Life Lessons from a Financial Analyst
Valuation is a negotiation
There is no “correct” value for a business. Since valuation is based on assumptions, two people rarely come to the same conclusion. Therefore, value is determined through a negotiation process driven by the motivations and assessment of the buyer and seller.
Finance adds no value
New products and services or improvements to existing ones add value. More efficient delivery of products and services adds value. This happens through innovation led by the management team. Finance supports this process.
Finance is a mirror
Good financial information combined with leadership allows a management team to make a hypothesis and test its financial impact on the business. This helps the management team understand the financial impact of their decisions.
Maximize value, not profit
The value of a business is a mix of risk and return. Those who say the objective of business is to maximize profit, miss that this should be done at the lowest risk possible. Also, remember that a business can lose money and create value simultaneously (Think: Amazon).
No one can consistently predict the future
Most of the time a person accurately predicts the future; you can attribute it to luck. If someone could consistently predict the future, they would quickly become the world’s richest and most powerful person. No matter how professionally packaged a person is, don’t be fooled into believing they have a crystal ball.
Believe nothing. Believe no one. Demand evidence.
Most people just repeat what they hear. If you dig deeper, you will find a shockingly tiny amount of evidence supporting their opinions. So, stop believing what they say. Assume they have made no effort to get the facts and evidence. Always ask people, “Can you prove that?” or “Can you provide the source?” And never play along when someone makes a statement and then demands that you disprove it. The “Burden of proof is on the affirmative,” in other words, those who propose an idea need to support it with evidence.
Advice to CEOs: Don’t follow to investors
Investors will never understand the challenges that a CEO faces. And most of them could never manage a business as well as the CEO. Yet, all investors have opinions about how to do it better. It’s OK to listen to what they say, but it is dangerous for a CEO to allow these opinions to guide the direction they take the business.
Always have on-time and accurate monthly financial statements
Most start-up businesses do not close their accounting books every month, resulting in tiny, daily unresolved accounting issues. Eventually, those tiny issues become big and complex and grow difficult and expensive to resolve. Your monthly balance sheet and P&L show you how you are doing. This monthly feedback is critical to making your business strongly profitable. Most importantly, consistently creating financial statements forces your accounting and finance teams to resolve all outstanding accounting issues.
Global average profit margins: Gross margin 30%, EBIT margin 10%, net margin 6%
Once you understand these averages, you can see the profit guard rails you are operating within, and you will be aware if you are letting your profits get off track.
Always answer the question, “Cui bono,” who benefits
Latin for who benefits? or, as Charlie Munger says, Show me the incentives, and I will show you the outcome. People rarely, purposefully, do things that harm themselves. Instead, they do things that benefit themselves. So, when trying to understand something you observe in this world, dig deeper and explore who benefits. From this, you will understand the motivations behind what is happening.
To succeed, a start-up needs to get to US$7.5m as fast as possible
Most companies start with limited resources and a single founder. But to be truly successful, a business needs skilled managers. The total annual cost of a team of seven to ten seasoned executives exceeds $1,000,000. In addition to the cost of management, a business will also face costs related to building a scalable infrastructure. I estimate that a company would need to generate $7,500,000 in revenue to offset the cost of a solid team and quality infrastructure to achieve average profitability.
Revenue equals price times quantity
Don’t overcomplicate revenue forecasting. It comes down to what you charge for your product or service and how many of those you sell. Get those two numbers right, and your revenue forecast will be accurate enough and understandable to an outside investor.
You will rarely get rich from working harder
Though we all have 24 hours a day, we only work 8-12 of those hours. I estimate that people engage in focused, value-added work for about 2-4 hours of their workday. If what you earn is based on the time you work and the price you are paid for your work (Price x Quantity) and time is fixed, then to get rich, you must find a way to get paid more for your time. Of course, a business leader’s job is to delegate work to expand their quantity massively but to get rich as an individual, you need to increase the price you are getting paid for hours worked.
Valuing a company is 70% forecasting and 30% valuation
The hardest part of valuing a business is correctly predicting the future. It is easy to apply valuation tools and methods to these forecasts. That is why I say, “A good valuation can never overcome a bad forecast.”
Individual KPIs could possibly be the most destructive management tool ever created
The biggest challenge in business is developing a common aim that inspires people to work together towards. Humans are complex, and there is no perfect measure of their behavior. Individual KPIs tied to compensation incentivize individuals to act in their interest to ensure they get a slice of a limited pool of compensation funding. KPIs unleash a powerful force opposing your objective of getting people to work towards a common aim.
Nothing good comes easy
Bad things often come easy. But to achieve anything of lasting value requires work.
Doing hard things makes life easier
Most people don’t want to work too hard. So don’t get discouraged when something is hard. Stick to it; eventually, you will stand out because most people will have given up a long time ago.
Winners slightly, but consistently, outperform their peers
You don’t have to be miles better than your peers. Just be a bit better; over time, your value will grow more significant than your peers.
First place is only slightly better than second, but rewards are 10x better
The gap between the number one and number two performer is tiny, but almost all the rewards go to number one. Life is winner takes all. So, where possible, win. The rewards will be worth the effort.
The job of a financial analyst is to think independently
Most people don’t have the skills, knowledge, or desire to think independently. And they often scorn those who don’t go along with the crowd. To succeed in the stock market, an analyst must implement non-consensus ideas, which must be proven right.
Caveat emptor
Latin for Let the buyer beware. In life, it is your responsibility to look after yourself.
Knowledge does not guarantee wisdom
When I was young, I admired and trusted doctors. But as I grew, I started to understand that being a doctor only guaranteed one thing, that this person was good at studying and memorizing. To be wise is to continually improve, which takes hard work, which most people don’t want to do.
Right or wrong, people rarely change their mind
Most people will stand by their initial decision even when faced with incontrovertible evidence. This is especially true when around others.
Being first is more impactful than being right
To change your mind takes considerable mental and emotional energy. Most people don’t want to expend their energy, so they stick with whatever they first believe.
Revenue is proof of concept; profit is proof of competence
Revenue proves that you created a product or service that the market wants and that you can deliver it to them. Well done. But profit takes things to another level. It shows that you can successfully manage every aspect of your business.
Weak minds hold strong opinions, strong minds hold weak opinions
One of the easiest things to do is to hold firm to an opinion. But a strong-minded person is one who works hard to see both sides of a story. An even bigger challenge is to keep two opposing ideas in your head at the same time. Most things in life are not as sure as they seem, so learn to be less confident in your opinions.