Thinking on Leverage: What it Means and How you Do it

Today, we talked about leverage from a couple of different aspects

Divya: Hi, I'm Divya.

Kahran: Hi, I'm Karin. And this was the 17th episode of thinking on Thinking. Today, we talked about leverage, from a couple of different aspects. We talked about the social sides of leverage and how you can think about your groups of friends and think about the relationships in your life and leverage those. And we talked about the financial side of leverage and how you can think about the assets, you have in your life, and also the assets that company has and the debts that companies have. To think about how you value a company and see if they are leveraged or nothing. Leveraged. It was a really interesting conversation. We touched on a lot of interesting aspects of the word and of how it impacts our lives, and we hope you really enjoy listening to it.

Divya: If we talk about leverage, where do you think, in your mind, that word sits both in social situations and in work situations?

Kahran: I mean, when I think about a lot of things that are, like, vaguely associated to personal finance, I tend to think about them from the lens of personal finance. So, like. And I don't think that's necessarily a bad one, because I think that's actually where the word comes from. Right? Like, it's.

Divya: The word comes from physics. Leverage lever. You have a fulcrum. you put a thing like, you know, the Archimedes statement, give me a lever with long enough arm, and I can move the earth. Yeah, he's talking about. I don't remember the entire exact thing, but, yeah, basically, that's what I. Yeah, yeah. That's where the word leverage comes from. Hm.

Kahran: Yeah. The further away you are, the more leverage you have. That's interesting. I think that's also true when you think about it in other ways. So, the further away you are from the core asset, oftentimes the more leverage you might have. Right. So, when you think about, like, derivatives. So, on one hand, you'll have, like, an equity or something, or, like, a commodity, and that's the core asset, but then you might be trading something that, is tracking something happening to that asset. So if you're trading futures, those are going to go up when people think that asset will go up. But you could be trading derivatives on the futures also, or you could be trading, things that might be, like, three x the change. So, one thing that exists, is that you'll have ETF's or mutual funds that will track a, commodity or track index, but you'll also have ones that will three x the tracking, or maybe three x in reverse. So if the commodity goes down, your tracking, ETF is going to go up.

Divya: Oh, interesting.

Kahran: So those are more leveraged funds because those are things that will have the change in the underlying asset will have a broader impact on the thing that you are investing in. if that's more highly leveraged, do.

Leverage is the ratio of a company's loan capital to its equity

Divya: You mind actually doing a explain like I'm five kind of thing for leverage? Because in financial terms, these terms are like thrown around a bunch. But like, what does it mean for something to be under leveraged? Like properly leveraged and over leveraged?

Kahran: Okay, so I was looking up the actual definition, which is the ratio of a company's loan capital, which is its debt, to the value of its common stock, which is its equity. So what that is saying is how much has a company borrowed against? How much is that company worth? and then there's two concepts in that. So one of those is let's just do borrowing first. So borrowing would have both long term and short term borrowing. A lot of companies which don't have a lot of working capital or they have like net 90 sort of pays, right? Where people will pay them after 90 days of them billing their invoices. Well, they have to like pay their employees or pay their. To keep their lights on. Yeah. So then they'll need to borrow money in the short term to be able to cover their short term debts. while they know that their long term money is going, depending on how well established of a company you are, you'll be able to command, you know, better interest rates, on your, line of credits, which is generally what these kinds of short term, borrowing is borrowed out of. You'll have a line of credit with a bank of up to maybe a million dollars or something, right? And then you'll be able to borrow money out of that, pretty easily. Then there's long term borrowing, which is generally sold as bonds, right? So companies will have bonds, just as municipalities web bonds, And that lets people finance, excuse me. That lets companies, or governments finance projects that may take longer, Or just take advantage of good prevailing interest rates, which is a lot of times when companies are issuing bonds, right? So that's the sum of the debt. And then on the other side is like, what is the value of a company? And then there's a lot of different ways to think about that. the simplest is just looking at what are all the assets of the company. So all the things that builds, all the things it owns, putting some sort of like way of putting taking the future value and calculating, it as today value. and then that gives you the sum of what the company is worth. And you look at that ratio, and that ratio is leverage.

Divya: M. But how does leverage come into play? So, like, I know that when people are thinking about money, maybe, like, I'll talk about when I am thinking about leverage in terms of social context or something. I don't think about it in terms of money because I don't think I have the context of money to that depth. like, when it comes to sort of trading or understanding debt and equity, or understanding, like, you know, how to make more money out of the money that you have.

Kahran: yeah. Or thinking about, like, how valuing a company is also the time that you'll think about the leverage. Right. How leveraged is the company? But. Yes, go on.

Divya: But it's very interesting because I think I feel that way about social relationships, at least in my mind. That's how, on a system level, things work. You have a limited amount of time, and in that time, you have a limited amount of social energy that you are gonna be willing to expend. Right. which means that you can accumulate different kinds of social capital in that duration. Not all social connections are worth the same, nor are they worth, like, same texturally. And you need a diverse portfolio. Like, you can't have all friends who are party animals, but you can't have all friends who are only introverts. Or, at least, like, I don't want to have all friends who are all introverts. Like, I wouldn't want all of my friends to have the same social behaviors. Right. Like, I don't remember what book it is, but you know that research that talks about, there is a central person, and, like, generally how social networks work is one person is connected to many people, and then those people on the ends are not connected to as many people. and I think that, like, you need a reasonable number of those well connected people, but you also need a reasonable number of, like, end people, because otherwise you can't. You can't arrive at depth with these hyper connected people very easily, and you can't arrive at breadth with the low connected people. So, at least from my perspective, I want a, like, reasonable amount of diversification between the people that I have. So, for example, it happened during COVID that I lost touch with a certain kind of friends. And, like, the touch with a certain kind of friends increased. Like, especially the ones who were always online and were used to being always online. And that's how they made their friendships. Those are the friends that I was hanging out a lot with, virtually.

Kahran: That's really interesting. I think that's what I did, too. I didn't think about that till this moment, but, yeah, the people who I used to play games with as a child, I suddenly was hanging out with so much more, and I still am in a lot of ways, than before.

Divya: COVID but, like, I honestly.

Kahran: I meant online games.

You describe leverage as a power dynamic in a relationship

Divya: Yeah. but, like, I honestly feel like that is where my idea of leverage comes into picture. Like, I don't want to over leverage a relationship by, like, stressing it out too much. And somehow, in my mind, there is some, understanding of, like, oh, how much time am I putting in a. In this thing? And how much request am I? Like, you know, how much am I requesting from the other party?

Kahran: Okay, I was waiting for you because you hadn't actually gotten to your definition of leverage yet. You had just explained the context around it. Say more about that.

Divya: So I would say, like, what feels okay for you to ask, and you're likely to get. So, for example, I think we were talking about it a few days back, but sometimes, you know, especially when you're younger, there would be people who would borrow a little bit of money from you, and then they would vanish, and it's like, oh, that friendship was worth, like, you know, $100. Okay, that's not, like, you know, maybe when you're younger, it's not an insignificant amount of money, but it's a, Like, you know, okay, cost to pay, because, like, that's kind of a worthless relationship in some ways. Right? Like, this is a side point, but I think that, like, when you are close to someone, you sort of build that trust. Or at least that's how I function. You build that trust, you build that understanding, and you sort of, you know, you play the infinite game together rather than playing the finite game together. And over time, you realize that, okay, I can. Because this person will reliably know that I'm willing to put in a certain amount. I can also reliably extract a certain amount of thing from the spot that we are mutually creating. That's where I would say leverage comes into picture for me. What am I putting in, what I think the other party's expectations are and how they function. And, like, what can I get out of? Like, you know, again, like, saying, what can I get out of? It is very, just the words feel very dry and very mean. But it's even something as simple as, I have certain friends that I know if I asked them to go meet me in a public event sort of thing every week, the amount of effort that would require would be way higher.

Kahran: When you first started talking, I felt like you were describing almost like, a power dynamic in a relationship. And then as you kept talking, I wasn't really sure about it, but then I just pondered it for a few seconds, and I feel like, yeah, the way you're using leverage, it feels like a descriptor for the power dynamic of the relationship. Does that seem right to you?

Divya: I don't think it's power dynamics. Right. Because, like, power dynamics almost always inherently have a concept of tension within them. But, like, that's not where I'm coming from. Like, it's not about tension. It's about, like. It's about knowing how much you have in the bank in some ways. And sometimes how much could you borrow because of, like you described, your line of credit is pretty good, so you can, like, you know, borrow more than you think you have in the bank.

Kahran: There's some people, I think, especially people that I worked with, in India, who I feel like, yeah, I know I could ask a lot of things to them, and they would do it without question. Right, I. Right, And in some ways, it has to do with the way our relationships evolved. maybe, you know, they feel like there's a debt in the relationship. So part of it is that I can capitalize on the fact that, you know, I know they feel like there's a debt in the relationship. I would say it's a leverageable relationship, but I don't think I would use, like, leveraged as a descriptor to describe it.

Divya: So I don't think that, like, I would say individual relationships can be at least, like, I don't actively evaluate them like that. I generally think of them as, like, am I doing well with this cluster right now? It's almost like,

Kahran: You know, what makes a cluster?

Divya: So I have observed over the last ten years that your friendships decay at a certain, rate. So you have to keep adding new people to your circle. Otherwise, like, it's not decay in the sense those people are gone from your life at all times. Like, many times, that's not the case. But still, people move away, people get busy in life. You're not going to be hanging out with the same group of people all the time. So how do you make sure that you always have that social, like, network the easiest way? Initially, I used to do a lot of effort to find new sources of people by myself. There would be, like, one group that I'm going to, and then another group that I'm going to and another group that I'm going to. but then I realized an easier way is to find very reliable people whose taste I trust and who are super social. And then I know that the people I meet through them will be already vetted. Like, most of the people that I've met through you, I really, really like, because I know that they are cool people. So I can make new friends like that. Right?

Kahran: Yeah. That's how I think about going to school. Like, if I wanted to do a masters, part of it would be. Cause I would, like, someone would pre vet all the people I would meet.

Divya: But, like, to me, if it feels like I am not making new friends, then I would think I'm not utilizing the social networks of my super social friends properly.

Kahran: Interesting. Because you just think it's a given that I'll be continually making new friends.

Divya: Or, you would have people that wouldn't like that. I would not be in group with other friends who are similar to you in personality, who have a lot of friends.

Kahran: That's interesting. Yeah, I think that's true. I think I do kind of keep meeting people. It just happens. Yeah, I mean, definitely. My sister constantly is meeting people. and it's very. Yeah. And maintains a lot of relationships. So whenever she comes anywhere, we usually end up meeting people. So it's not always meeting new people necessarily. Like, sometimes it's like, people you've already met, but, like, because you're having new experiences with them, you are. Yeah. You are making new friends and, you know, finding new depth in relationships.

You were discussing leverage in context of money, but also social situations

So you might feel like, here's an objective I want to achieve in my life, and, like, am I being able to use the resources that I have available to me to achieve it? Like, that's the kind of way you're thinking about leverage.

Divya: I'm not even sure if there is.

Kahran: Objective, but in this case, you have an objective, which is like, you want to be m meeting new people and making new friends.

Divya: I mean, that's as broad an objective as, like, it's that, I want a constantly thriving social circle. Like, my objective is that, that I want a constantly thriving social circle. And there is an attrition rate, so I want an input rate in it also. Right. Like, that's similar to people keep expanding their money portfolio, not because there is a particular, of course, everybody says, oh, have your objectives and all, but, like, I don't think that people just keep doing it. Especially the ones who get good at it. Don't do it just because they want to get a good retirement. They do it because, like, that's just how their brain starts operating in situations, and they start thinking like that.

Kahran: Yeah. I mean, I think there's a. You brought up a bunch of really interesting things right there. Right. Like, I think that there is a sense of risk profile. Right. When people think about what they own, and that can kind of help you think about whether or not you're willing to, like, risk leveraging that asset. Right. So it's interesting, because I. When you. Right. I realize that there's quite a connection between the two ways you were thinking about it, because, like, some people will note they won't work with their family. They don't want to, like, ask their friends for recommendations. Right. There's, like, they like to keep their professional life and their personal lives completely separate because they never want to, like, risk kind of those personal relationships. and then similarly, right. Some people look at assets that they have built, whether it's, like, their house or whether it's their car or money, and they're like, you know, these are things that I feel conservative about. I'm not willing to risk them. and so that kind of precludes them from thinking about, like, oh, you know, maybe I could give out my car on toro and, people could rent it.

Divya: You know, it is also super interesting. We started from talking about. You were explaining leverage in context of money. and then when I was trying to talk about leverage in context of social situations or how I see it, I used a lot of money terms.

Kahran: Yeah.

Divya: And, like, now you are implementing this model in social situations that you have seen. It almost feels to me, like, I mean, maybe this is a topic for a different day, but, like, there is this tendency for power to, like, self organize. Have you heard that thing? Life is self organizing complexity. It goes against entropy.

Kahran: Yeah. So, actually, when I went to the National Museum of Science of Art and Science in Singapore, they had an exhibition that showed how different particles of light it was on three massive walls around you. They showed how different particles of light would organize together, but then when you would touch them or interact with them, it would cause them to separate. it would just cause a disruption to the thing, but then over time, they would just come back together. It was really beautifully done, and it just kind of showed, I think, exactly what you're saying. Right. The self organizing tendency of life.

Divya: well, like, nothing else in universe is, like, that, but I feel like power is also like that. And I think that's where we have an inherent understanding of leverage. Probably, as human beings, even if we don't formally understand it, we are able to utilize this information. It's almost like I can't tell what m muscles I need for walking, but I can walk reasonably well, one would say.

Kahran: I don't know if I agree with you. I was thinking about that for a minute. yeah, I don't know if I agree with you because I feel like I've met people that don't understand how to leverage.

Divya: Okay.

Kahran: And, I feel like you and I have talked about it, too. Right. Like you were sharing an example on the podcast, I think, a few episodes ago. If you have a friend who thought she couldn't do art, and you were like, well, do you know how to write? And. Right. this person is not able to look and say, oh, what skills do I have in my motor control that I could leverage to be able to create? They're like, no, I have a rigid definition of what creation is or that creation processes, and it doesn't allow for me to look and say how my, skills, my assets could be leveraged for that. And I just. I feel like I see things like that all the time, across different skill sets and arenas. a lot of times it's, like there's. I think if I divide it into big categories, I would say there's, like, people who are afraid or unwilling to leverage their, like, personal assets and their social connections, to kind of achieve their goals. And then I think there's also people who are afraid to leverage their financial assets, because of perceived or actual risk.

Divya: Interesting. In financial terms, is risk very tied.

Kahran: To leverage, something highly leveraged. So you borrowed a lot of money. Right. So that, will be a riskier asset because for the underlying core capital. Right. So the underlying value of the business, there's more borrowed against it, which means that you have to reduce the actual value of that asset.

Divya: Okay, simur, I don't think I understood that.

Kahran: so the value of an asset is the equity of the asset minus the debt of the asset. Right. So what I'm saying is that as the debt grows, the, the value is let reduced because there's more debt in proportion to the equity. Now, does that inherently make it a riskier asset? Yes, but I don't know if I can explain that as cleanly. I think just when you have a lot of debt that you're trying to service that means that there's a lot weighing on your ability to perform quarter on quarter or annually, whenever that debt has to be paid. So I would say in some ways that I think contributes to the riskiness of the asset because it doesn't have as much flexibility as it would have if you didn't have this kind of regular payments required.

Divya: So either one would need a lot of dilution or a lot of confidence or a lot of information that the market doesn't have to over leverage something.

Kahran: Yeah. So my understanding is that we're kind of coming out of a period of historically low interest rates. Right. This is a fact, actually. And because of that, and because of where money has been over the last 2030 years, there's been more of these leveraged buyouts, which is basically what you're doing is you're borrowing money against the asset you're buying, and then you're using that money to buy the asset. So the net entity at the end of the acquisition has more debt than it. Than the entity before the acquisition had.

Divya: I have no idea how you can do that.

Valuation has two components: whatever is being multiplied and then the multiplier

This is some of those things that financial institutions do that should not be legal, but is legal.

Kahran: Yeah, it's kind of crazy. Okay, let's say that you and I are very successful in building this business, right? And so we have this product design marketing firm, And it gets valued at, ah, $100 million. Okay. And we are doing, relatively high value work. Well, let's say it's really high value work. Right. And, everything is a 50% margin. Okay. To be. And we're being valued at, ah, let's say. So, continuing with our example and giving us easy numbers to work with, let's say we're doing $200 million a year in revenue and we're making $100 million, in cash every year. And, we're paying probably 25% of that in taxes. So whatever. Let's say we're finishing with $50 million in cash at the end of the year. and we are being valued at two x profit, which is kind of insane, but we'll keep that aside. Should I pause and explain why that's crazy?

Divya: Yeah.

Kahran: Okay. so I would say at the low end of things, are companies that do straight staffing. And now I'm just talking about how services companies are valued. Valuation has two components. there's whatever is being multiplied and then there's the multiplier. Depending on the type of industry, those two things can be different. In some industries, the thing that's being multiplied will be revenue. In some industries, the thing that's multiplied will be EBITDA, which is earnings before appreciation, interest, depreciation and amortization. and in companies where it's perceived that the value you're adding is less, you'll generally be against actual earnings, and you'll also get a less big multiplier. obviously, when you go from revenue to earnings as being the thing being multiplied, there's a huge difference because you paid a bunch of stuff out of your revenue to get to your actual earnings.

Divya: Yeah.

Kahran: So at one end of the spectrum in services business is something like a staffing business, and a staffing business will be like six to nine times EBITDA. so whatever the company is earning, right, you're going to value that company at under ten x of that. at the end of the end of the spectrum is stuff where you're doing really highly valued work where it feels like the people are very irreplaceable. and, you know, you built a lot of value into the company and especially kind of high growth companies that are not yet showing money yet. I'm sorry. Especially high growth companies that are not yet showing earnings. Right. They may be operating at a loss, especially in the era that we were coming out of. those might be valued against their revenue and then it might be much smaller. Right. It could be one x times revenue or two x times revenue. I was part of an acquisition in 2015 that was, I think I, about, 1.2 times revenue. And then we also had a, ah, kicker, which is basically like an earn out component where if you can meet a certain revenue target, you will make more money. And that was again about one x. So basically every million dollars we made would have been added to the purchase price, up to a certain cap.

Divya: So you are saying that, it would be crazy to expect that like a, services company is valued at two x the profit.

Kahran: Yes, I was saying that we would never be valued at something so low as that because we are not building like a straight. Yeah, right. So that's why I was saying that we were not actually valued at $100 million. Right. So we'll keep all of that aside, but that. So our $100 million valuation for our company is actually quite low if we were actually making $50 million a year in profit now. but we'll just stay with 100 million for a second. Now, what someone could go and do is say, okay, I'm going to pay two x, sort of markup on what this company is worth. So I'm going to offer $200 million for this company, and I'm going to put in 100 million of my own, but I'm going to go to the bank and say, look at, ah, how much money this company brings in every year. They can easily, do that under my ownership, and they'll be able to do even more under my ownership. So you should give me a loan against the value of this company's future earnings. And, in fact, this is what Elon Musk did when he went to the banks and he got them to give, I think, what, $27 billion in loans against Twitter. So saying that he would be able to get Twitter to give revenue in the future and grow the revenue in the future, and because of that, he would be able to pay back these loans as the owner of Twitter. So Twitter now has these huge amounts of loans it has to service every year. But anyway, so that's what I was saying, about how you can do these kind of leveraged buyouts, which is where someone would come in, basically get the bank to agree to front the money, and with the proposition that you would be a better owner than the current owners would be, and you do a better job of running the company.

Divya: M but, like, so, basically here, there is confidence or delusion, whichever one. It's not like somebody has a secret amount of information about the system that you can leverage it. Like you would need something to leverage. Right.

Kahran: So in some cases, it can be like, the company I. Yeah, the company that acquired us, was part of a consortium of companies. So it had a parent group, and that parent group would go and buy companies that could outsource their it and their outsourced. It was then given to the company that acquired us. So, he kind of had this knowledge that a lot of companies in laggard industries had these big overhead infrastructure spends, and by being able to outsource a lot of that, both in terms of BPO and iT outsourcing, he was able to reduce their costs, so make the companies more competitive, more profitable, and then also bolster his burgeoning iT outsourcing firm. So he kind of knew something the market didn't. Right. But it's not like a major insight. It's kind of a temporal insight. But temporal insights can make you a lot of money for 30, 50 years.

You said something about investing with time as much as you invest with money

Divya: I mean, this is the reason why this topic even came to my mind, because I remember you saying that at some point a couple of weeks back when you were talking about investing just as a general principle. And you said something around, how you have invested with time as much as you have invested with money, and not time in terms of effort, but time in terms of. While time in terms of effort could also be another way of investment, but you have invested in timing, as in, like, the knowledge of when to invest in what thing has been as important and has been one of the leverages. Right? Like, that's information. Wow. I, just like, thought of that. Like, while time can be on both sides, right? Like, you have the right information at the right time, while time can also be. I can just put in more time here. And that can also result in some amount of returns in some ways. Like, I don't think effort is like linearly scaling everywhere. I think in terms of information and knowledge, effort scales exponentially if you know how to build it correctly. In other cases, effort would scale linearly, so you can't put in more hours and expect exponential returns.

Kahran: Yeah, that's what I was going to say. It reminded me of what we talked about many weeks ago. But I think when you were talking about how you feel like if you can improve your rate of learning, then it will improve so many other things in your life because you're able to learn just so many things faster. And I was going to say like that, that I think if you're improving, if you're putting effort into improving something, that's a derivative. So it depends on are you trying to improve your ability to leverage relationships or grow connections? You know what I'm saying? Like, if you're improving, like, if you're improving a derivative, you, I think you'll continue. It can be exponential growth, but if you're improving, just focused on improving the core thing, it's only going to be a linear growth situation.

Divya: Oh, and that's what leverage is like. It is that the thing that you began with, the more distant you are, the more leverage you have because.

Kahran: Yeah, when you said that, it totally caught me. Yeah.

Divya: Like, the higher order derivatives you are able to get to, the more leverage you'll be able to build.

Kahran: And I think in a lot of cases, that kind of, leverage does come with more risk because you're so highly concentrated. Right. When you start to move further away, that means the smaller and smaller impacts of the underlying thing has a bigger and bigger impact on you because you're further away from it. So, ah, a small deviation can really cause a really big change. Like, even if you'd say you take it to a knowledge example, and say that you really went deep into a certain area. Right. Depending on where that area is, if things that, if an underlying assumption that sent that place that way. I have an example, actually. My husband's PhD work was looking at next gen solar, but he was looking at a polymer based approach where you do layers of polymers, that are not carbon based, excuse, me. That are not silicon based, that are carbon based, which would dramatically reduce the cost of building solar panels. But, there's a different type of technology. I think it's called, Pebrosky's. okay. But yes, I really mispronounce that it has a v and an r and a k in it. and, it's not a polymer chemistry based approach. there's a different way of doing it. And so. Yeah, right. He was highly leveraged into this one kind of particular area, and of course he can do other things with it, because once you're a material scientist and once you really understand organic chemistry, there's a bunch of stuff you can do. But that area of research is actually to just not be the thing. Like maybe they'll do kind of polymer based. I mean, obviously they'll do polymer based chemistry for other things, but they won't be what is going to be done for kind of the next generation of solar cells.

Divya: this is also similar to how like a lot of tech, early adopters, adopted nfts during last two years. And that was a dud. Like, not just nfts, the entire blockchain implementation in crypto and NFT and all of the, Daos and all of that. But on the other hand, generative, like, a lot of those people are now skeptical to invest into Genai, while Genai is a lot more stable tech. And they, you know that there are two things that happened. One, they were highly leveraged towards the wrong thing, so it reduced their ability to take risks in future. So you lose on two fronts, because now you cannot leverage a, a thing that is going to give you shorter returns also.

Kahran: Yeah. both people lost their core assets, so they have less to leverage because there's just been a lot of capital lost in the last year. And then also they lost their risk appetite. Right. So they're like, oh, no, we can't bet on more new technology is like how that worked last time. Interesting. It probably means there's an opportunity for people who are willing to take the risks.

Divya: Yeah, I hope so. interesting. This was a lot of interesting stuff.

Kahran: Yeah, I was worried in the middle, but I think I often get worried in the middle. So we'll talk that up to a good episode.

Divya: Yeah. Okay. Bye bye. Thanks for listening to this episode of thinking on thinking. Our, theme music is by Steve Gomes.

Kahran: If you found any of the topics we talked about interesting this week, we'd invite you to get in touch with us. We'd love to invite you on the podcast or just have a conversation about how these topics apply in your business and in the decisions and problems that you're struggling with. You can get in touch with us on our website, Joyous studio, or by reaching out to Divya, or me, Kyun directly.