2. Value a Small Business like Warren Buffett

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In this lesson, students learn about Net Income, Total Revenue, Cost of Revenue, and very basic valuation techniques.

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Closed Caption:

ok welcome the course one unit one
lesson to valuing a small business okay
in this course we are going to learn
four objectives
first we're going to describe a small
business model next we're going to look
at how money flows to risk all business
we're going to look at a comparison of a
small business to a large business and
then we're going to really basic
valuation techniques for a small
business
ok so let's describe a small business in
order to do that we'll start with them
with a owner
let's have a very wise and knowledgeable
owner named Nancy
now in this scenario we only have one
owner just Nancy that's it is getting
more into the advanced lessons you might
have a hundred thousand hours that you
start dealing with stocks and really
large corporations
regardless of how many owners there are
you need to always remember that owners
owned the business
now you might be laughing but that
simple concept is something that people
really get confused I've heard people
say that they bought shares and they
think that they're like one of the
company's employees and I mean some
people really get some twisted ideas
whenever they think that they buy a
share or a stock and that they are
anything but the owner but that's what
you are you're the owner when you buy
shares of a business
so just keep that in mind as we go
through this small business scenario
ok in this scenario let's say that Nancy
had an idea for a small ice cream
business that she put in the parking lot
of the mall since Nancy's kind of bold
she doesn't actually like to work at her
business she doesn't want anything to do
with your business the business she's
going to hire one person to run the
stand to sell the ice cream to manage
all the finances to do everything and
all Nancy is going to get at the end of
the year is a check on how much her
business made so our employees are going
to run the entire business and I use
that model in that scenario because
whenever you get into this to buying
stocks that's what the scenario is as an
owner as a shareholder you're not
working for the company now you can you
can you can do both but when you're
doing valuing techniques and you're
trying to figure out the intrinsic value
of business you always want to look at
it from the standpoint that you are
not physically working in the business
you are an outside owner and that
everything that happens inside of that
business is going to be paid to you and
you're not in there actually eating up
the income that is producing
ok so that's the second part so you
first have to have an honor
the second part you have to have a
business and then the third part is
you've got to have the customer
those are the three parts regardless of
the size of the business you can have
this small little ice cream stand that
Nancy owns or you can be talking about
General Electric those three pieces are
always in the model
so now that we've got the model
established under the customer the
business
let's look at how money flows through
Nancy's business
ok so this is just in one hour on
and mind you i I've never had an ice
cream stand so i really have no idea
what it generates and how much it costs
to run one but i'm just going to throw
out these generic figures is we go
through this
so the flow the money in one hour of
Nancy's ice cream stand so we start off
at the beginning we look at the customer
ok the customers go to the business and
they spend a hundred dollars in one out
so that would be the total revenue
now as I go through these figures you
want to absolutely remember the
terminology because i'm using
terminology that directly relates to
stock investing so whenever we go down
that that path a little bit further all
these terms are going to translate over
so the total revenue would be that money
that all those people spend so that
hundred dollars comes into the ice cream
stand we're not even talking about any
of the cost that Nancy had or the
employees that are working for Nancy had
while they were running the streets down
as you take that hundred dollars you
walk across
now we step inside the business and we
see where that hundred dollars goes ok
so twenty dollars of that hundred
dollars in that our time frame went to
her one employee now we're just using
one employee to keep things simple and
that one employee manages everything
from scooping the ice cream - starting
it to keeping track of the books and
everything she's Nancy is paying her
twenty dollars an hour
we had twenty dollars go straight out of
the hundred grand a pop
then we got the cost of this these are
all costs of red
- all each one of these are mention the
next one is the material costs so it
costs money to make the ice cream to
have the middle to do whatever it takes
the bowls the spoons that they're gonna
have to hand out all that costs money so
we're just gonna say that that was forty
dollars and then the last one that I
threw in there was the cost for the land
or for her shack that she's paying you
know she might not have a paid off but
that costs per that our if we you know
divided it all out would be
let's just say ten dollars for that hour
that she had to rent that space
so when we add up all those numbers
that's called the cost of revenue
ok so we had the revenue which was a
hundred but the cost to get that revenue
with seventy dollars combined when we
took the hundred and we subtract the 70
we were left with thirty dollars so
that's the income before the taxes
Nancy's business made thirty dollars in
income before taxes
so let's just assume that we take ten
dollars off of the taxes and that leaves
us with twenty dollars of net income for
the earnings that term is vitally
important you want to write that down
five times in a row and then write it
down another five times in a row
you never want to forget that term net
income and whenever you get into
investing in shares in stock that net
income when you divide it down into a
one share is called the earnings that's
why i have both of those those terms up
there your net income and your earnings
are pretty much the exact same thing
the only difference is when you talk
means you're talking for one share
so when a person says earnings you need
to listen because that is a very very
important term when the person says net
income
you need to listen because that's pretty
much the most important term you can
understand because that's the end result
that's that's the money that has gone
through the process and that is left
over on the tray sitting right there for
you as an owner
so that's the owners money and when you
want to share when you own one share of
a business
those earnings that is your mind never
forget that
ok so the twenty dollars is what's left
at the end
that's your net income your earnings and
the owner now has the choice to do what
they want with that twenty dollars so
the ansi in this situation you can see I
have two arrows there one pointing
towards Nancy and one pointing towards
her business she could take that twenty
dollars that she earned in that one hour
and she can pay herself or she can put
the money back into the business so that
the business can make more than a
hundred dollars in an hour so she can
invest in a lemonade squeezer or a no
new ice cream machine that's going to
produce more income and she could do
this - she could take ten dollars for
herself and just pay yourself and she
could take ten dollars of that earnings
and put it back into the business and
that's what you'll see a lot of
businesses do is that they take a cut
and they also put money back into the
business
so that's the thing is is that earnings
can go to directions and that's
something you absolutely have to
understand when you start talking about
stocks the money that's going towards
the owner is is a dividend and the money
that's going back into the business can
be retained in the equity but we'll get
into that later so that the main thing I
want you to really understand is net
income earnings very important number
and it can be paid to the owner or back
into the business
ok so we understand that model that
model makes sense for pretty much
anybody is they look at that because
it's just really easy to understand
so when we look over here i'm going to
do a comparison between a small business
in a large business
so as you look on the left there is that
small business that we just talked about
how we saw the money flow from the
customer to the business and then to the
owner
so when you talk about a large business
it's the exact same thing like we had
said
so let me put some pictures in here to
represent how that bigger business looks
so a lot of people have heard board of
directors but they have no idea what
that really means or where that fits in
the grand scheme of things but now you
do is you look at the schematic here you
can see that the owners the board of
directors represents the shareholders
so let's say you went and bought 10
shares of GE ok
use your voice as an owner is
represented by that board of directors
those people sitting there in those
chairs there
you know Hugh
shareholders they might have 10 million
shares of the company and because they
own so many shares that's why they are a
member of the board of directors
but when you and let's say you just own
10 shares you have a voice and you have
a voting power with the shares and that
voting power is delegated to one of
those board of directors
ok so those board of directors represent
the shareholders and they're the ones
that are actually you know representing
all the owners for that one specific
business so what does call this business
GE general electric
ok and those are just assume that those
are the board of directors
so as you step down to the business
itself
this is where the CEO which a lot of
people know that term the CFO and always
be those are all employees there they
can be owners at the same time but their
role as the CEO is he's that he's the
head guy he's the guy in charge of
making sure that the product that that
will say GE is producing here is
actually being made and that everyone is
is being paid on time and that all the
products are being pushed out on time so
a lot of the times people get confused
between like board of directors and CEO
at that CEO is an employee and that CEO
works for the board of directors and all
the shareholders and then your customer
doesn't change customers still you know
buying up the product
ok so let's value the business and
that's what we're really getting at here
and that's our last objective is so
what's this thing worth you know is is
we looked at first scenario and Warren
Buffett says that the company's worth
forty dollars but its trading for 30 how
does he figure that out how does he
possibly look at something and figure
out what it's worth
so this is a really generic scenario how
how you can understand what a business
is worth so let's try to value
Nancy's little ice cream stand business
we know and what I did here is I change
the cash flow from being one hour to one
year and all I did was just throw some
zeros on all those numbers and you can
see instead of it being a hundred
dollars coming in for the total revenue
now it's a hundred thousand dollars
coming in so the revenue comes into the
business at a hundred thousand it cost
her seventy thousand dollars in order to
make the hundred thou
that's your cost of the revenue which
leaves you thirty thousand dollars
before the income tax
you take 10,000 for the taxes which
leaves Nancy twenty thousand dollars in
net income or earnings for a year
so what's that worth if nancy was going
to try to sell this ice cream stand what
is it worth
and that's that I'll tell you what pause
I want you to pause the video and I want
you to think about what would you be
willing to buy this business for knowing
that you are absolutely going to make
twenty thousand dollars and you're not
going to have to work one hour in order
to get your employee is going to take
care of everything you're just going to
make the 20,000 it's a hypothetical
question but think about that
ok now that you've thought about that
question you pause the screen you
thought about
let's look at some different values here
we know that then that income or the
learning is $20,000 Nancy doesn't have
to do anything she's just gonna get paid
that twenty thousand dollars after one
year
so what would she be willing to pay in
order to earn that twenty thousand
dollars after one year
so let's just say four hundred thousand
dollars is what somebody's gonna buy
this business for so if you had four
hundred thousand dollars and you
purchase this ice cream stand and
everything was running
you know smoothly the employees weren't
leaving and all the stuff that you
typically run into with ice creams now
let's just assume that it's running like
a top
there's no problems she could expect to
get a five percent return on that
investment
ok because she's going to get twenty
thousand dollars at the end of one year
and she paid four hundred thousand
dollars four that's five percent so then
we go to two hundred thousand dollars if
she if you could buy that business for
two hundred thousand dollars
one year later you make your twenty
thousand dollars because that number
doesn't change it that's the net income
that's what that business makes in a
year that investment that that purchase
price would you ten percent on your
money
ok and as we obviously look down the
hundred thousand if you could buy that
business for a hundred thousand dollars
you're going to make twenty percent on
your money as you look at those figures
you can see that this is the this is the
point that i really want you to take
away her business never changed
ok that business state 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 at those different price
points is going to get a different
return
ok the business didn't change it's
exactly the same its producing the
twenty-thousand-dollar but as you went
through different purchase prices as you
paid more for that business your return
and went down drastically as you is as
those price points changed and the same
exact thing happens when you're buying
stocks if you overpay for a stock your
percent that you can expect to get each
year
goes down significantly so the name of
the game really comes down to what is
the stock worth and that's why warren
buffett takes so much time into the so
much detail as he's figuring out what
these companies are worth because he
knows that if he overpays for it
his yield will go down ten percent
fifteen percent twenty percent so that's
really the name of the game and that's
what I really wanted you to get out of
this lesson
so to summarize we had four objectives
the first was to describe a small
business model the next was how money
flows through a small business
a comparison of a small business in a
large business and how do you value
generically how do you how do you value
a small business so that concludes
lesson too and i look forward to seeing
you guys in less than three