To the accountants who read my blog, this post won’t tell you anything new, except possibly the details of muddled-thinking that the rest of us bring to corporate valuation. If you spot anything egregiously incorrect, please do say.
3 times when we want to know if a company is makes money or not
For the rest of us, let’s begin with the basics of valuing a business. There are three times when we want to know if a company is healthy or not.
- When we are thinking about investing in a company by buying stocks & shares on the stock exchange, or lending money to somebody running a small business.
- When we are thinking of joining a company
- As an employee
- As a supplier who will sell the company something
- as a buyer who depends on goods & services being delivered on time and the warranties and other long term commitments being met.
- When as general citizens we trying to understand what is happening in the economy and how to position ourselves for growth, decline or stagnation.
The key step to judging whether a business makes money
The first step is to “think company”. Accountants do this all the time. Their job is to worry whether the company is a “going concern”. Will the company still be there tomorrow?
Corporate financiers ask a slightly different but related question. If I put $1 into the company, will I get back 10c a year, or 20c, or nothing, and moreover find that when I sell my share I get back 85c not $1?
Can lay people really judge the value of a company?
We might ask whether it is so easy to do this. After all, look at all the people who mistook sick banks for healthy banks.
One thing is for sure, though, if we don’t start paying attention, we will get bitten again. We as employees, suppliers, buyers and citizens will pay the price of not paying attention.
4 basics for understanding whether a business makes money or not
Yesterday, I came across an article valuing companies in the shipping industry. I am not particularly interested in shipping but the article was well structured and it provided a checklist that we can use as a starting point for understanding any business.
#1 How does organization or company finance itself?
- Does the company finance itself by borrowing money from a bank or from other lenders of money? That is, with debt.
- Does the company finance itself with money from investors who will put money into the company for a share of the profit and if it comes to that, be prepared to lose their money? That is, with equity.
- Does the company finance its new ventures out of profits they are making? That is, from revenue.
The answer will tell you a little about the pressures on the company. Who are they answerable too? And what for?
#2 What kind of contracts does the organization or company finance itself?
- Does the company have any long term agreements with customers or do they come and go?
- What are the advantages & disadvantages of the ways they have chosen to structure their relationship with their customers?
#3 What dividends does the company or organization pay?
This question about dividends looks as it is for investors who buy stocks & shares. And so it is. If I buy a share for $1, how many cents can I expect back in each 6 monthly dividend?
We can also ask the question more broadly. Where does the money go in the business?
Have a look at the director’s offices & vehicles? Check out their bonuses. Company’s like to flash money around in a rather school boy manner and it is a bad sign not a good sign. Flash means money is being used to show off and not being used to run the business.
An agricultural economist once said that he could see on arrival at a farm whether or not it was viable. If they had more vehicles than drivers, then they were in trouble because their money wasn’t being used well.
So look around and followed the money. Use some common sense. Sound business people don’t skimp on the necessities, and they don’t allow money to sit around unproductively either.
If they must have to have ‘flash’ assets to impress people in the business they are in, are they really flash, or are they copies, and do they look after their assets. Do they protect their re-sale value?
If they give high bonuses, do they look after their staff, or do they exhaust their staff and then wastefully buy more expensive ones from the market.
It can be tough to separate the appearance of money with sound business. When money is being chucked about, quite naturally we would like to get our hands on some of it. Just stop to do a proper evaluation. How long is this money-wasting going to last? And when it goes bang, will you be sucked down with it?
#4 What are their assets?
In a shipping company, this is easy. Which ships de they own? In a mining company, we can ask what mines do they own?
In some businesses, they organization owns very little. Is it the John Lewis Shops who deliberately don’t own the buildings they use? Holiday Inn and Coca-Cola are the same? They own some of their hotels and some of their bottling plants but they generally stay out property business.
Universities are the opposite. Their wealth is usually in their real estate and you can see immediately the problem. The need to protect their real estate value might become more important than anything else.
With banks in recent times, and indeed now, we have to ask what exactly do they own. This is the ‘mark to market’ debate. The value of their assets is volatile.
But let’s keep it simple for now and ask, what exactly does this company own and how do the assets impact on the business?
Will your career make money?
Now if you see you career as a business, will your career make you money? Would it be better to start a business. Let’s compare two scenarios.
Let’s take a young person who leaves university and goes to work. The 4 questions apply equally to them.
- They support themselves through revenue and are paying off the debt of their student loan.
- They have committed themselves to one customer to whom they are wholly dependent.
- Their income is their salary and their profit is their salary less their debt repayment, their taxes, insurance, and the expenses of going to work (which in the UK can hit 10000 before tax)
- Their assets are their qualification which is declining in value by the minute as knowledge replaces itself.
They have one more intangible item which is “career capital”. But I’ll leave that to another post.
Now let’s take a young person who leaves university and starts their own business (or who prepares to while they are taking some starter jobs to get some experience).
- They support themselves through revenue and are paying off the debt of their student loan. They could look for venture capital and share their profits with a financier or they could work with friends and share their future profits as partners. They can also borrow more money from family and friends. Those are their basic choices.
- They will be thinking through who their customers are. In their early stages they probably go to one of two extremes. They have lots of small customers on B2C model or they desperately look for one large customer who acts like an employer. They have many choices though. Will their customers be consumers or businesses? What kinds of contract go with the services they offer? How can they encourage repeat business & loyalty? What mix of customers do they want? For many people, solving this puzzle is the key to future autonomy and freedom for dependence on “rats & mice” business at the one extreme and dependence on an employer at the other.
- The income of the young person is now salary & revenue from the business, less student loan, less taxes, insurance and going to work & of course, expenses of running the business. Other choices the young person needs to make are whether to spend their free money on travel, on property or investing in the business. It is very likely that someone climbing the corporate ladder looks fairly flush. They are travelling to and from work (at 10 000 per year), they are buying expensive clothes for another 1000 or so, and they are probably buying a good house. A large salary helps get consumer credit and living will look good. Look twice though. What is their eventual wealth going to look like> And what will happen if their one and only customer lets them down? And what is the probability of their own an only customer, their employer, letting them down?
- Their assets remain their qualification and their ability to keep it up-to-date. What else do they have? What exactly are they working on that has value over and above their own skill and know how? You can see I am in services because this section is thin. Maybe somebody else can flesh this section out.
4 questions to manage your career and your business
So there you are. Here are your choices.
- How do you intend to finance your company? Debt, investments or revenue.
- What kind of contracts with customers match your style of business (and why)?
- What do you intend to spend your proceeds on? Consumption or building your base further?
- What assets are you developing that you could sell or convert into regular revenue?
That’s not hard, is it? Now why didn’t we understand the banks were in trouble? Because we confuse consumption with wealth. Consumption is the opposite of wealth. Look twice when someone is living large. Something is wrong. At best, they don’t know of any way to make their money work for them.