Businesses Valuation and Why Most Librarians Aren’t Rich
A guy goes to a mathematician and asks him how much is 2 plus 2. The mathematician explains that there are so many different mathematical systems, that he can’t possibly answer that question without lecturing for at least an hour about the philosophical underpinnings of mathematics.
The guy next goes to an accountant to ask how much 2 + 2 equals. The accountant takes out his spreadsheet does the calculation, and informs him that using generally accepted accounting principles, 2 + 2 equals exactly 4.
Next stop is a lawyer’s office. The guy asks the lawyer the same question — how much is 2 plus 2. The lawyer looks around for a bit, pulls down the window shades and closes the door. Then he asks in a whispered tone: “How much do you want it to be?”
While this is a story created to make fun of lawyers (I’m a lawyer, but always appreciated lawyer jokes), there’s a basic truth about valuing businesses embedded in the story. There are literally hundreds of ways to value a business but there is no right way. Ultimately the marketplace will value a company.
I’ll spend some time in future newsletters considering some of the more popular valuation approaches. In this newsletter though, I’m going to try to gently suggest a slightly different mindset than is often used among small business buyers and sellers.
Armed with three years or five years worth of financial statements, the typical small business seller or buyer sits down with his calculator, software program, and preferred formulas, and proudly comes out with a piece of paper disclosing the value of a business.
This exercise is actually an excellent way to determine what a business was worth last year, or the year before. But historical information–which is what financial statements are–can’t reveal what a business is worth today, because what it’s worth today is based on future results.
The buggy whip manufacturers in the late 1800s learned this lesson to their dismay, when their strong financial results led them into a false state of comfort right before they were about to get run over (literally) by the newly emerging automobile industry.
Similarly, investors who shied away from Amazon.com because of the rivers of red ink in the early years missed out on buying a great business.
To borrow some wisdom from Warren Buffet:
“If past history was all there was to the game, the richest people would be librarians.”
So, it’s pretty simple to explain how to price a business. Figure out its future performance, and price in an appropriate rate of return.
Simple to explain. Hard to do.
Yogi Berra put his finger on the real dilemma:
“It’s tough to make predictions, especially about the future.”
How do you value a business based on the future, given that you can’t predict the future?
For now, our point is simpler. Don’t fall into the trap of thinking that the value of a business is based on its past. Don’t ignore financial statements. They’re important for a lot of reasons. But, consider whether their greatest importance may be based on the clues they can provide about the future.
Consider using the same approach that large corporations use. In contrast to small businesses, larger corporations consciously spend almost all their time thinking about the future and not the past. They develop pro forma financial statements, and then use due diligence to verify the inputs that underlie their analysis of the future.