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“John, I don’t think most people view their business in terms of an investment. They view their business in terms of providing a job for themselves. I would ask, what is your rate of return and how much do you have in assets and equity?”
If you invest $100,000 in a stock and it goes up to $120,000, you have $120,000 in assets. If it goes down to $80,000, you have $80,000 in assets. If you start a business, let’s say a retail store, purchase a building for $50,000, spend $30,000 on improvements and labor and allocate $20,000 to working capital, what does your balance sheet look like? If the building holds its purchase price market value, then it will be worth at least $50,000. The improvements may add value to the investment. For argument’s sake, let’s say the improvements add $15,000 of value to the building (remember, you paid for improvement and the contractor labor. The money used for labor disappears as an expense.) Let’s assume also that you still hold the working capital money as cash. Your balance sheet will be as follows:
Assets: $85,000
Liabilities: $0 (you put in all cash)
Equity: $85,000
“You can see John, that in the above simple example that you lost $15,000 because it disappeared through the renovation labor.
“Now, your hope is that you built an earnings generating business and thus have added value in that respect as well. Now the question is, how much do the earnings add to the business? Well, let me tell you how Warren Buffett would value the business. Let me use a simple example.
“If Warren believes that the business can consistently generate earnings of $10,000 a year for the next 10 years, he asks himself, how much is a future $100,000 worth today? He might use a discount rate of 10%, punch in a future value of $100,000 on a handy business financial calculator, use 10 for the number of years, and again 10% for the interest rate and calculate the present value. In this case, if you expect to earn a rate of return of 10% on a business that earns $10,000 a year that you expect can continue to earn at this rate for 10 years, a fair price to pay for the business will be $36,941.”
You can see that this analysis at its core, relies on the predictability of earnings. Thus the need to identify a business with a consumer monopoly or toll bridge.
The whole purpose of this exercise is to view your business as Warren Buffett would view it:
He looks for consistent, steady, growing earnings year after year (this would be your profit on your profit and loss, look at a 10 year period.)
He looks to see that the business can reinvest these earnings into the business and continue to compound a high return on equity.
In general a company that is able to compound earnings, has low capital expenditures – they don’t have to reinvest yearly to update or fix machinery, plant or equipment – and they generally have low R and D costs.
Again, he asks himself, how much am I willing to pay for this business by taking the yearly earnings, multiplying by 10 years and then discounting this back to present day by a rate of return, say of 15%.
Warren also looks for low long term debt (Debt divided by Equity should be 33% or less).
He also looks for low yearly investments in capital expenditures( You don’t have to reinvest yearly to update or fix machinery, plant or equipment, otherwise you might be a commodity type business)
A consumer monopoly business will have relatively high gross margins and net margins.
“In addition John, I always calculate my cash on cash rate of return in any investment. If I have to put $100,000 into an investment and it generates $20,000 a year in earnings, then my rate of return is 20%. For your business, this would be your yearly earnings divided by how much equity you have in the business. The question is, is it enough? If you can get 30% in another investment, does 20% cut it?
“Warren is looking for a “Coke” or a “Fruit of the Loom.” In analyzing your own business, you must always ask yourself, am I the “Coke” brand of my market? To answer this question, ask yourself, ‘If I had one million dollars, and the brightest business minds in my area, could I take down my own business?’ The answer may be very revealing as to certain weaknesses in your business model but also, if you answer no, you can’t take me down, then you may have a consumer monopoly that Warren would be interested in buying.”
The over-arching vision of Building a Small Business That Warren Buffett Would Loveis to create
One Million Jobs.
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