The Metric Warren Buffet Cares Most About and How To Use it to Take Home More Cash Ep 292

In a detailed discussion about entrepreneurial finance, the speaker, identified as Speaker A, emphasizes the importance of net free cash flow for business owners, a concept endorsed by Warren Buffett. Speaker A shares personal experiences, including the pitfalls of reinvesting profits back into the business without taking out cash, and the harsh reality that most businesses never achieve a lucrative exit. By focusing on net free cash flow, entrepreneurs can ensure they're rewarding themselves for their risks and growing their businesses sustainably. Speaker A also touches upon the significance of PE ratio and return on capital, as described in the book "The Little Book that Beats the Market," and advises entrepreneurs to regularly extract profits to mitigate operational risk and increase personal wealth.

• Understanding the right metrics is crucial for business success.
• Net free cash flow is highlighted as a primary metric to track.
• Warren Buffett is mentioned as an advocate for focusing on net free cash flow.

"So the number one metric that I track for our businesses is this one. And you may not even heard this one, but I think it is the most important. And Warren Buffett agrees with me."

This quote emphasizes the importance of net free cash flow as a metric, suggesting it is often overlooked despite its significance, as endorsed by Warren Buffett.

• Net free cash flow is the money an owner can take out of the business after reinvestment for competitive advantage.
• It's a measure of financial health and profitability.
• The concept is applicable to various types of businesses.

"But what net free cash flow is, is the amount of money that an owner of a business can take out of the business after the business reinvests in staying ahead of the competition and maintaining its competitive advantage."

This quote defines net free cash flow and explains its relevance to maintaining a business's market position.

• Many businesses do not make a profit, which is a fundamental issue.
• Some profitable businesses reinvest all profits back, which can hinder personal financial growth.
• The speaker shares personal entrepreneurial experiences to illustrate these points.

"And so the problem with the vast majority of businesses and or business owners is that what they do is at some level, I mean, the first problem is that many of them don't make any profit, right?"

This quote addresses a common pitfall where businesses fail to generate profits, which is a critical first step in financial success.

• Speaker A shares the experience of being "asset rich and cash poor" from starting gyms and an online fitness coaching business.
• The expansion of business locations led to financial strain.
• Selling the businesses resulted in minimal profit due to the nature of the sales.

"Whenever I would make money from my gym, I would open up another location, which sucked, right? I mean, it sounds great, but I was asset rich and cash poor."

The speaker reflects on the challenges faced when expanding business without sufficient cash flow, leading to financial difficulties despite owning valuable assets.

• Speaker A experienced financial loss after selling gym businesses and entering a failed partnership.
• Despite generating millions in revenue, the speaker ended up with no savings.
• This experience led to a resolution to avoid similar mistakes in the future.

"And at that moment, I promised myself, I'm never making the mist mistake again. Because what ended up happening is that after all those years and all that time and the money that I had made, all of it was gone."

The quote conveys a moment of realization for the speaker, where past financial mistakes became a lesson for future business endeavors.

• The majority of businesses never get sold.
• Even when businesses are sold, the financial outcome may not be as lucrative as expected.
• Entrepreneurs often have unrealistic expectations of a large exit from their business.

"99% of businesses don't get sold, ever. Right? And so this idea that we're going to have this mythical exit someday for most businesses isn't true."

This quote highlights the misconception among entrepreneurs regarding the likelihood of selling their business for a significant profit.

• Speaker A sold six business locations but did not make life-changing money.
• The total profit from the sale was not substantial when distributed over the years of operation.
• This serves as an example of the potential overestimation of business exit outcomes.

"I technically exited those businesses, but I wasn't set for life. You know what I mean? I think it was multiple. It was like 200 grand, 300. It wasn't a lot of money that I made from those."

Speaker A reflects on their own business exit, emphasizing that the financial gain was not as significant as one might expect from selling a business.

• Entrepreneurs often fail to focus on generating net free cash flow from their businesses.
• There is a tendency to prioritize growth over profitability, which can lead to increased risk and inefficiency.
• Net free cash flow is crucial for rewarding the entrepreneur for the risks taken.

"And so this is a mistake that I see a lot of entrepreneurs make, is that they're not focused on this net free cash flow, right."

Speaker A points out a common mistake among entrepreneurs, which is not prioritizing the generation of net free cash flow in their business strategy.

• Entrepreneurs sometimes pursue rapid growth without a clear reason, leading to irresponsible and wasteful expansion.
• Balancing growth with the ability to generate profits is essential for sustainable business development.
• Speaker A emphasizes the importance of net free cash flow as a measure of being paid to grow the business.

"But we end up just growing irresponsibly, and then in so doing, do it wastefully and expose ourselves to higher risk and more mistakes, and in the process, also lose the one thing that we get along the way if you do it the right way, which is net free cash flow."

This quote discusses the pitfalls of prioritizing growth over profitability, which can result in increased risk and loss of net free cash flow.

• Taking on business risk should be compensated by rewarding oneself.
• Speaker A uses a personal anecdote to illustrate the concept of risk and reward to employees.
• It's important for entrepreneurs to recognize and compensate themselves for the risks they take in running a business.

"And so that's the thing, is we take on so much risk, and you start to get used to the risk because you've just been doing it for such a long time, but you have to reward yourself for the risk that you are taking."

Speaker A emphasizes the necessity of rewarding oneself for the risks involved in entrepreneurship, drawing from their own experiences.

• Net free cash flow indicates the company's profitability beyond the costs of operation and growth.
• Speaker A prioritizes this metric for financial reporting within their entities.
• The concept is aligned with the investment philosophy of Warren Buffett and Charlie Munger, who favor businesses that generate owner earnings without requiring constant reinvestment.

"Now, the reason that I like net free cash flow is that it focuses the entire company on not just making a profit, but making a profit in excess of what is required to continue to run and grow the business."

Speaker A explains why net free cash flow is their preferred financial metric, as it measures profitability beyond basic operational needs.

• Warren Buffett and Charlie Munger prefer companies that do not require reinvestment of all profits back into the business.
• They dislike businesses with high capital expenses, as these can impede the generation of net free cash flow.
• Speaker A aligns with this investment philosophy and tracks net free cash flow as a critical indicator.

"This is what Warren Buffett and Charlie Munger calculate with the companies that they want to buy, because they're like, we hate companies where we buy them, and then we take all the profit and have to reinvest all that money back into the same business, right?"

The quote outlines the investment strategy of Buffett and Munger, which involves seeking companies that can generate profits without constant reinvestment, highlighting the importance of net free cash flow.

• Speaker A recommends a book titled "The Little Book that Beats the Market" for further understanding of investment and business growth strategies.

"And if you are interested at all, I was reading a book recently called the Little Book that beats the market."

By suggesting this book, Speaker A provides a resource for listeners to explore the concepts discussed, particularly regarding profitable investment and business strategies.

• The PE (price to earnings) ratio is a critical metric for evaluating the value of a business.
• Warren Buffett's strategy of buying good businesses for cheap prices is linked to the PE ratio.
• The PE ratio helps investors determine if the business is priced fairly based on its earnings.
• Companies with low PE ratios are considered cheaper and potentially more attractive investments.

"The first is the PE ratio, which is the price to earnings ratio." "So the figuring out whether it's a cheap price is going to be the price to earnings ratio."

These quotes emphasize the significance of the PE ratio as a tool for assessing whether a stock is priced attractively relative to its earnings. It is a fundamental concept in value investing, advocated by Warren Buffett.

• The podcast offers a video version on YouTube with enhanced features like effects, visuals, and graphs.
• The video content is designed to cater to different learning preferences and may aid comprehension.

"If you ever want to have the video version of this, which usually has more effects, more visuals, more graphs, drawn out stuff, sometimes it can help hit the brain centers in different ways."

This quote highlights the availability and potential benefits of accessing the podcast's content in video format, which might provide a more engaging and visually stimulating learning experience.

• Return on capital is the second key metric for achieving above-average returns.
• It measures how efficiently a company can generate profits from its investments.
• High return on capital indicates a company's ability to turn a small amount of money into significant cash flow.
• Comparing return on capital between companies can reveal which ones are better at reinvesting their profits.

"Now, the second thing is return on capital." "That's a 10% return on capital, right? That's what that means."

These quotes define return on capital and provide a simple example to illustrate the concept. A 10% return on capital means that for every dollar invested, the company earns an additional ten cents in profit.

• Combining low PE ratios with high return on capital can lead to consistently beating the market.
• An algorithm using these two metrics outperformed the S&P 500 over 25 years.
• Companies fitting these criteria often face issues, leading to mispricing.
• Investors can capitalize on mispriced bets, where some companies may fail, but others are undervalued and will outperform in the future.

"By combining these two things, finding the companies that have the lowest PE ratio with the highest return on capital, you can consistently beat the market."

This quote conveys the strategy of using both PE ratio and return on capital to identify undervalued companies that have the potential to offer superior returns, which has been historically successful according to the book mentioned.

• For business owners, net free cash flow is a fundamental concern.
• It represents the actual profit available for withdrawal at the end of each period.
• Businesses must consider the potential for unforeseen events that could impact their operations.

"As business owners, net free cash flow is my home base. This is what I care about."

This quote underscores the importance of net free cash flow to business owners as a measure of the real, tangible earnings they can take from their business. It is a crucial metric for financial stability and planning.

• Operational risk is often underestimated but affects all businesses.
• Entrepreneurs commonly hope to sell their business but face high odds against success.
• Regularly extracting profits from the business is advised for financial enjoyment and reduced stress.

"And so what we are all exposed to that we discount on a regular basis is something called operational risk."

This quote emphasizes the common oversight of operational risk by business owners and its universal impact.

"You have a 99 to one chance of not actually succeeding doing that."

Here, the speaker highlights the low probability of successfully selling a business, which underscores the importance of taking profits regularly.

• Monitoring net free cash flow is critical for understanding business performance.
• Leaving profits in the business account can obscure the true financial state.
• Depositing money into a personal account provides a tangible sense of business performance compared to the previous month.

"But you should be able to deposit money in your account this month and be like, this was better than last month or this was worse than last month, and you got to feel that not just the numbers, but literally what you put into your account."

The speaker is advising that personal profit-taking allows for a more intuitive understanding of business performance.

• Establishing a non-negotiable profit line in the business account ensures consistent profit-taking.
• Setting a clear threshold for profit extraction holds the business owner accountable.
• This strategy involves clearing the business account down to a predetermined level each month.

"Everything over this we take out every month, all right? So everything over 100 grand, everything over 500 grand, we're going to take out of the business every single month."

This quote describes the process of setting a specific benchmark for when to take profits out of the business.

• Tracking net free cash flow is a key financial metric used by successful investors like Charlie Munger and Warren Buffett.
• This metric provides clarity for the business owner and their team.

"If you're not measuring net free cash flow, you absolutely should, because you're losing out on one of the most important tricks."

The speaker stresses the importance of measuring net free cash flow as a critical aspect of financial management.

• Ensure that reinvested capital yields the highest possible return.
• Comparing potential returns from business reinvestment to standard market returns, like the S&P 500, can be a useful benchmark.

"If you're thinking about reinvesting in the business, make sure that the dollars that you're choosing to reinvest, you're getting the best return on capital you possibly can."

This quote advises on the careful consideration of return on investment when reinvesting in the business.

• Wealth can be generated through consistent investment in the stock market, not just from business profits or a future sale.
• Diversifying wealth generation strategies can be beneficial and lead to significant wealth accumulation.

"If you make a million bucks a year, you make 500,000 a year, and you just put it in the S&P every single year, you're going to be really, really wealthy, right?"

The speaker suggests that investing profits in the stock market can be a reliable path to wealth, separate from business earnings.

• The speaker concludes with a call to action for tracking net free cash flow.
• Emphasizes the importance of stacking the right account, which is the personal bank account, not just the business account.

"Net free cash flow. Track it, stack it, and make sure that you empty your bank account every single month. And stack the right account, which is your personal bank account."

The final quote reinforces the message of monitoring cash flow and prioritizing personal financial growth through profit-taking.