7 Ways To Measure Business Value Ep 314



In his instructional video, Speaker A demystifies the seven methods used to measure business value, cautioning viewers against common deceptions in the entrepreneurial world. He explains that contract value, lifetime revenue, and business valuation are often overstated metrics that don't necessarily reflect a company's actual financial health. He emphasizes the importance of distinguishing between revenue and cash collected, and advocates for focusing on more tangible metrics like EBITDA, net free cash flow, and net worth. Speaker A argues that these figures provide a more accurate representation of a business's and its owner's real value. He also encourages entrepreneurs to extract dividends to de-risk and build personal wealth, rather than relying solely on business valuation. Throughout the video, Speaker B provides affirming responses, underscoring Speaker A's insights.

Summary Notes

Understanding Business Value Measurement

  • Speaker A aims to educate the audience on how business value is often misrepresented online.
  • The focus is to discern between legitimate and deceptive claims of business value.
  • The video promises to teach viewers how to identify misinformation and what questions to ask for clarity.

In this video I'm going to show you the seven ways to measure business value and how you're probably being deceived by most people you see on the Internet simply because you're not understanding the words and terms they are using.

The quote sets the premise of the video, highlighting the importance of understanding business terminology to avoid being misled about business value.

Extrapolating Contract Value

  • Speaker A discusses the first way of measuring business value: extrapolating a single month of contract value into eternity.
  • This method often overstates the actual performance by assuming a one-time event's sales will continue indefinitely.
  • The legitimacy of this method depends on the reliability of the contracts and the nature of the business.

So the first of the seven types of ways that people will measure value is that they will extrapolate a single month of contract value into eternity, or at least over a year.

The quote introduces the first misleading tactic used to measure business value, emphasizing the need to differentiate between actual cash flow and projected contract value.

Lifetime Revenue

  • Speaker A explains the second way of measuring business value: total lifetime revenue.
  • This metric can be misleading as it aggregates all revenue over the business's lifetime, which can inflate the perceived success of the business.
  • Speaker A suggests asking for specifics about the revenue, like whether it refers to yearly revenue or profit.

The second is lifetime revenue. So this is when someone says, we've done x amount of total revenue collected in our business.

This quote introduces the second method, lifetime revenue, and points out how it can be used to exaggerate business success.

Revenue vs. Cash Collected

  • Speaker A clarifies the difference between revenue and cash collected.
  • Revenue often refers to the total contract value, while cash collected reflects the actual money received by the business.
  • Speaker A advocates for transparency and honesty in reporting financial figures.

Those are two very different things, right. Revenue is contract value. But cash collected is really reality.

The quote distinguishes between revenue and cash collected, emphasizing the importance of understanding what is being referred to in financial claims.

Business Valuation

  • The third method discussed by Speaker A is business valuation.
  • Speaker A mentions receiving an award for achieving a certain revenue milestone with Clickfunnels.
  • The speaker promises to share the actual annual revenue figures to provide transparency and context.

So anyways, number three is business valuation.

The quote briefly introduces the third method of measuring business value, setting the stage for further explanation on the topic.

Business Valuation Based on Market Value

  • Valuation can be influenced by the market's perception of a business's worth.
  • The value assigned depends on the evaluator and the metrics used.
  • Small businesses, typically under $5 million in revenue, often get valued at two to three times EBITDA.

"So this one is one where it's based on the market's value of the Business if it were sold." This quote explains that one valuation method is based on what the market would pay for the business if it were sold.

"For most businesses that are small businesses... most of those guys are getting two to three times EBITDA." This quote details the common valuation multiple for small businesses based on EBITDA, which is a metric for earnings before interest, taxes, depreciation, and amortization.

Business Valuation Multiples by Revenue Size

  • Different sizes of businesses have different typical valuation multiples.
  • Mid-market businesses ($10 to $100 million in revenue) may see multiples of six to eight times EBITDA.
  • Businesses with over $100 million in revenue can have even higher multiples, often based on EBITDA.

"So if you're a mid market... then you might have a six to eight times multiple." This quote provides the standard EBITDA multiples for mid-market businesses.

"If you get above $100 million, then a lot of times you can get into the twelve s cetera." This quote indicates that businesses with revenues exceeding $100 million can command multiples higher than twelve times EBITDA.

Valuation Based on Growth and Investment Potential

  • Fast-growing companies with significant capital reinvestment needs may be valued differently.
  • High growth and strategic reinvestment can lead to valuations based on top-line revenue in rare cases.

"And that is in a fast growth company that has high amounts of capital that need to be reinvested in it that they believe are going to give it a strategic advantage for high gross profits in the future that they'reinvesting capital into." This quote explains that companies with fast growth and high reinvestment needs might be valued on their revenue rather than EBITDA due to their potential for future profits.

Misleading Valuation Metrics

  • Outlier valuations can create misconceptions about business worth.
  • High multiples can sometimes result from low profits, making the valuation appear more impressive than it is.

"What that really means is that this is what I want everybody to watch this video to be thinking, well, either they had a really crazy business, or more likely they were making almost no profit in their business and just got a high valuation because of, or not even necessarily a high valuation." This quote suggests that an extraordinarily high multiple may not reflect a high valuation but rather a low profit margin, which can mislead about the business's actual success.

Yearly Revenue vs. Cash Collected

  • Yearly revenue is a closer measure of reality but must be considered alongside cash collected.
  • The type of business affects the correlation between revenue and cash, with service businesses having contracts and e-commerce being transactional.
  • Revenue does not account for refunds or chargebacks, which leads to the concept of net revenue.

"Now, again, revenue versus cash collect, it depends on the type of business." This quote emphasizes the difference between revenue and actual cash collected, which varies by business type.

Understanding Business Metrics

  • There are many metrics for measuring business value due to the complexity of valuation.
  • Entrepreneurs and investors must understand these metrics to assess true value.
  • Some metrics are more indicative of reality than others.

"And so for you, as a keen entrepreneur or investor or person who wants to grow within the business world, understanding all of these metrics and how they work together to assess or get as close to true value as possible, these are going to be tools in your skill set." This quote underscores the importance of understanding various business metrics for accurate valuation and decision-making.

Profit and EBITDA

  • Profit and EBITDA are not the same but are related.
  • EBITDA is a common basis for valuation, especially for mid-market and smaller businesses.
  • Real-world examples often involve lower multiples than publicized outlier cases.

"Now, the next one is profit or EBITDA. Now, these two things are not necessarily the same, but I'm going to say EBITDA being earnings before interest, tax, depreciation, and amortization." This quote clarifies the difference between profit and EBITDA and defines EBITDA.

"Just no one wants to talk about it, right?" This quote implies that typical business valuations are less talked about than the exceptional cases that make headlines.

Call to Action for Podcast Support

  • The host does not run ads or sell products on the podcast.
  • Listeners are encouraged to spread the word to help more entrepreneurs.
  • Supporting the podcast can have a positive impact on the broader entrepreneurial community.

"Real quick, guys, you guys already know that I don't run any ads on this, and I don't sell anything. And so the only ask that I can ever have of you guys is that you help me spread the word so we can help more entrepreneurs make more money, feed their families, make better products, and have better experiences for their employees and customers." This quote is a call to action for listeners to support the podcast by sharing it, which in turn supports the entrepreneurial ecosystem.

Capital Allocation and Competitive Advantage

  • Businesses requiring significant capital reinvestment to maintain a competitive edge are less favored by investors like Charlie Munger and Warren Buffett.
  • Munger and Buffett prefer businesses that generate high net free cash flow (NFCF) without the need for substantial additional capital.
  • NFCF is crucial as it represents the actual earnings an owner can extract from the business after reinvesting to maintain and grow its competitive advantage.
  • Extracting cash flow is a way to de-risk, especially since most businesses do not sell for their perceived value.

"Depending on your type of business, you might have to reallocate all that money back into the business to just maintain your competitive advantage, which Charlie Munger, Warren Buffett, they talk about how their least favorite type of businesses are businesses that require lots of additional capital."

This quote emphasizes the importance of capital efficiency in a business and the preference of successful investors for businesses that do not require constant reinvestment to stay competitive.

Realities of Business Ownership and Cash Flow

  • The reality for entrepreneurs is that businesses often fail and selling a business is not guaranteed.
  • A key measure of a business's value is the owner earnings or the cash flow that can be extracted from the business.
  • Entrepreneurs should focus on the real, tangible cash flows of a business rather than hypothetical valuations.

"A lot of times businesses fail. There are tons of risks. That's why business is one of the riskiest things to get into. Most businesses do not succeed."

This quote highlights the inherent risks in entrepreneurship and the high failure rate of new businesses, underscoring the importance of focusing on cash flow.

Entrepreneurial Net Worth and Revenue Misconceptions

  • Entrepreneurs may shy away from discussing net worth, which is a more accurate reflection of financial success than revenue figures.
  • Revenue over time can be misleading; a business boasting $1 million in lifetime revenue over ten years is only generating $100,000 a year.
  • High revenue does not necessarily translate to high net worth or authority in business.

"And there's two aspects of net worth, all right? You have your net worth that comes from your investable assets, which is what you've extracted, right? What you've extracted, paid your taxes on and then been able to reinvest and grow."

This quote explains that net worth consists of two parts: investable assets that have been extracted and grown after taxes, and the ownership percentage in businesses.

Valuation Multiples and True Business Value

  • True market value of a business should be based on a fair and reasonable valuation.
  • EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and the multiples applied to it are key in determining business value.
  • The type of multiple and the basis for it (top line or bottom line) must be justified.

"Business valuation survey says yes, but caveat on this. You want to know what type of multiple are you assuming and what is that off of, top line or bottom line? And why can you defend that?"

This quote stresses the importance of understanding and justifying the valuation multiples used when assessing a business's worth.

Critical Analysis of Business Metrics

  • Contract value and lifetime revenue are not reliable sole indicators of business acumen or success.
  • It is essential to ask probing questions to understand the context and reality behind these figures.

"Is this something that I'd be looking at in terms of whether I'm going to value this person's opinion based on this stat alone? Survey says contract value. No, I would not do that."

This quote suggests skepticism towards using contract value as the sole metric for valuing someone's business expertise, advocating for a more nuanced approach.

Metrics of Value

  • Metrics exist to ascribe and measure value in businesses and entrepreneurial ventures.
  • Understanding these metrics is crucial for evaluating the worth of a business.

It's so that people can ascribe and measure value.

This quote emphasizes the purpose of metrics, which is to assign and quantify the value of business entities or initiatives.

Yearly Revenue and Profit

  • Yearly revenue and profit are partially linked and are important for assessing a business's financial health.
  • High revenue with low profit can still be valuable if the business is reinvesting to grow.
  • The value of a business is not just in its revenue but also in its profit margins and growth potential.

Yearly revenue survey says partial answer because it goes with number five, which is yearly profit.

This quote links yearly revenue to yearly profit, indicating that both metrics must be considered together when evaluating a business.

Now, that's a super valuable business. And it's because the bankers and the people who bought it saw that they had reinvested everything into growing the business.

This quote highlights a case where a business with relatively low profit compared to revenue was still considered valuable due to reinvestment strategies for growth.

Strategic Reinvestment and Business Valuation

  • Strategic decisions on reinvesting in the business can affect its valuation.
  • Capital costs and future growth potential are considered by potential investors.
  • The valuation of software businesses may particularly reflect their reinvestment and growth strategies.

So understanding that they might be making some strategic decisions about how they're reinvesting the business, et cetera, or some capital costs that might have cost them, but they see what it's going to yield them in the future, et cetera.

The quote discusses how strategic decisions on reinvestment and capital costs are important for understanding a business's valuation.

Net Free Cash Flow

  • Net free cash flow is a primary metric for Warren Buffett and Charlie Munger to measure business value.
  • It indicates the amount of cash a company generates after accounting for capital expenditures.
  • Multiplying net free cash flow can approximate what an investor might pay for a business.

This is UNcLE Warren. This is Uncle Charlie Munger. This is their primary metric for measuring business.

This quote references Warren Buffett and Charlie Munger's preference for using net free cash flow as a key indicator of business value.

Entrepreneur's Net Worth

  • An entrepreneur's net worth is what remains after all business activities and is an excellent measure of value.
  • The net worth reflects the entrepreneur's ability to create personal wealth through the business.
  • Diversification of assets and extracting dividends can de-risk an entrepreneur's financial position.

And the thing that remains is you, your net worth as an entrepreneur.

This quote emphasizes the importance of the entrepreneur’s net worth as a lasting measure of value beyond the business's operational life.

Historical Perspective on Business Longevity

  • Fortune 500 companies from 50 years ago have changed significantly, with only General Electric (GE) and Ford remaining.
  • This historical perspective suggests the importance of creating personal wealth over reliance on business longevity.

And if you look at the Ink 500, sorry, the Fortune 500, and you look at it 50 years ago, what you'll see is that there's only two businesses that are still on the Fortune 500 from now, from 50 years ago. G and forD.

The quote provides an observation on the transient nature of corporate giants and the rarity of long-term survival on the Fortune 500 list.

Diversification and Risk Management

  • Extracting dividends and diversifying income sources are important for entrepreneurs to manage risk.
  • Betting solely on one's business can lead to significant losses; hence, diversification is advocated.
  • The speaker suggests that even though a large part of their net worth is in business valuations, they maintain a significant amount in investable assets.

And so it is my belief that if you are generating a profit, you should be purposely taking some out every month.

The quote advises entrepreneurs to regularly extract profits from their business to secure and diversify their income.

Assessing Business Value

  • When evaluating claims of business worth, it's important to ask about the nature of the revenue, the basis of business valuation, net free cash flow, and dividends.
  • Understanding the interplay between different valuation metrics is key to ascertaining true business value.
  • Sharing net worth numbers can be a transparent way of discussing value, although opinions on this practice vary.

And so these are the seven ways that I wanted to highlight for measuring value.

This quote introduces the various methods the speaker believes are important for measuring the value of a business or entrepreneur.

It's understanding the interplay between them so that you can ascertain what the true value of a business and or the burner that owns it is.

The quote stresses the importance of understanding how different value metrics interact to determine the true value of a business and its owner.

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