2. Value a Small Business like Warren Buffett

Summary

This lesson focuses on understanding the basics of small business valuation. It covers key topics such as defining a small business model, the flow of money through a business, and comparing small businesses to large corporations. Using a simple ice cream stand as an example, the lesson demonstrates how costs, revenue, and net income are calculated. The importance of earnings and net income is highlighted, along with basic concepts of investment return based on business value. The lesson emphasizes that accurate valuation is crucial for maximizing investment returns, just as in stock investing.

Takeaways

• 📊 A small business model involves three key components: the owner, the business, and the customer, which apply to both small and large businesses.
• 💼 Owners own the business, whether it’s a small ice cream stand or a large corporation. Buying shares means you own a part of the business, not an employee role.
• 🍦 In the example of Nancy's ice cream stand, she is a hands-off owner who hires employees to manage the business while she collects the profits.
• 💵 The flow of money in a business starts with revenue from customers, and expenses such as wages, materials, and rent, resulting in net income or earnings.
• 📈 The net income (or earnings) is what’s left after all costs and taxes. It’s a crucial concept in business valuation and stock investing.
• 📉 Business earnings can be used in two ways: paid to the owner (dividends) or reinvested into the business to grow and generate more income.
• 🏢 Large businesses function similarly to small ones, but with a Board of Directors representing shareholders and managing the company through the CEO and other executives.
• 💼 Valuing a business involves determining how much it is worth based on the income it generates and what return on investment (ROI) a buyer would expect.
• 🧮 In business valuation, the price paid for a business impacts the ROI. Paying more results in a lower percentage return, while paying less increases the ROI.
• 📝 Understanding concepts like net income and valuation is key to making informed decisions about buying shares or valuing businesses, as exemplified by Warren Buffett's investment strategies.

Q & A

What are the four main objectives covered in this lesson about valuing a small business?

The four main objectives are: describing a small business model, understanding how money flows through a small business, comparing a small business to a large business, and learning basic valuation techniques for a small business.

What role does the owner play in a small business, according to the example of Nancy?

In the example of Nancy, the owner does not actively work in the business. Nancy hires employees to run the business and only collects the profits. This is analogous to how shareholders in a company receive earnings without being involved in daily operations.

What is meant by 'total revenue' in the context of Nancy's ice cream stand?

Total revenue refers to the amount of money generated by the business from customer sales. In the case of Nancy's ice cream stand, it's the $100 that customers spend in one hour.

What are the components that make up the cost of revenue in Nancy's business model?

The cost of revenue in Nancy's business includes the wages of the employee ($20), the cost of materials (like milk, bowls, spoons, etc., $40), and the cost for the land or rent of the stand ($10). These add up to $70.

What is 'net income' and why is it important in business valuation?

Net income is the profit remaining after all expenses (including taxes) have been subtracted from total revenue. In Nancy's case, it’s $20 after taxes. It's crucial in business valuation because it represents the actual earnings available to the owner or shareholders.

How does the value of a business change depending on the price someone is willing to pay for it?

The value of a business is related to its earnings, but the return on investment changes depending on the purchase price. For example, if someone pays $400,000 for Nancy's business, they'd get a 5% return on the $20,000 earnings. However, if they paid only $100,000, they'd get a 20% return.

What is the difference between net income and earnings in this lesson?

Net income refers to the total profit of the business, while earnings refer to the portion of net income divided per share when valuing stocks. Both terms are important for understanding a company's profitability.

What is the importance of understanding the flow of money through a business?

Understanding the flow of money through a business is crucial because it helps determine how much revenue is being generated, how expenses affect profits, and ultimately what the business is worth. This insight helps owners and investors make informed decisions.

How does the lesson compare small businesses to large corporations in terms of ownership structure?

In small businesses like Nancy’s, there's usually a single owner managing the operations. In large corporations, ownership is divided among shareholders, who are represented by a board of directors. The board makes decisions on behalf of the shareholders, and the CEO manages the business.

Why is it important to not overpay when purchasing a business or investing in stocks?

Overpaying for a business or stock reduces the percentage return on investment. Even if the earnings remain the same, a higher purchase price leads to lower profitability. This is why investors like Warren Buffett focus on determining the intrinsic value of a business before buying.