to us, how we actually need to think about these things in regular life, and what are the ways we can benefit from this knowledge.
So, first I’ll throw this over to you guys. What is accounting? What would you say? What words would you use? What ideas would you express? Numbers.
Audience member: Counting.
Audience member: Tracking money.
Badolato: Tracking money. Sure.
Audience member: Budgets.
Audience member: Spreadsheets.
Audience member: Margins.
Audience member: Bean counters.
Badolato: Bean counters. We’ll talk specifically about. That is excellent. You’re leading into this very well. Those all sound like exciting ideas—said no one, ever. All right. So, a little bit more fun there. Who are accountants?
Audience member: My aunt.
Badolato: Your aunt.
Audience member: Yeah.
Badolato: Then you laugh. Where have we seen accountants? What do we know about accountants? And, if it helps on this particular question, imagine I’m not here, right?
Audience member: Loophole finder.
Badolato: Loophole finder. Excellent. What else?
Audience member: People who really know what’s going on in the company.
Badolato: People who can really know what’s going on in the company. Hopefully not the only ones, but…. What else?
Audience member: Details.
Badolato: Details. People who like details. Let’s go to the movies. Has someone seen this film? [Shows slide of The Untouchables.] It’s classic. It’s a classic one. If you haven’t, you should. It’s not recent, but going back a little bit. Take a look at these gentlemen. The Untouchables is a story of Al Capone. How they brought down Al Capone. Right? The general idea. There was more to the story than is represented directly in this movie, but it’s a good movie. It’s definitely a classic. If you haven’t seen it, I would recommend it.
What was it that brought down Al Capone, the Chicago mobster?
Audience member: Taxes.
Badolato: Yeah, he was committing tax evasion. It was the IRS that was actually able to get him on those particular charges, which is different than directly being involved in criminal activities, the contributions to murdering of individuals, et cetera, everything else. It was the tax evasion that was easiest thing to basically book him on to end his criminal career, and shift that to a life in jail.
The IRS, the accountants. All right. These three, these four gentlemen. I like to use this, and when I teach accounting I like to emphasize things that I believe are relatively simple, skill sets that we already know. You already know accounting, you already know analysis, which is where I’ll ended up analyzing companies. We already know this stuff. Let’s demonstrate with the skill sets that we’ve had. I’m going to use this one. I got this from Sesame Street.
The skill is called “one of these things is not like the others,” and we’ll do this with analysis. When I teach financial statement analysis, I actually constantly stress how important that line is. [Points to slide] One of these things is not like the others. Who can identify any of these men?
Audience member: Sean Connery.
Badolato: Sean Connery is the second from the left.
Audience member: Andy Garcia.
Badolato: Andy Garcia, on the far left.
Audience member: Kevin Costner.
Badolato: Kevin Costner. Good. That was real good. So if you, if you aren’t familiar with them, this is Andy Garcia, he is younger; this is Sean Connery in the twilight of his very, very established career in movies; Kevin Costner. We have one more to go.
Audience member: Yeah?
Audience member: If that that’s not Matt Damon, then I don’t know.
Badolato: That is definitely not Matt Damon. That’d be off by a couple of decades, too. That is the accountant. He’s the accountant. He’s the individual who actually was processing the books, doing everything else. So one of these things is not like the other. We were able to identify based on their being very well-established actors. Three of these four gentlemen, all but the accountant. Interesting. All right.
[Shows another slide.] Dilbert. Has someone seen the commercial—uh, the cartoon Dilbert, read these? The vast majority of what the material he focuses on is? No. More broadly, what?
Audience member: Work life.
Badolato: Work life, office life. So, the work life that will revolve around the idea of an office. That’s the cubicle office, the corporation, that type of work life. What’s so fun about work life? Why do we find Dilbert cartoons to be hilarious? Why has he done so well?
Audience member: It’s relatable.
Badolato: It’s relatable. There’s a psychological phenomenon at play here.
Audience member: It’s funny because it’s true.
Badolato: It’s funny because it’s true. Downward social comparison. Researchers have proven this. The paper I’m citing there from 1985. The general idea that we as humans feel better when we can do what?
Audience member: Imagine someone being worse.
Badolato: Imagine, look down upon someone who we perceive as worse. Who is the primary butt of all the jokes, the worst, the lowest in the office around the Dilbert cartoons?
Audience member: [Inaudible]
Badolato: Lower. It’s not a very positive or optimistic outlook all over—the accountants. The worst of the worst are the accountants. So, the butt of the many of the jokes, and as I have in these three, is the accountants are even lower than those who are not really enjoying their work or the … whatever they’re doing when they show up to this office in the variety of Dilbert cartoons. The accountants.
It gets worse. [Shows next slide.] There are Pinterest pages that basically are just collections of cartoons that make fun of accountants. It’s an interesting thing to spend your time on, but we do it.
[Shows next slide.] There is an academic paper that was looking at stereotypes and shows accountants as the stereotype to examine. They were potentially hoping to show that this stereotype had decreased across time. And the end conclusion of this paper [was] that this boring, joyless character—[this] clear stereotype of the accountant—has not decreased but simply become more nuanced as time has progressed. The lowest of the low. All right.
Can we explain this joyless area, then? I really set this up well, huh? I’m not a marketer, I’m an accountant myself. [Shows next slide.] This is the definition of accrual accounting. Accrual accounting. I’ll give you some comments here. This is directly from Investopedia. This is a relatively straightforward and approachable way that an accountant has written about accounting, and it’s still, generally speaking, pretty dense. A lot going on there. What is accrual accounting?
I’m also willing to bet that just—in just a moment, this will be a concept that we can all understand away from this dense nature, and into what does it mean with routine transactions. [Shows airplane slide.] I like to choose one that most, if not all, people are familiar with. I’m going to start with this one. Flying a plane. What is accrual accounting? One of the things that it gets at is, when do we represent business being conducted? When do we represent revenue recognition is one of the things we talk about, and this can get pretty dense and complicated, but I promise you, you could all do the same thing. You buy a ticket in April, and you fly in May. When should United, or any airline, recognize the revenue?
Audience member: [Inaudible]
Badolato: The second it’s in their hands. So, April. April, 25th. Other people were saying May.
Audience member: [Inaudible]
Badolato: OK. What if it’s nonrefundable! Their tickets are mostly nonrefundable. Is that it, though?
Audience member: It might be in April and not in May because that’s when the action was accomplished.
Badolato: The action was accomplished. That’s a really valuable insight, and I want to show it a different way. We didn’t have a great answer, as everybody wasn’t feeling very confident about this or even knowing it, or not even wanting to put forth something. But I’ve got a game we can play that will solve that.
Charades. Who’s ever played charades? Revenue recognition, when we do is talk about accounting, can get complex. Talk about a lot of different things. At the end of the day, it’s based on actions being taken. You recognize revenue when you, the company, take actions, when you do your job. That’s why I’ve chosen an airline. When does an airline recognize revenue? When they do what? [Extends arms out to the side, imitating flying.] When do they recognize revenue?
Audience member: When they fly.
Badolato: Let’s see it. Don’t hit everybody around you. You’re probably too close quarters. When they technically—someone said this correctly—when they do what? There’s one moment, it’s when they land. Why? Their action is getting you from point A to point B, flying that plane, getting you to your destination.
So, this idea of accrual accounting, which can actually be relatively complex, still focuses on one main aspect. We recognize things, we recognize progress, when we take actions. For the plane, it’s flying a plane. So if you’re ever trying to figure out—and I do this in the introductory class: When do I determine a company’s recognition of revenue?
Can you act it out? What is that charade you would do? And, if it’s not an action you can take, you may want to think about, maybe not yet. It still should be based on the company completing its primary action. For planes, got to put those arms out. They’ve got to complete that flight. That is the essence of accrual accounting.
All right. Other applications in our own lives: Is there a difference to you between buying a movie ticket and a couch?
Audience member: One is much more expensive.
Badolato: One is much more what? Sorry?
Audience member: Tickets are much more expensive.
Badolato: Sure. Other than the total price. It depends, right?
Audience member: You could sell the couch later.
Badolato: You could sell the couch later? Can’t sell the movie tickets. You only use the ticket once.
Audience member: Depreciation.
Badolato: Depreciation, we’ll get to that next. That’s an exciting topic. When you buy a couch, or you invest in something like a 401K, what’s … Are you spending money? Are you putting up money on all these cases? Are you spending? Is there an outflow? Yes, but what do you have to show for it?
Audience member: An investment.
Badolato: Something. An investment. In accounting, we talked with the idea of capitalizing assets. That’s the fancy term, but at its core, what we’re working through in accounting is, when you make—when you have an expenditure, when you outlay, when you pay for something, we want to determine some things that you pay for provide us with future benefits. Some things give us the opportunity to have advantages, benefits, enjoyment in some way going forward; and some are consumed on the spot. The difference with a movie ticket and buying a couch is you expect the piece of furniture is going to give you some enjoyment, some pleasure, some benefit going forward. The movie is going to be consumed in that period in time.
Accounting basically says, represent that there is value to that couch being purchased. The teaching last week in one of our programs at University of Texas, and a student kept using the phrase “losing money, losing money.” Well, I don’t have it anymore, so I’m losing money. And I kept trying to redirect that conversation towards investment, spending on, and then towards the idea of “Now we have assets to show for it.”
Spending money—we don’t want to just think about there’s an outflow. Cash accounting says an outflow is an outflow; it’s gone. In accounting, accrual accounting, the idea we actually try to emphasize is, what we can do with it next matters. So we distinguish those two.
Second big aspect of it is, what do we do with assets? So the first thing I was talking about was revenue. Second thing I have is assets. Here’s basically what we have. Assets—a big part of accounting are things we own that we expect to give us a future benefit. Revenue, it’s based on actions. Assets were the things we own with expected future benefits.
Other side of this: Electricity, meals, insurance—has anyone encountered these items in their own lives? What’s the difference with these three, generally speaking, with respect to payment? When do you pay for insurance?
Audience member: Regularly.
Badolato: Regularly, and what else?
Audience member: In advance.
Badolato: In advance. When do you pay for electricity? After the fact. And when do you usually pay for a meal—or concurrently. Three ways of enjoying things. Things that we pay for up front, ahead of time; things we pay for after the fact; things we pay for concurrently. What do we do in accounting? We want to recognize that the method of payment matters. But, in all cases, when we talk about the idea of expenses, it’s not based on the literal day that we make the payment. It’s based on when we use those things up.
So we have an expense for utilities when we use up the expense. We have an expense for a meal, the day that we eat it. And we have an expense for insurance—not the day that we make the payment, but over time as we receive that coverage. So we get into the idea of how do we recognize expenses, and how do we determine whether or not we have liabilities, whether or not we’ve paid for something we still need to take into consideration? I have an obligation [and] I’ve got to make good on that.
Expenses are based on when we use things up; assets are based on things with future benefits. Revenue is based on actions, covering those pieces. We have one last aspect of accounting to cover. Mortgages or car loans fit into this one pretty well. What do we make payments for? When you have a car or a mortgage loan that you have to pay off, what two things are those payments for?
Audience member: Principal and interest.
Badolato: Principal and the interest. What’s the advantage of paying our principal? As we pay more of it, we have more what?
Audience member: Equity.
Badolato: Equity. The term we use in that realm is equity. That’s exactly what we’ll see in accounting as well. The home is our asset, the loan is the amount we borrowed, and the difference between those two is the amount that is ours. So the idea of equity—assets equal liabilities plus equity, sorry—is the same idea that we see when we think about paying down a mortgage. There are payments we can make, there’s progress we can make, and at the end of that we have more ownership. Things we own, things we have to settle, like the loan; things that become ours, equity.
Those are all the core ideas of accounting that we’ve seen in our regular basic lives. Somebody mentioned depreciation, so I want to go there next because that’s fun. Depreciation versus appreciation. What’s the difference? Appreciation means value goes …
Audience member: Down.
Badolato: Appreciation means it goes up. Cars versus real estate. I have a couple of finance professors I’m friends with, and they recommend or they criticize me, and fairly. They say, “Why don’t you spend your money on a nicer car? You should buy a nicer car.” I have in the past actually invested in real estate, and my answer is to them, “I like assets that appreciate.” And they like to chase assets that depreciate. Cars are a great example of assets that depreciate quickly. Real estate, generally speaking, is an asset that appreciates, so let’s apply this idea of depreciation. Why do cars depreciate? Why is it the case that cars depreciate?
Audience member: Wear and tear.
Badolato: Wear and tear.
Audience member: Newer models.
Badolato: Newer models, technology changes. The things that were new and attractive are less new and attractive.
Audience member: Amount of driving [inaudible].
Badolato: Amount of driving, or the future benefits that you can get from that decreases. Who came up with the idea of depreciation? Was it accountants?
Audience member: Society.
Audience member: Customers.
Badolato: Society? What discipline, what subject discipline we all took in high school actually came up with depreciation?
Audience member: Physics.
Badolato: Physics. It’s a construct of physics. Things wear out across time. Even if you think about the economic implications, things that were attractive and new at one point in time aren’t always attractive and new. It’s because technology underlying them has changed. Depreciation’s a construct of physics, so we also have this. [Shows next slide.] Why do we say that cars depreciate as soon as they come off the lot, as soon as we drive them off the lot? Why do we say that?
Audience member: It’s no longer brand-new.
Badolato: It’s no longer brand-new. It’s only seconds old. It depreciates much more than whatever mathematical equivalent of a few seconds. You drive the car home, you have it for two days. The argument is you could sell for significantly less than what you bought it for. Why?
Audience member: Because a brand-new car is different.
Badolato: Is fundamentally different than a two-day-old car. Is it?
Audience member: Who’s going to buy it?
Audience member: Prestige.
Badolato: Prestige. A two-day-old car is different in terms of prestige than a zero-day-old car?
Audience member: Fear of the unknown.
Badolato: Fear of the unknown.
Audience member: The vision in the market. Something new is huge data or …
Badolato: That’s true. Why, though? It’s an economic concept here, what do we assume? This is the—George Akerlof came up with this idea. What do we assume if someone’s trying to sell a car they just recently bought?
Audience member: Something’s wrong.
Badolato: Something’s wrong. So, why do they depreciate quickly right off the lot? It’s not because there’s a meaningful thing in two days, because if you’re trying to sell it back, doesn’t that imply to the outsider you didn’t have time to drive around for a couple of weeks, or days. Something is wrong. That’s the idea of the lemon. The lemon is: The only rational reason to resell your car that you just bought is you found out something is wrong, and you think that the potential individual on the other side doesn’t know that.
So if the individual on the other side knows that that’s what you’re doing, if you think about backwards induction, he or she has to assume there’s something wrong with this car—substantial decrease to value that occurs immediately or near immediately, because of what it implies. All right. I covered the assets, revenue, assets, expenses, liabilities, depreciation.
Let’s put it all together. [Shows next slide.] You’re shopping for a car loan. You’re shopping for a mortgage. Why do you need to both understand the cash outflows and also what I’ll refer to as accrual accounting? Or if you want to think about it, the economic aspects behind this—your expenses, your liabilities?
First, the cash piece. Why do you have to understand the cash transaction, the cash component of shopping for a car loan or a mortgage?
Audience member: [Inaudible]
Badolato: On what basis?
Audience member: [Inaudible]
Badolato: On what basis? Someone mentioned this initially—when do you worry about your cash budget? Monthly. Do I have enough cash to make up this payment each and every month? Which is the way these are usually constructed. Do I have enough cash? Will it be able to come up with enough cash? That’s one level, and hopefully that answer is yes. But I would also argue you need to look at the expenses, what things you want to analyze, negotiate, or bargain for on a mortgage—when shopping for a mortgage, I’m sorry.
Audience member: Interest rates.
Badolato: The interest rates.
You’re going to have a tough time shopping for that, or arguing about that. You could have improved it prior to the fact—but your interest rate. You wanted the lower rate, and you want to also reduce what else?
Audience member: [Inaudible]
Badolato: If you can.
Audience member: The initial principal.
Badolato: The initial principal would come down to the bargaining of the house, but what about, excuse me, just shopping for the mortgage piece? The mortgage charges you up in addition to the interest across time, up front. Points, which can be a component of what broader idea?
Audience member: Fees.
Badolato: Fees or closing costs. So, points are one of the aspects of the fee. The fee or closing costs to the initiation of a mortgage—what are you trying to negotiate? You want lower closing costs and a lower rate, but you also need to make sure that on a cash perspective, you can make those payments across time.
I want to bring this back to car loans. What’s the easy way for a dealer to make you be able to afford a payment? “I only can pay $300 a month. Is there anything you can do?” I say, “Yeah. Initially it’s priced at 350. I can’t afford that. It needs to be under $300.” They come back to you, they say, “We got you in for 289 a month.” Exactly what you wanted. It’s going to work out perfectly.
Audience member: Longer loan.
Badolato: Longer loan. Yep. The fine print, and not really the fine print—the basic print took that loan from 60 days, which we’ve seen. That’s traditional, car loans used to be 60 days to 7 years … Sorry, 60 months. Sorry. That’d be crazy. Sixty months. Five years to 7 years, 84 months. One of the things we’ve seen in the car industry is that it’s easier to sell cars when the payment goes down. The easiest way to make the payment go down is increase the months.
Shopping for a car loan, make sure that you’re holding, if you’re in negotiating and bargaining, or comparing two things, or holding, number of payments constant. Easy way to make it fit in your budget on a cash basis is extend those payments. Why does that leave you worse off? Your total obligation or your total liability would be increasing significantly. You’re on the hook for much longer time. All right. Questions on anything so far? All right.
I want to go into a different topic: financial reporting, and the jargon that exists here. [Shows slide.] So, these are all real acronyms. These were, I think, unfortunately not that hard to come up with. I think I did most of these, if not all of them, off my head. But they exist. A lot of acronyms here. I’d like to move away from that and think about what do we do with all this stuff. And, to me, that actually begins with the invention of accounting.
Why did humans invent accounting? Why did we invent accounting? The easiest way to answer that question is to think about it this way: When? When did we invent accounting? We started trading.
Audience member: Agricultural.
Audience member: When we invented money.
Badolato: When we invented mon— it proceeded currency, in fact.
Audience member: OK. [Crosstalk]
Badolato: In fact, the argument is that came alongside what? Accounting helped develop what?
Audience member: Debtors.
Badolato: Before that? Sorry?
Audience member: Language.
Badolato: Language. So, the anthropologists that have examined this have concluded that accounting helped the development of the written language. Not spoken language, but written language. Written language is a form of what, at its core?
Audience member: Record.
Badolato: Record, record keeping. So, accounting was essential in developing the idea of written language. So, it long preceded currency, it long preceded capital markets, it long preceded all that stuff. Why? Why did we invent accounting? What problems did we have, as humans, that we were trying to solve?
Audience member: Making promises.
Badolato: We make promises, but …
Audience member: Resource allocation.
Badolato: Enforce them because we may do what? Resource allocations are complex terms, but correct. We make mistakes.
Audience member: We forget.
Badolato: We forget. Lie. Cheat, steal, lie. That’s actually—I’ve asked that question across different groups, and I usually refer to it as a revelation of your type—the audience. In my mind, I’m actually polling you to figure out, what do you say first? Is it lie, cheat, and steal, right? OK. I’m dealing with a bunch of future crooks trying to figure out how they scam the system, what loopholes can I figure out?
On the other side, the main reason we have this is the perfectly harmless fact that we forget, we make mistakes. Accounting was invented to the fact that humans then and now had problems with forgetting, making mistakes, not always able to perfectly track things in our mind. So we found out initially it was actually clay balls with tokens that can be moved in and out, would help us facilitate that process, which led to writing.
So, the next time you see an accountant, please thank them for all the wonderful things that came to society after this point. We really should take credit for everything. Everything after the invention of writing. So, I usually ask this question and, you know, who invented accounting? Who invented accounting, then?
Cavemen. Cavemen and women, right after they invented the paleo diet, came up with the idea of accounting. All right? Two greatest contributions to society.
[Shows next slide.] We in accounting have these three financial statements. [You’ve] probably heard of them. They go by, somewhat, different names. There’s the balance sheet, which I was mentioning before: keeps track of our assets, liabilities, and equity. If you’re curious, that would be similar to an individual thinking about, “I have assets, I have obligations, and I have my net worth.” So, fun exercise for tonight: Create your own balance sheet, right?
We have the income statement, which focuses on revenues and expenses. Revenues are these actions: what’s earned, when do you complete that action. Expenses are what’s being incurred. It’s a representation which is best described as a video. So the income statement talks about your progress during a period, and the balance sheet is a photo, a snapshot in time. What do you have at a specific point in time is the balance sheet. The income statement says what happened over the course of time, which is usually a year. We have the statement of cash flows, which also talks about the inflows and outflows, which leads to this question: Which is most important? You apply for interviews. This question can be asked. Some of our business students face this relatively often. Which is most important?
Audience member: For what?
Badolato: That’s a good answer. For what? It’s a trick question. Why?
Audience member: They tell you different things.
Badolato: They tell us different things. Which is most important? All of them. All of them. So, if you look back at all the way this stuff is written in relatively complex language, there is not a ranking, and the accounting standards boards that came up with this idea is very clear that this is a system. A system of three, because collectively they tell us a lot about a business. I also want to argue that collectively they would tell you a lot about an individual; and only looking at one, [you] may overlook some pieces.
This chart, recent article I read, talks about debt by age group, and importantly it actually talks about the different types—education, loans and mortgages, et cetera. Debt by age group. Less than 35—these are years old: 35 to 44, 45 to 54, 75 or older. So, these different cohorts. Which one’s the best? Which one’s the worst? Is there best or the worst? Best? What’s the worst then? The 35? Sorry, I mean of the age groups. What’s the best age group? What’s the worst age group? Sorry.
Audience member: 75 or more.
Badolato: 75 or more is the worst?
Audience member: Yeah.
Audience member: They still have debt at that age.
Badolato: They still have data at that age. Why? What are you getting at?
Audience member: They have less time to pay down their debt.
Badolato: Less time to pay down your debts. Less time for what? Think about the financial statements I just mentioned. Less time to pay down your debts, because you have less time to do what? What do younger people have in a negative way? A lot more what? A lot more in the negative way, they have a lot more time. This is arguably a good thing, but debatable. They have a lot more, this is not as if—this is what?
Audience member: Debt.
Badolato: Debt. A lot more debt to pay off. A lot more debt to settle. What does a younger person, certainly a 35-year-old, have on his or her side? Time, and the next extension of that is time to earn income to pay this off. What does the 75-year-old—I really liked that point. The worst ones off—wait, 75-year-olds, this is just the state of the US, still have a significant amount of debt. Why is that a particular challenge? That is generally speaking an age when income is not going to increase and may actually stop.
Audience member: [Inaudible]
Badolato: You have other needs and day-to-day lives. Excellent. And you have this debt to settle. Who’s best, who’s worse? Just to be clear here, this graph doesn’t tell. We need to think about income. We need to think about inflows and outflows. Another thing we need to think about with debt is what? Back to one of my way earlier slides, before we critique a high level of debt, we need to think about what?
Audience member: Assets.
Badolato: Assets. What do you have to show for it? What’s the nice thing, what’s the negative thing about a mortgage here? It’s a massive amount of debt. What’s the positive or the upside of a mortgage? You have what?
Audience member: A house. [Crosstalk]
Badolato: A house. You have a house, which can appreciate, you have a place to live, and it can appreciate, it can end up being a good investment. But at one point you have to swallow a massive amount of debt, and take care of that across time. It’s an interesting idea, and it represents the state of data across different age groups in the United States, but it overlooks a couple of critical things. We still need to think about income, the ability to generate money, and our salaries and income to pay that off, and also the assets that show for it.
What’s another good type of debt to take on as a result, other than a mortgage debt? Sure, but as—as the thing behind the debt.
Audience member: In theory, education.
Badolato: In theory, education. Excellent, perfect answer. Why? In theory, what should education provide?
Audience member: Augment your ability to generate income.
Badolato: Augment your ability to generate income. It should give you future benefits. In theory, it should be what? Something you control, something that’s at your disposal and that can give you future benefits. Education, in theory, should be …
Audience member: An asset.
Badolato: That’s because it could be the best type of what?
Badolato: Asset. You spent the money. This looks like you have nothing to show for it. It’s just all of your obligations. What we need to see on top of this is yes, but mortgage comes with a house, that has its benefits. Yes, but education, I’m going to use your words, in theory, should provide you with the opportunity to do more, right? To make more, but to be more satisfied, and have all the future benefits.
Which statement matters most? What I was demonstrating there is you can’t look at any individual metric. We need to expand that and think about, yeah, but what’s behind it? What’s related to that, and what’s going to come next? The basic idea of even at 75, we want to think about earning potential. The amount of debt in and of itself isn’t going to tell us the full picture. All right.
I want to go to the last area I want to cover today, which is analysis. [Shows next slide] The get-rich-quick scheme of today’s conversation is going to start right here. Definitively, what is the best investment any individual can make?
Audience member: Put actions on Snapchat. [Laughter]
Badolato: Good. What’s the best investment any individual in terms of personal finance? What you’re going to do constantly, monthly, commit to?
Badolato: Savings? No. Working? Maybe. Sure. It’s a little different and because you have to … Not savings. Not a house necessarily. Should…that argument, I can’t prove whether…that’s hard to quantify, but I would agree with that.
Audience member: Take all to Vegas, and then [inaudible].
Badolato: Yes, that’s it. What is the thing? What do I have here? [Shows slide.] Historical credit card rates hover around what? They’re in the 20s, sometimes 14, 15 percent, even when right now we’re in very low interest rates, credit card rates are still very high. What’s the best investment you can make?
Audience member: Eliminate debt.
Badolato: No, not eliminate debt. Pay your credit card bills, not on time. In full, each and every month. What are you effectively saving if you do that? Right now, 15 to 20 percent. Which investors across time have beaten 15 to 20 percent. There’s one answer here.
Audience member: Warren Buffett.
Badolato: No. Warren Buffett is consistently beating the market. I’ll actually kind of talk a little bit about some of his tenets I talk about in class, but he has not performed at this level. He’s arguably the greatest investor of all time. There’s one and only one individual who was beating 15 to 20 percent, year after year, after year.
Audience member: [Inaudible]
Badolato: Bernie Madoff. The only one who was beating this was not actually beating it; he was running a pyramid scheme. So Bernie Madoff was shut down for running a pyramid scheme where he brought in investors’ money and was just returning it by saying he was earning that amount, but he was just returning the new funds that came in, and lots of new funds came in for a while because that’s an incredible return.
Paying down your credit card as a bit of a legitimate personal finance advice is an excellent way to generate a 15 to 20 percent not returns on paying you, but savings. You can save your money in any vehicle, you can invest in the stock market. You could buy the Snapchat options. You can do what you want. You’re not going to beat, across time, the savings from paying down the credit card balance in full, right? So, the best piece of personal finance and investment advice I can give: Don’t invest, pay down your credit cards. All right.
This is what I was mentioning—Ben Graham wrote The Intelligent Investor quite some time ago. He was the professor, the teacher of Warren Buffett. Warren Buffet, generally speaking—many people have heard of him as being one of the greatest investors of all time for his success in investing in individual companies across decades. He’s invested in Coke and GEICO, and a bunch of other sort of classic stories.
[Shows next slide.] Ben Graham wrote the book The Intelligent Investor, and he lays out his main tenets for investing. This is not a complete list, but there’s four I want to share with you that I hope actually are, or I find to be, brilliant for this reason: They work. When I teach financial statement analysis, we analyze individual companies, but above and beyond that, they should come across as valuable lessons for life.
There shouldn’t be anything—in contrast to that earlier slide I have with all those acronyms—there shouldn’t be anything that is exceptionally detailed, jargon related or complicated. What he focuses on, on things that are, I hope, are relatively straightforward:
We’re not buying stocks, we’re buying a business.
[If] you’re going to buy a business, understand that business.
Ignore information at your peril—or don’t ignore information that will likely be very costly.
And finally, understand what you know, and don’t mix what you know with speculation.
These four tenants are critical in analyzing a company, making an investment decision. You’re not in any way going to walk out of this lecture being able to make your own investments, or do all this stuff, but I want to apply this to a couple of cases that I’ve covered in financial statement analysis.
The brilliance of his wisdom is its simplicity.
[Show next slide.] Zynga. Zynga, it’s IPO a couple of years ago; I’ll jump to the punch line here. What I’ve presented on the bottom half of the slide is Zynga’s stock price relative to three other companies that Mark Pincus, the CEO and founder of Zynga, mentioned in a commentary about what would happen next with this company, preceding their IPO. Those companies are Amazon, Facebook, and Google.
One of these things is not like the other. I’m assuming everybody’s familiar with Amazon, Facebook, and Google. On the surface, what’s the difference between these? And this is Ben Graham’s idea of don’t—understand what you know and don’t mix that with speculation. What’s the difference? What’s the similarity between Amazon, Facebook, and Google? They’ve cornered their markets.
Audience member: They all provide some kind of actual utility, where Zynga provides opportunity.
Badolato: I think there’s a lot of people who would classify mindless entertainment as utility, right? The opportunity to, “I don’t like my own life, but I have the opportunity to escape it, and have the fake online life on Farmville.” It’s a massive amount of utility. Speaking from personal experience? No. [Laughter] What do we have here?
Audience member: There’s specific for Amazon, Facebook, and Google [inaudible].
Badolato: What do Amazon, Facebook, and Google all offer at the fundamental level? They are all are what?
Audience member: They have a product.
Badolato: Yeah, true. Yeah, that’s true. What do they do that … what do they offer? How do they sell their stuff? How do they interact with customers? Zynga’s all online. Zynga’s a service, too.
Audience member: Search.
Audience member: So, you’re searching friends on Facebook, searching Instagram.
Badolato: They have that opportunity to add in an element of search. Yes.
Audience member: They have their own line of distributors.
Badolato: They’re their own distributors. They all actually are operating a what? On this point—there’s a word I want to use here, that’s perfectly in line: platforms. They’re platforms. Platforms to stream content, platforms to buy stuff, platforms to buy ads, platforms to access customers, platforms to get to know data about customers. For better or for worse, they’re all massively successful because of their platforms. Zynga created a bunch of online games, and some of them were very popular. Was Zynga a platform? They were what? A really good game developer with some excellent hits. But where did the customers have to go?
Audience member: Facebook.
Badolato: Facebook. So, Facebook was the platform. Facebook controls Zynga’s upside. Facebook is the company that’s able to perform well across time that has the true investment advantage. Zynga—and this is a brilliant categorization of arguing they’re similar to these other companies—but is meaningfully different.
[Shows next slide.] Second case: Groupon. Everyone’s familiar with Groupon. Has anyone ever bought a Groupon? Understand the business. Can someone describe to me what a Groupon daily deal involves? You pay Groupon, and then you do what? You buy that deal, and then what happens?
Audience member: You get a discount on whatever you’ve bought.
Badolato: Then what? How do you get whatever you paid for?
Audience member: You have to get to that seller.
Badolato: Seller, provider, service, salon, movie theater, spa, whatever. This chart here on the screen is from research done in part of a Forbes article. [It] demonstrated that Groupon would be, at that time, the fastest growing—fastest company to achieve a billion dollars of revenue. So they achieve a billion dollars in revenue right around two years. Every other company—and there are some pretty successful companies up there—took significantly longer. Significantly longer. So this means there’s this greatest-of-all-time debate that seems to get more attention during the NBA finals. All right, is it Michael Jordan? Is it Lebron James? Is it UT former student, Kevin Durant, right? And the answer is Groupon. This puts them at the greatest of all time in terms of generating quickest—fewest amount of years to achieve a billion dollars of revenue. The greatest of all time. And, arguably, they should be worth more than any company that comes after them.
Groupon had their IPO. It was for quite a bit, and then it dropped off 80, 90 percent, never was recovered. What were they doing here in terms of revenue recognition? Think about the experience of buying a Groupon.
Audience member: Didn’t really regenerate a lot of return services.
Badolato: Sure. That’s a long-term issue with the company.
Audience member: They were lowering prices, which can’t go on forever.
Badolato: Sure. At the core, though, what did they count as revenue?
Audience member: They counted their vendor revenue as growth revenue.
Badolato: They counted revenue as if they were doing what? Let’s go back to United, the flight. They counted the revenue when you buy the deal as if they were going to …
Audience member: Provide the service.
Badolato: Fly the plane. What does that actually make Groupon, if you think about it?
Audience member: A fraud.
Badolato: No, [laughter] let’s be clear there. A massive collection of what? An endless amount of services that can be bought or sold at different markets. So that means they’re likely a conglomerate that controls all these barber shops, all these movie theaters, all these restaurants. All these small businesses become under their umbrella, and that’s the main thing that enabled them to get to the top of the list. They tried this, they were actually shut down. They weren’t allowed to do this. And the basic answer is, you can’t claim full revenue from United. United wasn’t one of the ones—because you’re are not flying that plane. Revenue and being at the top of this list still needs to translate to “What actions do you take?” What is the action that Groupon actually takes?
Audience member: They email you a coupon.
Badolato: They email you a coupon, and what else have they done?
Audience member: Negotiated.
Badolato: Negotiated. So, what have they done? They’ve negotiated, they’ve emailed you a coupon. They’ve done what? Consumer, merchant—served as a middleman, connected them. Is there an action there? Yes. Is there a revenue associated with that? What do we call that?
Audience member: Commission.
Badolato: Commission. The agent’s commission. The reason why they didn’t want to refuse their agent’s commission when they initially put this information out there, instead of the total revenue from all those merchants, is that would rank them at number 3,241 on this list, and that’s far from the greatest of all time.
Understand the business. Their business was not providing all these services; it was serving as an agent. That’s a business model. It’s a fundamentally different business model than being a massive conglomerate.
Some of you mentioned some of the other challenges they had, which was with respect to sustainable revenue—merchants not being totally thrilled with the experience, and the idea that discounting is something that’s hard to repeat period after period. So, I’ll end with this last question, was Groupon’s business model new? Where has this existed for decades? Decades. Long before the Internet?
Audience member: Value Pak.
Badolato: Value Pak. Valpack. Those coupons—if you still get snail mail, the coupons we get in the snail mail—are common packages that offer discounts on stuff. Randomly collect it and put together in one package for the consumer. What did Groupon do differently? They took that, they took it from snail mail, translated it to email spam, and went with it.
I’m thinking about our time. I had this last one, but I won’t be able to get to cover this last slide. So, I feel like-
Audience member: Two minutes.
Badolato: Two minutes. That is actually all we’re going to have for today because I won’t….
[Shows next slide.] I can fly through this last one, [but] I think you would find that very hard to get much out of it. But I’ll just kind of give you a quick preview here, which is ratio is the last piece we can cover. This is a lot to cover. Sorry, I went through that too quickly.
Ratio is our last piece you can use in financial analysis. I want to emphasize though—which I talk about in class—it’s a lot less about the numbers, determining better or worse based on larger or smaller numbers, and a lot more about what does it mean, what’s behind it. So I’ll draw your attention to this first one there, which is days inventory.
Apple is known for having a very low days inventory. They sell their stuff very quickly, very quickly. On average, 6 days. Samsung, a competitor, looks like it takes a lot longer. Well, there’s more to the story. What does Apple do differently in its manufacturing process that will enable it to look so much better here? And I will be clear: It doesn’t make them better or worse. What do they do differently that enables them to have a much lower inventory and much fewer days?
Audience member: [Inaudible]
Audience member: The supply is less for Apple products. They make less products.
Badolato: They make less products. Who makes most Apple products?
Audience member: China.
Badolato: Who makes most Apple products?
Audience member: Foxconn.
Badolato: Other entities, Foxconn being one of the biggest, right? So, what are they actually doing here? They’ve outsourced the manufacturing. Samsung’s a true manufacturer. Apple, at its core, is a research, sales, and marketing company. But a fundamental difference is, the way they operate is less like a traditional manufacturer, like Samsung, and much more like a product development company.
They develop the product, they advance the product, they sell the product, but in many ways they actually have others produce, manufacture it for them. What does that end up meaning? It looks like they do better in inventory, and they sell their products very quickly, but we always have to take a step back to understand how are these companies that appear to be very similar—if we think about the phones we buy—actually very different in terms of the way they operate their business?
Understand the business. Don’t ignore information, and don’t—like was potentially the goal of the Zynga IPO—make speculation with what we actually understand and know.
All of those ideas from Ben Graham serve as the basis for engaging in analysis, or try to understand and analyze companies. Which ultimately is what we want to try to do and be able to do with the vast pieces of accounting information that can come together to try to make the determination of what investments, or which companies look stronger or worse than others.
And with that, I will conclude. So, thank you very much.