The Game with Alex Hormozi - How Businesses Exaggerate Their Value | Ep 332

Episode Date: September 30, 2021

The worst thing you can do is deceive yourself. Today, Alex (@AlexHormozi) talks about the 7 most common ways people measure value when looking at a business, which ones are his favorites, and which ones are completely ridiculous!Welcome to The Game w/Alex Hormozi, hosted by entrepreneur, founder, investor, author, public speaker, and content creator Alex Hormozi. On this podcast you’ll hear how to get more customers, make more profit per customer, how to keep them longer, and the many failures and lessons Alex has learned on his path from $100M to $1B in net worth.Timestamps:(0:33) - 1st & 2nd: Contract Value, Revenue Over Lifetime(2:58) - 3rd & 4th: Business Valuation, Actual Yearly Revenue(4:49) - 5th & 6th: Yearly Profit, Owner Earning(6:55) - 7th: Net Worth, Pros and cons of each way(17:28) - Alex's preferred way: Net Worth, What's left after everythingFollow Alex Hormozi’s Socials:LinkedIn | Instagram | Facebook | YouTube | Twitter | Acquisition

One of the ways that people are trying to deceive you into thinking that they have a more valuable business. Welcome to the game where we talk about how to get more customers, how to make more per customer, and how to keep them longer, and the many failures and lessons we have learned along the way. I hope you enjoy and subscribe. In this video, I'm going to talk to you about the seven most common ways that people measure or measure the value that they are providing in business and to the marketplace. This is kind of the eggplant measuring contest, if you will, of entrepreneurs. And I want to tell you which ones are BS and which ones are my favorite. in the remainder of this video.

All right. So the first and possibly the most BS way, especially in the information space of measuring this, is on contract value. All right? That's when someone says, I like to call this marketer math, and that's when someone goes to an event

and pitches something of some sort and gets people to sign up for a one-year program, for example. And, you know, that means that people are paying monthly, but when they say, hey, we did $2 million in sales, right? the reality or that we're doing two million dollars a month right they're extrapolating a single month that's a one-time event based on contract value in the future that's in no way guaranteed right and so in the reality they might have signed up a hundred people at twenty five hundred dollars a

month and in their minds they say we did two we're doing two point five million dollars a month so in your mind you're thinking oh this is a thirty million dollar your revenue business but in fact they literally only added two hundred and fifty thousand dollars a month in one month that they did and they have probably lots of turn and people leave And so one of the ways that people are trying to deceive you into thinking that they have a more valuable business is that they will tell you the contract value And so on the BSometer of this one actually I'll rate them at the very end. So it'll be a little bit of fun All right so number two so we've got contract value the next one is revenue over a lifetime right

So that is the total amount of sales that was that was collected right now mind you the different like in in terminology revenue versus cash collected are two different terms. Most of the time people use them interchangeably. They shouldn't be used interchangeably. But for the purpose of this video, I will talk about revenue from a perspective of cash collected. And so revenue over lifetime is basically saying, all right, I've been in business for 10 years.

And over those 10 years, we've done, you know, $2 million. Right. Now, that sounds impressive because then they have an award and it says, I've done over a million dollars in sales of my business, but the reality is they were doing $200,000 a year. And if it was a business, let's say they ran 40% margins. It means they were making $80,000 a year for 10 years, which you can do just driving Uber and not have any of the stresses of running a business.

And so I find this one kind of funny, but it is one of the ways that people talk about business revenue. All right. And I'll get to rating these and some of the pros and costs at the end. All right. So contract values number one, lifetime, lifetime revenues number two. Number three is business valuation. So that means how much is the business worth to the marketplace? So if I were to sell my business today, how much is that worth? Now, this is actually fairly common, especially in more publicly traded companies. That's where you get the CEOs like Jeff Bezos has, you know, his personal net worth is based on the business valuation, right? That means that if someone to buy the business today, what would they value at?

And a lot of that is taking the profit of the EBITA at the end of the year, which is earnings before interest, tax, and wordization, right? And depreciating that on a multiple. So it's like if I'm doing a million dollars a year in EBTA, and I might say that in my particular industry, let's say we're growing, so we'd get a higher multiple because they're buying discounted cash flows off future earnings. Let's say that on that multiple, I get 10 times, right? So I might say I have a $10 million company when in fact I'm only doing a million dollars a year in profit.

That's not necessarily incorrect. It's just a different way of measuring the value that you've provided in the marketplace. The fourth way of doing this is the actual yearly revenue, right? This is starting to get a little bit closer to reality in my opinion for most people. Because remember, only like 1% plus of businesses actually sell. And so 99 times out of 100, they're not going to sell. All right, so getting a little bit closer to reality here, we've got yearly revenue, which is how much actual, and again, the difference I said earlier between revenue and cash collected, for me, I look at cash collected. Revenue, and a lot of times it's just dreams of what they think is going to happen versus what actually will happen. But yearly revenue, how much cash is being collected on a yearly basis in the business. All right. So if a company collects $30 million a year in revenue, then that is what they might describe their business as. All right. The fifth, in this little equation here is yearly profit all right so it's yearly profit that's how much

in excess or you better right at the end of the year so I say profit even these aren't perfectly exchangeable here all right I recognize that but for the purposes of this video this is what's left what's the top at the end of the year now what's important is that this does not take into account the fact you may reinvest a lot of that stuff in the business right so if you have good returns on capital in your business and you want to expand, et cetera, which many businesses do, right? As long as the return on capital in your business is in access of what you'd get in the in the passive marketplace, which it should be

because this is your active business, then this is how people grow wealth, right? This is how you grow, this is literally how entrepreneurs make money is by reinvesting a certain percentage of the profit into the business because the growth of the business exceeds the growth that they would be able to get passively from the marketplace. That is the whole entire idea. And so when people describe how much they make as we're measuring value in the business, how much profit they're making per year is one of those ways. Again, I'll tell you at the very end where I rate these and the pros and cons of them. The sixth one is owner earnings. So this is the extraction. So how much was I as the owner or the shareholders of the business able to take out of that yearly EBIT or yearly profit?

What kind of distributions am I personally taking? Because this is, you know, Warren Buffett is famous for measuring net-free cash flow, which I'll put right here, net-free cash flow. All right. He's famous for measuring businesses not on this, but on this, which is, well, sure, what if I have a manufacturing business that's making lots of profit? But every three years, I need to invest three times my earnings into buying another machine. It's like, well, that's not a very fun business because it means that every single, I never actually get to make any money because I consistently have to buy a new machine to stay updated with advancements in technology, etc. Right? And so that is why this one can be somewhat deceiving versus how much am I able to take out as a business owner every single year. because that, to me, is the value of the business if I want to reallocate the capital in other places. All right. And then finally, we've got the good old-fashioned net worth. All right? This is how much me as an owner?

And the reason that you're like, be like, wait, some of these are kind of different from another. And the answer is, you're right. They are very different from another. But when you see YouTube videos and you see thumbnails and you see people describe their business. Or as they describe themselves, which most entrepreneurs have merged their identities with their business, which I'd encourage you not to do for other reasons. logically, but people do merge those things, which is why net worth somehow also gets conflated with all of these different things. So let's get to the measurement of, you know, ascribing

values to each of these things. All right. So if I'm looking at a business, a business itself, I don't care about the lifetime revenue of the business, right? I don't care about this very much at all. It does make really, it makes for great headlines and sexy numbers. There's one of my other videos that said we did $122 million in revenue over three or four years. And that is because it definitely sounds extra than saying we do $32 million a year in revenue, right? Which is kind of this guy. And in case you're curious at the time of this video, actually, I'll share at the end of this year what we did. But I'll say that I was stuck at mid-30s for three years in yearly revenue cash collected.

And this year will be all breakout year. So stay tuned for that video. Anyways, the next one, and this is probably the most BS of all measures entirely because it's completely made up, right? Now, the only time this matters, the only time this would be of any value whatsoever is if you have a type of contract that's 100% enforceable and you have negative churn, or these contracts only go up in value, right? But the vast, vast, vast majority of businesses do not have this because people do not consistently follow the contract. that they sign up for or they do not have enforceable contracts or they are not secured by anything. And so that means that these contracts are barely worth the paper that they are written on, which means that they are completely fictitious value and only there for your ego.

So I would say this is probably the worst way of measuring value. I would say the second worst way of measuring value is lifetime revenue. So let's work our way down this ladder here. The next one, business valuation, I actually think that's a pretty decent measure. but the question is who's valuing it, right? And how are they measuring the value? When someone says, yeah, well, we're going to get 20 times top line, it has to take an extremely, extremely unicorn special business

with crazy growth, competitive moats, in a fast growth market that has some sort of unique technology that people think is going to become a monopoly or category king in order to get that type of valuation. But when people ascribe that type of valuation of their business, most of times they're just doing it completely subjectively and making it up because it just makes them feel better. All right. And so I would not get duped into believing something like that. Now, if someone says, I believe our business is reasonably valued at five or six times EBITA, which is this number, right? In most cases, that is a pretty accurate assessment if you're looking at businesses. It might be two to three. If you're looking at middle market businesses, you're looking at six to eight. And if you're looking at publicly traded companies, well, I mean, if you look at the stock market now, that's closer to like 30 times and it's nuts right now. But for the most, you'll get.

get into the kind of the 20s range is kind of more common in kind of the public markets. And you're like, well, why is that? It's usually just because there's so much capital and they're so easy to invest in. And that's like the ease of access to liquidity and other people's money also increases the valuation because it's so much easier for people to purchase shares of the company. Right. But from a true value standpoint, like the reason business valuation is even interesting is that, like you have to think about as return on capital.

If I'm going to buy a company that's doing $10 million a year or literally a million a year in profit, well, if I put, you know, if I say that the company is worth $10 million, if I put $10 million in, then I'm getting a 10% return on the money, right? Where this gets all thrown to craziness, which I'll make in a different video, is the reason people do a 10x multiple and still make tons of money on it. And it's all based on leverage. So how they can use other people's money to fund these deals at lower interest rates than it costs them that they're going to make from the business, which is called covering debt, which I won't even get into. All right. So first we get a contract value, which is a

I think is most of the time's BS. Revenue lifetime is really good for your ego, but not really good for valuing a business. Business valuation, if done properly, is an excellent measure of a business, but it has to be done fairly with a third party that doesn't have their ego invested in it. The fourth way is yearly revenue.

The nice thing about this is that I think it just, this is a top line measure. This is a measure of how much revenue or cash is being collected at this time, defining it over a period of time. Now, the reason that I think this is somewhat nice is it gives you an idea of what kind of volume someone's doing, right? Now, because that is why profit, which is the next one,

these ones, you want to kind of report on these together, right? Because let's say someone's saying, you know, I'm doing $500,000 in profit, you might be like, oh, it's a small business. But if he says, well, we're growing and we're doing, you know, $100 million a year and we just continue to plow all the profit into the business, and that's because we have lots of founders and we want to grow this as an asset because we think you're getting superior returns on capital, then in that case, then you're like, oh, it paints a very different picture saying

we're doing $100 million and we're, quote, profiting. 500,000, right, versus versus, you know, a million-dollar business that's doing 500, million-dollar in revenue business that's doing 500,000, all right? That's kind of the difference here. Now, again, I'm trying not to, I'm trying not, because there's lots of different terms for this, right? Because if I can take out $500,000 in net free cash flow, but there's, you know, $40 million in EBIT in the business, but we're plowing all that into growth, then, again, the numbers can be a little bit more confusing. And if this sounds confusing, that's okay. You'll learn it over time. But the entire point of this video, and I'm going to get to the last two in a

second, is that you should understand what each of these are so that when someone says a number, you can push back and say, well, what are you talking about specifically? You're talking about, you're talking about lifetime revenue? Are you talking about yearly revenue? Or you're talking about business valuation? You're talking about contract value of what people sign? Like, what are we talking about? Are we talking about EBIT? Like, what are we talking about here? Real quick, guys, if you can think about how you found this podcast, somebody probably tweeted it, told you about it, shared it on Instagram or something like that.

The only way this grows is through word of mouth. And so I don't run ads. I don't do sponsorships. I don't sell anything. My only ask is that you continue to pay it forward to whoever showed you or however you found out about this podcast that you do the exact same thing. So if it was a review, if it was a post, if you do that, it would mean the world to me

and you'll throw some good karma out there for another entrepreneur. Right. And then I just give you another lens to which to see business. so that you can, at the end of the day, the goal is to be able to describe your own value to the business. And so I'll show you what mine is at the very end of kind of what I think through. But these are the different ways that you guys will see on YouTube and on podcast when people talk about values of their business and their own value, what they'll use. This one, number six, is net free cash flow. All right?

So this is near and dear to my heart because Uncle Warren Buffett. This is what he uses. It was good enough for him. It's good enough for me. this is how much money is this thing actually making me the owner, right? Where the shareholders. How much money is this producing in access of what it costs to run the business or reinvest in maintaining a competitive advantage?

All right, that's why Seas Candy, one of his most famous companies that he acquired for $25 million. And over the course of its career has generated over a billion dollars in net free cash flow for him as an owner, which is insane. Right? Think about the return on that investment. It's because there really was no additional increase that they had to spend to keep. that business competitively advantage. It's chocolate, right, or candies. And so there's not like new technology,

taste buds aren't really changing. And so they were able to consistently generate and pump out cash flow for the owners that they could reallocate into other businesses. All right, and the final one here is net worth. And the reason I'm bringing this one up is because as entrepreneurs like to measure each other's eggplants, right, in their business success,

which is a totally different thing from net, from self-worth, right? Net worth. Side note, don't make your self-worth into your a net worth because if your net worth goes down then so too will your self-worth. And on the flip side, if your net worth goes up and your self-worth goes up with it, then you will become an arrogant prick. So don't do that. Anyways, so the final one here is net worth, which is after taxes, after, you know, depreciation, after everything is said and

done, what is my net worth, right? Now, net worth is going to be somewhat tied to business valuation. If you're like, wait, some of these are tied together. The answer is yes. And if I could make everything neat into a single number, then I would. But the reason the business world works the way it does is because there's lots of different metrics that are used to measure value slowly so that we can get it the intrinsic thing of value. What is what is this worth? Right. And so a person's net worth is going to be a percentage of what the of the businesses that they own. Now, if you give a fair valuation to business, right, there's kind of two aspects to net worth. There's their investable net worth, which is how much do they have outside that they can put into investing into things?

And then how much do they have in like their core business? And I'm describing this purely for founders and entrepreneurs. If you're purely an investor, then all you're going to have is investable assets that you, that you, you know, that you have access to. And so with net worth, like I said, there's the two buckets. There's what you can invest and then what you own in terms of business valuation. Oops, here. And so when we're looking at that, I like this one a lot because it's BS free, right? Because imagine a guy who says, I've done.

You know, a McDonald's employee, for example, over the course of their entire career, would do a million dollars in lifetime revenue. Most of us would not consider McDonald's employees very well off, right? And there's nothing against being a McDonald's employee. I'm just saying from a purely income standpoint, it's not considered a very fruitful, you know, income producer, right? But if you work for 45 years at McDonald's, you'll make a million dollars, right? And so they could start selling advice on how to make a million dollars at McDonald's by being a frontline employee. Right. And so that is why these things can be somewhat deceptive and make people think that they are doing better than they are. And the worst person to see is yourself, right? Which is what oftentimes people are doing with these numbers, which is why I try and be as open and honest about the numbers that we have.

Everyone in my companies knows what we make. And I choose to run our companies that way because I don't like to hide things. Because, you know, to the same degree, if expenses go up and profit goes down, I want people to see that. If we have a downturn, I want people to see that I'm taking on risk here and I'm paying everyone's mortgages in the meantime, basically out of Uncle Alex's pocket. And so understanding this is important. And so for me, the measure that I do, as promised in the video, I'll separate the final two things here. So in terms of personal, I measure people not on revenue over lifetime or their yearly revenue or their yearly profit or their contract value or any of that stuff, I look at net worth. And net worth is what is left after everything is done at the end of the day, because this is the thing that you are trying to build.

This is the nest egg. This is the wealth that hopefully will continue to grow. And if you do it properly, we'll grow tax-free because you're buying smart and buying for long-term holds without having any intention of selling them. And if you buy that way, then the tax system is incentivized for you to buy in that manner so that you can grow tax-free. And so another way of thinking about the tax system is thinking of it as an incentive system that the macroeconomic economists of the government have set in place to grow the economy, right?

The tax system is a penalty system, but it also means that if you're not being penalized or you get right officer, you get or ways of getting tax free, it means that those are things that are going to benefit everyone. And so if you play the game, the way they want, the way they've set up the rules is because they believe that those things would be the things that are going to grow the economy, right? trying to arbitrage two things doesn't necessarily grow the economy and so they take percentages of that if you buy things with the intention of investing long term so that you get something that builds infrastructure within the economy makes everyone's life better off and they do not tax you on that and so if you buy things that are going to grow slowly over time or just

grow over time in general with no intention of selling them then your net worth will grow disproportionately again tax-free and so this is what I look at when I look at entrepreneurs in general's I look at their net worth which is a combination of their investable assets and the businesses that they own percentages of, which is the business valuation. And as long as that is being done in a truthful manner, which is usually going to be a multiple of this guy, right, times six to eight, you know, if you're mid-market, mid-market being, you know, 10 to $100 million a year in revenue, then these are, that is a fair valuation for most people. All right. And so next time you see someone who's, you know, who's got, I don't know if you can even see this in this,

Let's see if I can turn this camera real quick. So I've got this fancy little award here. Boom. That's for doing 100 million in sales. Through our businesses. We got that, I think, November of 2020 is when we cross that line. Since then, we've done, I don't know, another 30 or 40. It doesn't matter.

I'll give you guys the year on numbers later. But the point is that that seems really impressive. And it's a good idea for the business that gives those because it makes everyone seem more successful. Right. But what I'm trying to warn you against is don't read too much into this stuff. try and put the pieces together so you can ascribe your own value to both the entrepreneur's contribution to society and also the value of the business itself and lots of things to look at are especially these three numbers four

five and six which is what are they actually doing yearly what's the EBITA in relation to that and then how much money can they take out in net free cash flow or earner earnings after reinvesting in the growth of the business and a lot of times we hear the Silicon Valley stories of you know these companies that are worth these crazy amounts but 99.9.9 percent of the times, you know, it's a, it's a guy who owns five dry cleaning shops, right? Or it's somebody who has a digital marketing agency, or it's somebody who has an education business of some sort.

Or it's, you know, and those types of businesses are not going to fetch the crazy evaluations that, you know, Salesforce does because there's a CRM that will never, you know, people, once they get on it, they never leave and they increase in revenue over time, and their contracts are enforceable, right? And so when you're thinking about these things, you need to basically make up your own darn mind by combining these things and not being fooled by people who will try and exaggerate their numbers in order to impress you. All right. And so I've said before, you know, we did 17, I think 174 in EBITDA in 2018. I think we did say three or four the year before that. But I almost

take 100% of my EBITA as personal income. And that's because by the nature of the businesses that I own, those businesses do not require huge capital investments to maintain a competitive advantage. We do have things that we have to do to maintain a competitive advantage. They are just not capital intensive. It means it doesn't cost a lot of money for us to stay the best at these services to continue to grow. And that's because that was how I chose to get into business. That was the game that I wanted to play. There are certainly other ways to play the game.

This is just the way that I've played it. And since then we've done, I think, just under 50 million in owner earnings. that I was able to extract just in the last four years. And so you can do your own back of napkin math. I'll give you our 2021 year end number soon. So stay posted for that video. But otherwise, measuring value, don't be tricked. Look at these numbers.

And at the end of the day, the chop of all chops is how much is the net worth of the shareholders and the owners of the company growing in a tax-free environment? Stay cool. Hit the subscribe button. And I'll see you in the next bit. Bye.