A deep dive into value creation in business
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A DEEP DIVE INTO VALUE CREATION IN BUSINESS
Enterprise value is a term used in the markets, but that formula is not what we’re talking about here.
Ultimately, business comes down to this. Is your business creating value, thus making you more money?
So, how is Enterprise Value created?
To understand this, you have to understand the basis of Financial Statements.
Let’s break it down.
Profit is the bottom line of the Income Statement. The Income Statement takes Revenue - Expense and turns this into a dollar value that reflects the value created by the set of transactions during that period of time.
If you think about it in terms of one unit of product, it’s pretty easy to understand.
You buy Widget A for $40. You sell it for $80. You had $10 of selling cost (say a listing fee).
That means you spent $50 and got $80 in return, which would reflect in a $30 profit.
In the broader economy, you’ve created $30 of value that wasn’t there before.
This profit dollar then goes to the Balance Sheet as Retained Earnings.
Increased Retained Earnings results in a higher Stockholder Equity, thus Enterprise Value.
Now, you have to actually collect that $80, which is where come to the next variable: cash.
So, you’ve billed the customer $80, but yet to be paid. You’re “out” $50 in the cost of the product + the listing fee.
Until you collect the $80, your cash flow a NEGATIVE $50. Once you collect the cash, you’re a POSITIVE $30 overall.
So, as you can see, collecting cash is extremely important.
As you move forward, you want to see your collection of cash exceed your distributions of cash.
You can only distribute cash that you have. That cash can be collected from:
- Owner’s contributions
Often, when a company starts, you see the owner put in money to pay for the initial expenses. But, unless the owner has no intention of making profit (which is rare), the company eventually needs to generate profits on their own, which should bring in cash.
When there is fast growth or asset cost is high, financing may be needed to allow for cash flow to come in.
When you distribute asset cost over 5 years, you’ve now taken something that would have cost in month 1 to splitting that cost over 60 months.
That allows cash flow to be positive, thus support continued operations.
Increased Asset Value
This is done all the time in real estate. Properties with negative cash flow can be purchased because of an assumption of a greater asset value in the future.
When you do the analysis, you can lose cash on a month basis but get a return on asset that’s reasonable.
Now, this is definitely risky. But, with the right team, some have had success with this.
Decreased Liability Value
As you pay down debts, you create value (assuming the value of the asset is not decreasing at the same rate).
If you’ve heard about “underwater” cars, this is exactly what’s happening. Often, the value of the loan is larger than the actual value of the asset. This can make it difficult to sell the asset unless the seller can cover the difference.
But back to the original point: when you pay down liabilities and asset values are staying stable, or increasing, paying down the liabilities increases your enterprise value.
When taking out debt, this is the assumption most often being made: that over time, the value created + the disposal value of the asset is greater than the cost of the loan.
How do we measure it?
Now that we understand how value is created, think about your situation and ask: which levers can I pull?
Some good formulas to measure the valuation creation are:
- Return on Assets = Net Income / Total Assets
- Return on Equity = Net Income / Shareholder’s Equity
- Return on Invested Capital = Operating Income after Taxes / Invested Capital
- Return on Capital Employed = Earnings before Interest & Tax (EBIT) / (Total Assets – Current Liabilities)
- Company Valuation
This list is not all-inclusive, either. But, it’s a good start.
What you’re trying to capture with Enterprise Value is: is the company that I own going up in value?
Reflecting back on the other 2 legs of this framework (profit & cash flow), when those two go up, the 3rd should as well.
We want to see all 3 legs moving together. When they’re not moving together, you need to dig in to find out why.
I hope that this last 3 weeks has laid the foundation for better understanding of your numbers.
But, this is just the start. Ultimately, each business shouldn’t be viewed on it’s own. It should be viewed in the larger scope of the whole economy, or investment opportunities available to you. When you choose one, you can’t take advantage of other opportunities. That is known as opportunity cost.
So, we need to measure value creation more broadly and “think like an investor.”
So, when thinking about enterprise value, we want to take into account these items:
- Return on investment
- Time requirement
Next week, we’ll dig into the concept of opportunity cost and how you should incorporate it into your decision-making.
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