How Businesses Exaggerate Their Value Ep 333

In a detailed discussion on business valuation, the host exposes common misconceptions about measuring a company's worth, emphasizing the pitfalls of relying on metrics like contract value and lifetime revenue, which can be misleading and inflate perceived success. The host underscores the importance of understanding different valuation methods, such as EBITDA, yearly profit, and owner earnings, to accurately assess a company's financial health. The ultimate measure, according to the host, is net worth, which reflects the true value after all deductions. The host, who has personally extracted nearly $50 million in owner earnings, advises entrepreneurs to focus on net worth growth in a tax-efficient manner, cautioning against conflating self-worth with net worth to avoid ego-driven financial decisions.

• Contract value is often used to inflate perceived business success.
• It is based on future expected earnings from contracts, not guaranteed income.
• This method extrapolates a single event's revenue over a longer period, such as a year, to present a larger figure.
• It can be misleading as it does not account for customer churn or the reality of monthly income.

"That's when someone says, I like to call this marketer math. And that's when someone goes to an event and pitches something of some sort and gets people to sign up for a one year program, for example." "But when they say, hey, we did $2 million in sales, right, the reality that we're doing $2 million a month, right?"

These quotes explain how contract value is often misused to represent a business's financial performance. The speaker describes "marketer math" as a technique where future contract values are presented as current or consistent monthly revenue, which is misleading.

• Lifetime revenue is the total sales collected over the entire lifespan of a business.
• It can sound impressive, but may not indicate strong annual performance.
• This metric does not reflect the profitability or the annual income of a business.
• Comparing lifetime revenue to annual profits can reveal the true scale of a business's success.

"And so revenue over lifetime is basically saying, all right, I've been in business for ten years. And over those ten years, we've done $2 million."

This quote explains the concept of revenue over lifetime, which aggregates all sales made over the business's lifespan. The speaker suggests that while the total can seem large, it might not be indicative of a successful annual performance.

• Business valuation is a measure of a company's worth to potential buyers.
• It is common in publicly traded companies and influences the net worth of CEOs like Jeff Bezos.
• Valuation often uses profit multiples based on EBITDA to estimate worth.
• It is a legitimate measure but differs from actual cash flow or yearly revenue.

"And a lot of that is taking the profit of the EBITDA at the end of the year, which is earnings before interest, tax amortization. And depreciation, and extrapolating that on a multiple."

The quote discusses how business valuation is calculated using EBITDA and a profit multiple. This method is a standard approach to estimating what a business might sell for in the market.

• Yearly revenue is a closer reflection of a business's actual financial performance.
• It is the total cash collected within a year, not just projected or expected income.
• This metric is more grounded in reality compared to business valuation, as most businesses do not sell.

"But yearly revenue, how much cash is being collected on a yearly basis in the business?"

This quote emphasizes the importance of yearly revenue as a measure of the tangible cash that a business collects over a year, distinguishing it from mere projections or valuations.

• Yearly profit is the actual excess cash at the end of the year, which may or may not be equivalent to EBITDA.
• It is crucial for understanding the financial health of a business.
• Yearly profit does not account for reinvestments made back into the business.
• Reinvesting profits can be a strategy for entrepreneurs to grow wealth if returns on capital are high.

"So it's yearly profit. That's how much in excess or eBItda, right. At the end of the year."

The quote clarifies that yearly profit, or EBITDA, is the remaining cash after expenses, not including reinvestments. This metric is vital for gauging a business's profitability and potential for growth through reinvestment.

• Contract value is often seen as a misleading measure of a business's worth.
• It only holds value if the business has enforceable contracts with negative churn or increasing value over time.
• Most businesses do not have such contracts, making the contract value unreliable and inflated for ego purposes.

"The only time this matters, the only time this would be of any value whatsoever, is if you have a type of contract that's 100% enforceable and you have negative churn or these contracts only go up in value."

This quote explains that contract value is only significant if the contracts are legally enforceable and have terms that ensure they either remain the same or increase in value, which is rarely the case for most businesses.

• Revenue and lifetime revenue are often used for boasting rather than accurately measuring a business's value.
• These metrics are less reliable for business valuation and can be considered the second worst way to measure value after contract value.
• They can be used to create impressive headlines but do not reflect the true financial health or profitability of a business.

"I would say the second worst way of measuring value is revenue. Is lifetime revenue."

This quote emphasizes that while revenue may sound impressive, it is not a strong indicator of a business's actual value and should be viewed with skepticism when used as a measure of success.

• Business valuation is a more reasonable measure if it's conducted fairly and objectively.
• Valuations can be inflated by subjective feelings or market hype rather than grounded in financial reality.
• The multiplier used in valuation varies by the size and type of business, with small businesses having lower multipliers and publicly traded companies often having much higher ones due to market liquidity.

"Business valuation, if done properly, is an excellent measure of a business, but it has to be done fairly."

This quote suggests that a proper business valuation, when done without bias and with accurate methods, can be a reliable indicator of a business's value.

• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is used to measure a company's operating performance.
• A fair business valuation often considers a multiple of EBITDA, reflecting a reasonable return on investment.
• The concept of return on capital is crucial for understanding valuations and investment decisions, where the value is related to the expected percentage return.

"If I'm going to buy a company that's doing a million dollars a year in profit, well, if I say that the company is worth $10 million, if I put $10 million in, then I'm getting a 10% return on the money, right?"

This quote explains the relationship between the purchase price of a business, its profit, and the resulting return on investment, which is a key consideration in valuations.

• Owner earnings refer to the actual cash that can be extracted by the owners from the business's profits.
• This metric is considered valuable because it reflects the real financial benefit to the business owner, as opposed to profits that are reinvested or spent on necessary expenses like machinery.
• Warren Buffett famously prefers net free cash flow over other metrics for evaluating a business's performance.

"Because that, to me, is the value of the business if I want to reallocate the capital in other places."

This quote conveys the importance of owner earnings, as it represents the money available to the owner for reinvestment or personal use, which can be a true measure of a business's value.

• Net worth is often conflated with other financial metrics but is distinct in its meaning.
• It represents the total value of an individual's or business's assets minus liabilities.
• Entrepreneurs often merge their personal identity with their business, leading to confusion between personal net worth and business financial metrics.

"But when you see YouTube videos and you see thumbnails and you see people describe their business, or as they describe themselves, which most entrepreneurs have merged their identities with their business, which I'd encourage you not to do for other reasons psychologically."

This quote highlights the tendency of entrepreneurs to equate their personal net worth with their business's value, which can be misleading and psychologically unhealthy.

• Yearly revenue is a top line measure indicating the amount of cash collected over a period of time.
• It provides insight into the current volume of business someone is doing.
• Yearly revenue should be reported alongside profit to give a complete picture of a business's financial health.

The fourth way is yearly revenue. The nice thing about this is that I think this is a top line measure. This is a measure of how much revenue or cash is being collected. This is how I'm defining it over a period of time.

This quote explains that yearly revenue is a fundamental financial metric that reflects the total cash inflow of a business over a specific timeframe.

• Profit alone can be misleading without context; it's important to report it alongside revenue.
• A high profit with substantial yearly revenue indicates a different scale of business compared to the same profit with lower revenue.
• Reinvesting profit into the business for growth can affect the perception of profitability.

Because let's say someone's saying, I'm doing $500,000 in profit, you might be like, oh, it's a small business. But if he says, well, we're growing and we're doing 100 million a year, and we just continue to plow all the profit into the business, and that's because we have lots of founders and we want to grow this as an asset because we think you're getting superior returns on capital. Then in that case, then you're like, oh, it paints a very different picture, saying we're doing 100 million and we're, quote, profiting 500,000.

This quote emphasizes the importance of understanding the context in which profit is presented, particularly in relation to revenue and business growth strategies.

• Knowledge of various financial terms is crucial for accurately assessing a business's value.
• It's important to clarify which specific financial metric is being referred to in discussions.
• Financial literacy develops over time and is key for entrepreneurs and investors.

But the entire point of this video, and I'm going to get to the last two in a second, is that you should understand what each of these are, so that when someone says a number, you can push back and say, well, what are you talking about specifically?

This quote underscores the importance of being financially literate to understand and question financial figures accurately.

• Net free cash flow indicates the actual money made by the business after covering operational costs and maintaining competitive advantage.
• It's a metric valued by investors like Warren Buffett for assessing the profitability of a business.
• A business's ability to generate consistent net free cash flow is a sign of a strong investment.

Net free cash flow, all right? So this is near and dear to my heart, because Uncle Warren Buffett, this is what he uses. It was good enough for him. It's good enough for me.

This quote highlights net free cash flow as a preferred financial metric for evaluating a business's performance and potential for return on investment.

• Net worth is a measure of value after accounting for taxes, depreciation, and other factors.
• Business valuation is linked to net worth, particularly for entrepreneurs and founders.
• Net worth consists of investable net worth and the value of business ownership.
• It's important not to equate self-worth with net worth to maintain a balanced perspective.

And so a person's net worth is going to be a percentage of the businesses that they own. Now, if you give a fair valuation to business, right, there's kind of two aspects to net worth. There's their investable net worth, which is how much do they have outside that they can put into investing into things, and then how much do they have in their core business?

This quote explains that net worth is a comprehensive measure of an individual's financial value, including both their investable assets and their stake in businesses.

• The podcast grows through word of mouth, as there are no ads, sponsorships, or sales involved.
• Listeners are encouraged to share the podcast in the same way they discovered it, to support the community and spread knowledge.

The only way this grows is through word of mouth. And so I don't run ads. I don't do sponsorships. I don't sell anything. My only ask is that you continue to pay it forward to whoever showed you or however you found out about this podcast, that you do the exact same thing.

This quote is a call to action for listeners to promote the podcast organically, emphasizing the role of community support in the growth of the platform.

• Deceptive financial advice can mislead people into thinking they are performing better financially than they actually are.
• The worst person to deceive is oneself, which often happens when people misinterpret financial numbers.
• Speaker A emphasizes the importance of transparency within companies regarding financials.

"And so that is why these things can be somewhat deceptive and make people think that they are doing better than they are."

This quote highlights the danger of misleading financial advice and the ease with which individuals can deceive themselves.

• Speaker A believes in openness about company finances and practices transparency by sharing financial details with everyone in the company.
• The rationale behind this practice is to show employees the real financial state of the company, including risks and downturns.

"Everyone in my companies knows what we make, and I choose to run our companies that way because I don't like to hide things."

Speaker A explains their policy of financial transparency within their companies, which is not a common practice in all businesses.

• Speaker A measures personal financial success by net worth rather than revenue, yearly profit, or contract value.
• Net worth is the remaining value after all obligations are met, and it is considered the true indicator of wealth accumulation.
• Investing smartly and for the long term can lead to tax-free wealth growth due to the tax system's incentives.

"I look at net worth, and net worth is what is left after everything is done at the end of the day, because this is the thing that you are trying to build."

The quote explains that net worth is the ultimate measure of financial success for individuals, according to Speaker A.

• The tax system is not just a penalty system; it's also designed to incentivize behaviors that benefit the economy.
• Long-term investments that contribute to the economy's infrastructure are often not taxed, encouraging wealth growth without tax liability.

"The tax system is a penalty system, but it also means that if you're not being penalized or you get write offs or you get ways of getting tax free, it means that those are things that are going to benefit everyone."

Speaker A describes how the tax system is structured to reward certain economic behaviors that are considered beneficial to the broader economy.

• Business valuation for mid-market companies, which earn $10 to $100 million a year in revenue, is typically six to eight times the EBITDA.
• This multiple provides a fair valuation for most businesses in that revenue range.

"Times six to eight, if you're mid market, mid market being ten to $100 million a year in revenue, then that is a fair valuation for most people."

Speaker A provides a standard for evaluating the worth of mid-market companies based on a multiple of their EBITDA.

• Achievements like sales awards can be misleading and make businesses appear more successful than they may be.
• Speaker A warns against placing too much value on such recognitions without understanding the underlying financials.

"But what I'm trying to warn you against is don't read too much into this stuff."

The quote advises caution when interpreting business achievements and the importance of understanding the real financial situation.

• When assessing the value of a business or entrepreneur, consider their yearly performance, EBITDA, and net free cash flow.
• Most businesses that are valued highly are not like Silicon Valley unicorns but are more traditional, such as dry cleaning shops or digital marketing agencies.

"Try and put the pieces together so you can ascribe your own value to both the entrepreneur's contribution to society and also the value of the business itself."

Speaker A encourages critical thinking when evaluating the true value of a business or entrepreneur, beyond surface-level numbers.

• Speaker A's businesses do not require large capital investments to maintain a competitive edge.
• Speaker A prefers businesses that allow significant personal income through EBITDA without the need for reinvestment.
• The strategy has resulted in substantial owner earnings for Speaker A.

"But I almost take 100% of my EBITDA as personal income."

This quote reveals Speaker A's approach to business, where they prioritize businesses that generate high EBITDA without necessitating significant reinvestment.

• Speaker A emphasizes the importance of not being tricked by inflated numbers and instead focusing on net worth growth in a tax-free environment.
• They remind viewers to take a critical approach when measuring value and to stay tuned for future updates.

"Don't be tricked. Look at these numbers. And at the end of the day, the chop of all chops is how much is the net worth of the shareholders and the owners of the company growing in a tax free environment."

Speaker A concludes with a final piece of advice on how to measure true financial success, highlighting the importance of net worth growth.