First off, let’s begin by describing a small business. In order to do that, Nancy, a knowledgeable business owner, will help us. In this scenario, we only have one owner, but as we move into the advanced lessons, we might have a thousand owners to talk about their large corporations.
Regardless of the number of owners, it’s essential to remember that owners OWN the business. That might sound funny, but a concept as simple as this confuses many people. Some say, “I bought shares in a company and now I am one of their employees!” What a twisted idea! Now, think about this: Would you pay thousands or millions of dollars just to become an employee? You might as well spend your money on other things if that’s the case! Keep this in mind: whenever you buy a share or a stock from a business, you are an owner.
Going back to the scenario, let’s assume that Nancy desires a small ice cream business to be set up in the parking lot of the mall. Since Nancy is aged, she neither wants to work at her business nor do anything with it. She’d say, “I’m going to hire one person to run the stand, sell the ice cream, manage all the finances, and just do everything.” All that Nancy’s going to get at the end of the year is a check, depending on the revenue of her business. Basically, her employees are going to run the entire business.
I modeled Nancy’s scenario to elaborate on what shares are and who you are when you buy it. Again, whenever you buy stocks, it means that you become an owner AND a shareholder. You’re NOT working for the company. However, you can do both if you wish. Just remember that when you’re figuring out valuing techniques and the intrinsic value of your business, you need to look at it from the standpoint that you aren’t physically working in the business. You are an outside owner. Everything that happens inside of that business is going to be paid to you and you’re not in there actually beating up the income it has produced.
Now that we got the model established, let’s take a look at how money flows through Nancy’s ice cream business in one hour. Let’s begin by looking at the customers. Assuming that the customers go to the business and spend $100 in one hour, the total revenue generated is a hundred dollars. Make sure you remember the terminologies as we go through these figures because these relate directly to stock investing. When we go down that path a little bit further, all these terms are going to be translated. The total revenue is the money that the customers spent – those hundred dollars. Take note that we are neither talking about the cost that Nancy had nor the employees that are working for Nancy yet.
Once we delve into the intricacies of the business, it’s easy to understand how $100 is used. As you can see, Nancy hired one single employee, so assuming that she pays $20 for an hour, the employee receives his money from the $100 revenue.
Now, let’s talk about the cost revenue. Every business costs money, so assuming that it costs $40 to prepare the ice cream, buy milk, bowls and spoons, Nancy will have to spend that too. The $40 is the material cost, which means that it’s the money spent for necessary ingredients and other stuff. Lastly, we arrive at the land cost, which is the money spent for the space taken for the business. Considering the rent is about $10 an hour, she has to pay that too. When we add up all those numbers, we derive the cost revenue.
Again, we had the revenue which was $100, but the combined cost to get that revenue was about $70. If you’re confused, $70 is the total adding $20 (Nancy’s labor cost), $40 (material cost), and $10 (land cost). We subtract $70 from $100, leaving us with $30. Nancy’s business made $30 in income before taxes. Assuming that tax is $10, that leaves $20 of net income or the earnings. As mentioned already, the term ‘Net Income’ is vitally important.
Net income and earnings are pretty much the same. The only minor difference is that the term ‘Earnings’ refers to the amount of profit produced during a specific period (monthly, quarterly, semiannually, etc.), while ’Net Income’ refers to the total earnings generated when all the earnings are added up. Again, net income and earnings is the money that has gone through the process. Tax and cost have been deducted and net income is all yours as an owner. Similarly, when you own a share, those earnings are your money.
Now going back to Nancy, she’s left with $20 remaining in her hands. She can either use that for her personal expenses or push it back into the business in order to make more money. For instance, she can invest in a lemonade squeezer or another new ice cream machine which will eventually produce more income.
Another option would be to split the $20 so that she can take $10 for her personal expenses and push the remaining $10 back into the business. Most businesses follow this procedure. Those earnings can go in two directions that you absolutely have to understand. When you start talking about stocks, the money going towards the owner is a dividend, while the money going back into the business can be retained into the equity, but we’ll get into that later.
Let us compare a small business and a large business. We now understand how money acquired through a small business flows from the customer to the business and then to the owner.
When you talk about a large business, it’s the exact same thing, so let me put some pictures in here to represent that bigger business. As you look at the schematics, you can see that the board of directors represents the owners. For example, let’s assume that you bought shares of GE. Your voice as an owner is represented by the board of directors who are huge share owners. They might own 1 million shares of the company, and that’s why they are a member of the board of directors.
However, when you just own ten shares, you have a voice and you have a voting power with those shares. That voting power is delegated to one of the members of the board of directors and they represent the shareholders and all other owners for that one specific business.
As you step down to the business itself, this is where the CEO and all other high rank employees come into action. They can be owners at the same time, but their role as the CEO is mainly focused on the product. A lot of times, people get confused between the board of directors and the CEO. The CEO is an employee and works for the board of directors.
Now let’s value the business. What is this thing worth? As we look at the scenario, Warren Buffett says that the company’s worth is $40 trading for $30. How did he figure that out?
This is a really generic scenario of how you can understand the businesses’ worth. Let’s try to value Nancy’s little Ice cream stand by changing the cash flow from an hour to a year by adding a few zeroes to those numbers. Now, we arrive at $100,000 total revenue, instead of the $100 we had seen earlier.
It costs her $70,000 to generate $100,000, as illustrated already. Once you subtract another $10,000 for taxes, it leaves Nancy with $20,000 as the annual net income. If Nancy had to sell this ice cream stand, what is it worth?
Pause now and answer this question:
If you could buy a business that earns $20,000 a year without any extra efforts, what would you be willing to buy it for? Assume this business has very little risk.
Now that you’ve thought about that question, look at some different values. We know that the net income earning is $20,000. Nancy doesn’t have to do anything, but she gets paid $20,000 after one year. What would she be willing to pay in order to earn that $20,000 after one year?
Let’s just say it takes $400,000 for someone to buy this business. If you had $400,000 and purchased the ice cream stand and everything was running smoothly (employees not leaving, customers keep coming, more requests for more flavors, etc.), she could expect to get 5% return on that investment by getting $20,000 at the end of one year which she paid $400,000 for.
Now we go to $200,000. If you could buy that business for $200,000, you could make $200,000 after a year. That number is the net income, which doesn’t change. That investment or purchase price would yield 10% on your money.
If you could buy that business for $100,000, you’re going to make 20% on your money. As you look at those figures, you can see that Nancy’s business never changed. Take note of this! The business stayed exactly the same! It was making $20,000 through each of those three scenarios, but you can see that the expected return of anybody who would buy those different price points gets a different return.
The business did not change but as you went through different purchase prices and paid more for that business, your return went down drastically since those price points changed. This is exactly what happens when you buy stocks too. If you overpay, expect your percentage to go down significantly every year. The name of the game really comes down to “What is the stock worth?” Warren Buffett takes so much time figuring this out. If he pays for work, his yield will go down 10%, 15%, 20%, and so on.
To summarize lesson two, we learned how to value a business. Although a lot of terms were used throughout the lesson, the most important term was net income (or “earnings” when referring to only 1 share).
Since the net income was the final figure that shows the profit of the company, we can use this number to determine the general value of the business. A very basic valuation technique is to use the net income (or earnings) to estimate the annual return one could expect from different price points.
If the net income of a business is $20,000, and a seller wants $100,000 for the business, we know that an investor would most likely earn a 20% return on their initial investment.
We also learned that Warren Buffett doesn’t like to pay more than 15 times the net income (or earnings) of a business when he buys stocks. Therefore, if the net income of a business was $20,000, Warren Buffett would try to buy the business for less than $300,000.
Remember, these basic valuation techniques are not even the tip of the iceberg, so don’t think this is enough to start trading stocks or buying businesses. In this very basic example, we haven’t considered the risk or other variables that are found commonly in most companies.