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Hi, I'm Bill Aman. I'm the CEO of Persing Square Capital Management and I'm here today to talk to you about, uh, everything you need to know about finance and investing. And I'm going to get it done in an hour and you'll be ready to go. So, let's begin.
In order for you to get a better sense of finance and some of the basic terms associated with a business and investing in a business, I'm going to use the example of a lemonade stand. We're going to go into business together. We're going to open up a lemonade stand. So the, the reason why I'm using the example of a lemonade stand is a very simple way to understand the basics of a business. How to understand how a business works, how a business generates profits, what's involved in raising capital to start a company, what you do when you're ready to decide to monetize your investment or take some money off the table. You'll be able to understand each of these concepts through the very simple lens of a small startup business like a lemonade stand.
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. It's a little filing that you make with the state. And you, you come up with a name for your 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 a,000 shares of stock. We just made up that number. And we're going to sell 500 shares more for a dollar each to an investor. Uh, the investor is going to put up $500. We're going to put up the, the name and the idea. We're going to have a thousand shares. He's going to have 500 shares. He's going to own a third of the business for his $500. So, what's 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, uh, 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 loan. 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 profits.
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 the balance sheet tells you where the company stands, what your assets are, what your liabilities are, and what your net worth or shareholders equity is. So you take your assets, in this case, we've raised $500. In exchange for the $500, the person who put up the money only got a third of the business. The other 2/3 is owned by us for starting the company. Well, that's $1,000 of goodwill, uh, for the business. Uh, we borrow $250. Well, we're going to owe, uh, $250. That's a liability. So we got $500 in cash from selling stock.2 $250 from raising debt and we owe $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's called a fixed asset. Unlike a lemon or sugar or water, this is something that you, like a building, you buy and you build it. It wears out over time, but it's, it's a fixed asset. And then you need some inventory. What do you need to make lemonade? Well, you need sugar. You need water. You need lemons. You need cups. You need, uh, 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 spent $500. We only have $250 left in the bank, but our fixed assets are now $300. That's 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. 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 lemonade stand business.
So, let's make some assumptions about how the business is going to do over time. We're going to assume we're going to sell 800 cups of lemonade a year. We're going to assume that each cup we can sell for a dollar. Uh, and it's going to cost us about $530 per year to staff our lemonade stand.
So, 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's left over, uh, for the owner of the company. So, we've got one lemonade stand. We're selling 800 cups of lemonade in our stand, charging a dollar, so we're generating about $800 a year in revenue. And we're spending $200 on inventory. There's 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 wears out over five years. So, it depreciates over five years. We've got our labor expense to, uh, for people to actually pour the lemonade and collect cash from customers. And we have a profit. We have EBIT. That's earnings before interest in taxes of $10. That's kind of our pre-tax profit for the business. We didn't make very much money because you take that pre-tax profit of $10 and you compare it to our revenues. It's about a 1.3% margin. That's 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.
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's going to look like over the next several years. Uh, 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. Let's, we're not going to pay a dividend. We're going to keep all the money in the company and reinvest it. As we build our brand, we can charge a little more each year. So, we're going to raise our prices about a nickel, 5 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 a built-in growth assumption.
So now let's take a look at the company. So take a look at this chart. You'll see in year one, we start out with one lemonade stand. We add one a year and then we, by year five, we're up to seven, because we 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, uh, cups of lemonade and it also comes from opening more stands. So by year five, we have almost $8,000 in revenue. Uh, our costs are relatively constant, which is lemonade and the sugar. Uh, that's about $1.72. We have depreciation as the more and more stands start to wear out over time. We've got labor expense. Um, but by year five, the business is actually doing pretty well. We went from a 1.3% margin to over a 28% margin. So the business is now up to scale. We're starting to cover some of our costs. We're growing. Uh, we're still paying $20 to $5 a year in interest for our loan. And we have an earnings before taxes after interest of $2,300 by the end of year five. So we put $500 into the business. We borrow $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's about 35%. And we generate what we net income, or another word for profits, of $1,500 by the fifth year and about a dollar a share. So, if you think about this, uh, our friend put up $500 to buy, uh, 500 shares of stock. He paid a dollar. And after five years, if our business goes as we expect, he's actually making a dollar a share in profit. That sounds like a pretty good deal.
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, uh, you know, again, the starting balance sheet had, uh, shareholders equity of $1,490, but as the business becomes more profitable, uh, 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. 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, but at the end of year five, it's earning over $1,500 in earnings. Uh, so that's over 100% return on the money that we put into the company. That's actually quite a high number. We 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's a very attractive return. Earnings have grown at a very rapid rate, uh, 155% per annum. This is really a, a growth company. And our profitability has gone from 1.3% to 28.6% by year five. That sounds, uh, pretty attractive and it is.
So, 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. Uh, but they've only made 10% of their money. 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's earning over a 100% or about 100% return on his investment versus only 10% for the lender. So who, 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, uh, the lender.
So, what's, what's 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. Uh, 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's senior debt, there's junior debt, there's mezzanine debt, there's convertible debt. Bottom line, it's all debt. Uh, it comes in different orders of priority in a company. Um, and your, the rate you charge is in, you know, 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 proceed, but you don't, you can avoid the complexity. All you need to think about is debt comes first. It's a safer loan, but your, your profit opportunity is limited.
Now, the equity also, they're very forms. There's something called preferred equity or preferred stock. There's 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's left over after the debt's paid off. So it's called a residual claim. Now, the good thing about the residual claim is the business grows in value. You don't own your, owe your lenders anymore. Uh, but all that value goes to the stockholder. 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, well, they could sell at the lemonade stand. You know, it cost $300 to make it. They would have some lemons, some lemonade. Even if they sold at a much lower price than the dollar they originally projected, the lender felt pretty comfortable that they'd get their money back. Whereas the stockholder was 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 was successful.
So, let's talk about risk. You know, a lot of people talk about risk in the stock market is 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's 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, will you get your money back? Will you earn a return on your investment?
How do you think about risk? One way to think about risk is to compare your risk to other alternatives. So you can buy government bonds and government bonds are considered today the lowest risk form of investment and the US Treasury issues, uh, 10-year, 3-year, 5-year debt. There's a stated interest rate and today a 10-year Treasury, you earn about a 3% return. So you give your government, uh, $1,000, 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're going to lend money to a lemonade stand, you want to earn meaningfully more. So, in this case, the, uh, 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, uh, business.
Equity investors sort of think about things similarly. So the higher the valuation, the more risky the business, uh, 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 receive 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've, as a, as having started the business, uh, coming up with the name and the concept, hired all the people, I've made nothing, right? So, the business has grown in value, but where's 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 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. These lemonade stands are more and more productive and it's grown the value of the business faster and faster. Now, my alternatives could include, well, 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 we can earn, you know, hundreds of dollars on each new stand, it makes sense to keep investing.
Well, 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? So, I can sell my lemonade stand business. You know, I started this one in New York. Maybe there's someone in New Jersey who wants to buy me, consolidate with my lemonade stand company. The problem with that is once I sell it, I can no longer participate in the opportunity going forward. I believe in this business. I think it's going to be very successful over time. So, that's one alternative. The other alternatives, other than selling 100% of the business, is to sell a piece of the business. Now I can do that privately. I can find an investor who wants to buy a private interest in the company. Uh, 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. An IPO, the abbreviation stands for an 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 by an interest in the company. And it's an offering because you're offering people the opportunity to participate.
What's 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. When 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. That's 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. Uh, but you get to raise money in the offering, and you can use that money to buy the car that we were talking about, uh, before.
Now, before you decide 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. The stock market is a, a list of companies that have sold shares to the public. And you can look in the, uh, 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 McDonald'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. Shares outstanding will be listed in various filings with the SEC. 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, uh, lemonade stand, we have 1500 shares of stock outstanding. We sold them for a dollar initially, one-third of them to an investor, and the business initially had an, uh, 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 profits. That will give you a sense of value. 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. 5 years later, it's worth $30,000. That's actually quite good. Uh, well, 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, what would that do? What would happen if we sold two of our share, 200 of our shares in the market? Well, our interest in the business would go down because we, right today, we own 66 and 2/3% or 2/3 of the company. A third is owned by our private investors. Well, if we sold stock in the market, uh, if we sold two, 200 of the shares that we would own, our share, 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, uh, 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. Um, 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 about.
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, uh, new investors wanted to come in, they could buy stock and our stock would now be liquid. Make me feel better about this business in terms of my ability to at some point exit or if I wanted to raise more money, I could sell stock fairly easily in the market because each day you could look up the price, uh, either on the web or on a New York Times or otherwise, and you can figure out what your business is worth.
Okay. Now, how does this matter, uh, to you? Now, the purpose of the example of our lemonade stand is just kind of 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, 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, whether you want to invest in a, a company on the market.
Let's assume at 22, you got a pretty good job and instead of spending your money on, you know, uh, gadgets or a fancy apartment or not so fancy apartment or going out and and drinking a fair amount, you put some money aside, 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 and you earn 10% on your money each year, you'd have $600,000 in year 43. And the reason for that is, well, in year one, your $10,000 would become $11,000. In year two, your $11,000 would grow by 10%. And so, you would be earning interest not just on your original principal, but you'd earn interest on the interest you'd earn in the previous year. And that compounding effect allows money to grow in an almost exponential fashion. Now, obviously, if you earn more than 10%, uh, you can earn even higher returns.
Now, that's if you put $10,000 aside at 22, you have $600,000 in 43 years. That's pretty good. What if you had to wait until you were 32? The problem there is by year 33, you'd only have $232,000. Maybe that's not enough to retire. So, a key thing here is if you're going to be an investor, it's really one of the most valuable assets you have today as someone who's 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%? Give you a better sense of how powerful compounding is. Remember, at 10% for 43 years, you'd have $600,000. That's pretty good. But if you earn 15%, you'd have over 4 million. Now, you're in a pretty good position. And, uh, so obviously making smart decisions about where you put your money, uh, has a huge difference in what your retirement assets are. And obviously if you put aside more than $10,000, if you could put aside $10,000 each year, then your, your wealth would be, you know, quite enormous.
Now, just for fun, if you were one of the world's great investors, uh, Warren Buffett being a good example, if you could earn 20% per year for 43 years, you'd have $25 million. Again, the original $10,000 investment would increase by 2500 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.
Okay. Um, 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, you know, every 12 years you lost half your money because you hit a bad patch in the market. You made dumb decisions. Well, your $25 million at 20% would now only be worth $1.8 million 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 losses over the, over the period. Okay.
So, as Warren Buffett 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 losses and earn an attractive return over time, you're going to have a lot of money, and many, if you can stick at it for a long period of time. Okay.
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 what 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 good places to invest? Well, 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, um, 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% over a long period of time, your money grows very significantly. So how do you avoid the riskiest investments? I would, my advice would be to invest in public securities, invest in listed companies, companies that trade on the stock market. Why? Because those businesses are 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.
Number 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 and your personal life, whether it's a retail store that you know because you like shopping there or it's a, a product, uh, your, your iPad or that you know, uh, you think is a great product, but you, 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. 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.
Another very important criteria is you want to invest at a reasonable price. It could be a fabulous business that's 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. The last bit is that you want to invest in a business that you could theoretically own forever. The stock market were to close for 10 years, you wouldn't be unhappy. What do I mean by that? You know, again, if you're going to compound your money at, at a 10 or 15% 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, what are businesses that you can own forever? Well, there sort of meet that standard. Uh, maybe a good example is Coca-Cola, right? What's good about Coca-Cola is it's a relatively easy business to understand. You understand how Coke makes money, right? They sell a, a formula, uh, or syrup, uh, to bottlers and to retail establishments and they make a profit every time they serve a Coca-Cola. People are going to drink a lot of Coca-Cola for a very long period of time. The world's population is growing. They sell 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, uh, competed away as a result of technology or some other new product. Right? It's been around long enough. People have grown used to the taste. Uh, you know, they, they parents give it to their children and you can expect that it'll be around a long period of time. I think that's one good example. Another good example might be McDonald's. You may not love McDonald's hamburgers, but it's a business that, it's 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're, they continue to grow every year. So, I think the consistent message here is try to find a business that you can understand, uh, that's not particularly complicated, that has a successful long-term track record, that makes an attractive profit, uh, and can grow over time.
So, what are the key things to look for in a business, as I say, that lasts forever? We want a business that sells a product or a service that people need and that is somewhat unique and, uh, they, they have a, a loyalty to this particular brand or or or product and that people are willing to pay a premium for that. I mean, a good, another good example would be a candy business. Well, people are willing to buy generic versions of many kind of food products, you know, 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, you know, the Hershey chocolate bar or the Cadbury chocolate bar or the Reese's candy. They want the, the brand and they're willing to pay a premium for that. And, um, so that's a, I think a key thing. You want the product to be unique. You, 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, at a better price and it's very hard to make a profit doing that.
If you're investing for the long term, you want to invest in businesses that have very little debt. We, in our little example before, we talked about our lemonade stand. You know, this $250 worth of debt didn't put too much pressure on the lemonade stand company. But if it had been $1,000, 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, it doesn't have a lot of debt. They generate vastly more profits than they need to pay the interest on their debt. That's a safe place to put your money over a long period of time.
You 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, and put you out of business. I mean, like going back to the Coca-Cola example, Coca-Cola has such a strong market presence. You know, 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. Now, of course, there's Pepsi and there are other soda brands, but Pepsi's been around a long time. Coca-Cola and Pepsi have continued to exist side by side over long periods of time. So when you're thinking about choosing a company, make sure that they sell a product or a service that's, it's hard for someone else to make a better one that you'll switch to tomorrow.
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, uh, will be affected dramatically if the price of a particular commodity goes up or if interest rates move up and down or if, uh, currency prices change, you want a company that's fairly immune to what's going on in the world. And I'll, I'll use my Coca-Cola example. I mean, if you think about Coca-Cola, it's a product that's been around probably 120 years. Over that period of time, there have been multiple world wars, development of nuclear weapons, all kinds of unfortunate events and tragedies and so on and so forth. Each year the company pretty much makes a little bit more money than it made them before and they're going to be around and you can be confident based on the history that this is a business that's going to be around almost regardless of whether interest rates are at 14%. Whether the US dollar is, you know, not worth very much or the price of gold's up or down. Those are the kind of companies you want to invest in the long term. Businesses that are extremely, uh, 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. 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 it doesn't, 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 projects.
I guess the last point I would make is that you can 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's someone that has a, a great track record for taking care of so-called minority investors, the non-controlling shareholders, it can be a risk 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's no assurance that in the future they might sell control to someone else who's not going to be as, uh, 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, uh, has 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, uh, 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 and you won't need for 5 years or 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. Your student loans are probably lower cost than your credit cards. But again, here my best advice would be, you know, once you, if your student loans are costing you 6 or 7%, well, if you pay them off, it's as if you earned a guaranteed 6 or 7% return. Uh, 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, uh, to the stock market. Even once you, you paid off your credit card debts, perhaps you pay down your student loans, you want to have enough money in the bank so that even if you were to lose your, lose your job tomorrow, you've got a good 6 months, maybe even 12 months of money set aside.
So, let's talk a little bit about the psychology of investing. Uh, so we've talked tech 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's going to exist forever, that has barriers to entry where it's going to be difficult for people to compete with you. Um, but all of those things are important and a lot of investors follow those principles. The problem is that when they put them into practice and there's a panic in the world and the stock market's heading down every day and they're watching the value of their IRA or their investment account decline, uh, the natural tendency is sort of to do the opposite of what makes sense. To be a successful investor, you have to be able to avoid some natural human tendencies to follow the herd. When the stock market's going down every day, your natural tendency is to want to sell. When the stock market's actually going up every day, your natural tendency is to want to buy. Uh, 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 market. A 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. Number two, you have to recognize that, uh, 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. Uh, 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 invest in. So you 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. Just the nature of the volatility of the stock market.
How do you get comfortable? 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. Make sure the price you're paying is reasonable relative to the earnings of the company.
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. Uh, what are your alternatives? Well, your 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 are mutual fund companies. So what's a mutual fund? A mutual fund is a, uh, I guess technically it's a corporation, but where you buy stock in this corporation and the, and the manager selects a portfolio of stock. So what they do is they pull together capital, money from a large group of investors. So let's 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, you, you can, even less than $1,000, you can buy into a diversified portfolio managed by a professional manager who's compensated to, uh, do a good job for you investing in the market. So, mutual funds are a good potential area for investment. The problem is they're 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 uh 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 or a money manager of any kind uh uh 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. uh 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 is probably should be number one, is you want someone with a reputation for integrity. And again, if you're starting out, you probably want to invest in some of a mutual fund that's sponsored by some of the larger uh mutual fund complexes as opposed to a tiny little mutual fund that's privately uh by a mutual fund company that you've never heard of. There's some benefit in uh the uh the larger institutions. You you can be more confident that they're not going to steal your money.
Um you want someone uh an approach where the investor invests money on the basis of value. I know this sounds kind of kind of obvious but you know value investing is has a very long-term track record and now there are other kinds of investing including technical investing where people are betting on stocks based on price movements. Uh but I highly uh recommend against those kind of approaches. So you want someone who's 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 uh to what the business is worth represents a significant uh discount.
You want to invest with someone that has a long-term track record, a long-term track record. And I would say 5 years is the absolute minimum. And ideally, you want someone who's got 10, 15, 20 years of experience investing in the markets because there's 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 yearbyear that they have a stated strategy that they've kept to thick and thin that's enabled them to earn an attractive return over uh their lifetime as an investor. And I always say in some ways most importantly you want someone who's investing the substantial majority of their own money alongside yours. 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 uh privately uh sold uh fund for investors who have uh higher net worths, you want a manager who's investing alongside you as well.
We started with a little lemonade stand company and the purpose of that was to give you some of the basics and how to think about a business. you know, where the profits come 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 uh what the difference between a good business is versus a bad business, how debt uh offer is generally 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 or lose more. We use that as a back just as the basics to get some of the vocabulary to think about investing. And we talked about uh investing in the stock market. Uh we talked about uh 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.
Now, 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 by induce you to watch this for an hour, but there's a lot more that can be learned and there's some wonderful books that can teach you on the topic.
So, I think what's interesting about investing, whether you choose this as a full-time 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. You we talked about the difference between a 10% return and a 15 and a 20% return over a very long lifetime. What impact that has in terms of how much wealth you create over the period. Uh 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 your uh your quality of life if if money is something that you need in order to uh meet some of your goals.
I got interested uh when I was probably 22 or 23. I started uh interested in being an investor and I read a book I read uh book called the intelligent investor. was written by Ben Graham and uh Ben Graham is a famous value investor and it's kind of like reading uh Jean Paul Sartra's ex essays on existentialism. You read it and it either is an epiphany and affects the way you live your life or it's of no interest to you and this was the equivalent but in investing I found it fascinating and uh what I liked about investing is was something very accessible even to someone who's 22 or 23. What's kept me intrigued is that one of it's one of the few jobs where every day you can study something new. You're constantly learning about new businesses, new situations, new management teams, new issues. Uh so it's infinitely challenging. Uh and uh the world and the stock market are obviously very dynamic places. So the challenges uh continue.
These same concepts, while they're useful in deciding how to invest your portfolio, they're also very useful to you in thinking about decisions like buying a home, uh making decisions in your line of work, whether to hire additional people. You know, this these kinds of calculations and thought processes are are helpful and they're helpful in life and I recommend that you learn more. Thank you for uh paying attention and