2. Value a Small Business like Warren Buffett Video Lecture | Become an Expert: Value Investing - Business Basics

okay welcome to course 1 unit 1 lesson 2
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 for
business we're going to look at a
comparison of a small business to a
large business and then we're going to
do really basic valuation techniques for
a small business
okay 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 as you get more
into the advanced lessons you might have
a hundred thousand owners as you start
dealing with stocks and really large
corporations regardless of how many
owners there are you need to always
remember that owners own 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've 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 countable she doesn't actually
like to work at her business she doesn't
want anything to do with her 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's gonna get at
the end of the year is a check on how
much her business made so her employees
are gonna 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 steam
point 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 okay so that's the second
part so you first have to have an owner
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 could be talking about
General Electric those three pieces are
always in the model so now that we've
got the model established the owner the
customer the business let's look at how
money flows through Nancy's business
okay so this is just in one hour and
mind you I have never owned an ice cream
stand so I really have no idea what it
generates and how much it costs to run
one bit I'm just going to throw out
these generic figures as we go through
this so the flow of the money in one
hour of Nancy's ice cream stand so we
start off at the beginning and we look
at the customer ok the customers go to
the business and they spend $100 in one
hour 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 and we're not even talking about
any of the costs that Nancy had or the
employees that are working for Nancy had
while they were running ice creams now
as you take that hundred dollars you
walk across now we step inside the
business and we see where that hundred
dollars goes okay so 20 dollars of that
hundred dollars in that hour time frame
went to her one employee no we're just
using one employee to keep things simple
and that one employee manages everything
from scooping the ice cream to starting
it to keeping track of the books and
everything she's Nancy's paying her $20
an hour we had $20 goes straight out of
the hundred right off the top then we
got the cost this and these are all cost
of revenue off each one of these about
mentioning
the next one is the material cost so it
costs money to make the ice cream to
have the milk to do whatever it takes
the bowls the spoons that they're gonna
have to hand out all that cost money so
we're just going to say that that was
$40 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 it paid off but that
cost her that hour if we you know
divided it all out would be let's just
say $10 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 okay so we had the revenue which
was a hundred but the cost to get that
revenue was seventy dollars combined
when we took the hundred and we
subtracted the seventy we were left with
$30 so that's the income before the
taxes Nancy's business made $30 in
income before taxes so let's just assume
that we take $10 out of the taxes and
that leaves us with $20 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 and in stock that
net income when you divide it down into
a one share is called the earnings so
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 earrings you're talking for one
chair 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 leftover on the tray sitting
right there for you as an owner so
that's the owners money and when you owe
to share when you own one share of a
business those earnings that is your
money
never forget that okay so the $20 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 $20 so Nancy in this
situation you can see I have two
Aeros there one pointing towards Nancy
and one pointing towards her business
she can take that $20 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 could invest in a lemonade
squeezer or a you know a new ice-cream
machine that's going to produce more
income and she could do this too she
could take ten dollars for herself and
just pay herself and she could take $10
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 there's 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 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 okay
so we understand that model that model
makes sense for pretty much anybody as
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 and
a large business so as you look on the
left there's that small business that we
just talked about and 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 as 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 ten shares
of GE okay you your voice as an owner is
represented by that board of directors
those people sitting there in those
chairs they're you know huge
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 own let's say you disown ten
shares you have a voice and you have a
putting power with those shares and that
voting power is delegated to one of
those Board of Directors okay 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 is call this business
GE General Electric okay and those are
what is assumed 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 all this B 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 but that CEO is an
employee and that CEO works for the
board of directors and all them
shareholders and then your customer
doesn't change customers still you know
buying up the product okay 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 we look that first
scenario and Warren Buffett says that
the company's worth $40 but it's 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 of 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 changed 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 $100 coming in for the total
revenue now it's $100,000 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 thousand that's your cost of the
revenue which leaves you thirty thousand
dollars before the income tax you take
ten thousand out for the taxes which
leaves Nancy twenty thousand dollars in
net income or earnings for a year
what's that worth if Nancy was going to
try to sell this ice cream stand what is
it worth
and that's 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 it your employee is going to take
care of everything you're just going to
make the twenty thousand it's a
hypothetical question but think about
that
okay now that you've thought about that
question and you pause the screen you
thought about let's look at some
different values here we know that the
net income or the earning is twenty
thousand dollars Nancy doesn't have to
do anything she's just going to 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 going to 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 an ice-cream
stand 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 okay because
she's going to get twenty thousand
dollars at the end of one year and she
paid $400,000 for it 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'd make your twenty thousand dollars
because that number doesn't change it's
that's the net income that's what that
business makes in a year that investment
that that purchase price would yield ten
percent on your money okay 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 okay that
business stayed exactly the same it was
making twenty thousand dollars 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
okay the business didn't change it's
exactly the same it's producing the
twenty thousand dollars but as you went
through different purchase prices as you
paid more for that business your return
went down drastically as you as those
price points change 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 significant
wait 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 and so much detail as he's
figuring out what these companies are
worth because he knows that if he ever
pays for it his yield will go down 10%
15% 20% 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 2 and I look forward to seeing
you guys in lesson 3