I always laugh (or cry) when I hear someone explain how their business is different or how their industry is unique and therefore the normal laws of finance don’t apply.
This kind of argument typically comes up when someone is trying to justify to themselves or someone else that their business or worth either a fortune or nothing. In one simple sentence they hope to prove that all of these thousand-page textbooks that business valuers are forced to read don’t apply to them because they’re special.
Obviously I sound a bit harsh but hear me out.
Every investment involves one or more outflows of money (or something else of value) with the anticipation of one or more future inflows of money (or something else of value). A rational investor will make an assessment of whether the money coming back is worth more than the money going out, after taking into account the risks and the time value of money.
We all understand how a term deposit works. We take our wheelbarrow of money down to the bank and hand it over on the anticipation of receiving more money back than we gave them originally. This is no different to what you do when you buy a business. But for some reason people like to ignore the laws of finance and invent their own as they go.
The only thing that changes is the terminology. Instead of calling the future inflow “interest” we call it “earnings” or “cash flow”. But the mathematics are exactly the same.
The bit that seems to confuse people is that interest is usually a fixed agreed amount, whereas business profits are hypothetical. The subsequent thought process is that if we have no “guarantee” of our future inflows then we can ignore basic financial theory and resort to rules of thumb, industry benchmarks and other self-serving methods.
To be clear, every investment, including a basic term deposit has uncertainty and is no more than a forecast. Ask people who have invested in term deposits in Europe or Northern Africa. Did the promise of agreed interest turn out to be a guarantee? Do you think it is impossible for an Australian bank or the Australian government to fail? Is there any such thing as a guarantee without risk…of course not. And if there was the return on the investment would be so low that it wouldn’t be worth investing in anyway. Think about those who put their money under their mattress during the GFC because they were scared of the banks. How would they go in a house fire or burglary?
The only two things that matter with any investment are the anticipated future inflows and the investor’s perception of risk in that particular investment. The formulas don’t change, only the variables. Whatever method you use to value a business you have to be able to tell me what you expect the future inflows to be (how much and when) and you need to explain what rate of return an investor would need to compensate them for their perception of the risks involved. If you can’t bring it back to this, then I can’t agree with you.
An Example – Restaurant
So what if you think that you can value the business based on the number of covers (paying customers) per week, compared to the number of covers of another restaurant that sold recently. Show me the money! What is the profit an investor can take from the business after they buy it? They can’t bank covers, the bank only accepts money. What is the average price of each cover? What are the margins after food and wages? What other fixed overheads and infrastructure are required? How will the fixed costs change if the revenue grows? How much money will the investor get back for their original investment and when will the receive it? You need to bring it back to these things as they are the only things that matter. If you can’t then you have more work to do.
Another Example – Accounting Firm
Accountants should really know better, but there’s a long-held myth that all accounting firms are worth around $1 for each $1 of revenue in the last year. This is stupid. You could have one firm doing basic tax returns making only $100,000 profit on $1m revenue. Another firm provides structured business advice and makes $500,000 on $1m revenue. Are these businesses really worth the same? Which one would you rather invest in?
The Lesson: By all means, get as much data as you can about the industry and any trends in rules-of thumb and benchmarks. But if you can’t justify the value in terms of return on investment then you’re not finished yet. You can’t just ignore the laws of finance just because it’s easier or it gives you the result you were hoping for.
I’d love to hear what you think. Comment below.