The Balance Sheet
At the center of investing is the balance sheet. A balance sheet is just a spreadsheet that calculates the point at which your idea is profitable and how profitable it is.
Here are the three basic steps for creating a balance sheet.
Step 1: Write It All Out
Just write out all the cash inflows and outflows from a project, which are all the different ways you will be spending and bringing in money, such as investors, sales, and costs of products.
McKeon elaborated on step one through the example of investing in a new corporate project: “There’s usually large outflow in the beginning in order to get the project going, and then, as you begin to sell whatever the good is—maybe that’s precious metals from an asteroid or maybe it’s tickets on your hyperloop, whatever revenue stream you have—those would be inflows that happen later in your project. So, the first step is you line those things up, and that usually requires a spreadsheet.”
Step 2: Apply Discount Rates
Once you have all your cash flows on the spreadsheet, you must discount them, which means to value them in accordance with how much they are worth today. So, here is where that popular term “discount rate” comes in. Luckily, there are lots of established metrics you can use to think about inflation and other factors.
McKeon explained further: “The second component is once you’ve analyzed the amount and the timing of these inflows and outflows, you need to discount them. So if it’s five years away, it’s not as valuable as if it’s three years away. And so, you need some sort of discount rate to discount everything back to today.”
McKeon then further elaborated on how to discount the project number you have for the future earnings of a company by comparing “something like GE, a very large stable company with stable cash flows and stable projects” or a company like “a startup drone software firm, [with] lots of uncertainly about future cash flows.” He explained that, “You’re pretty sure GE is going to make that amount, so you wouldn’t discount it. There’s still some uncertainty. But with the drone software company, it could be a 1,000—or it could be 5,000—or it could be zero. So in that case you’re going to discount it more heavily, so the cash flows from the software company are worth less to you today than those from a company like GE because you’ve got more uncertainty revolving around the software firm.”
Step 3: See What It Says
“Then it’s simple,” McKeon said. For step three, “You take all the different streams of things that are happening over different years and discount them back to today and add them up. And if it’s positive, we call that a positive net value project, and that’s something that you want to pursue.”