Table of Contents
Cover
Title page
Copyright page
Dedication
Foreword
Acknowledgments
Introduction: Painting the Picture of the Ideal Business
There Is a Template
The Context—Focus on the Fundamentals First
Who Says? Warren Buffett Does
CHAPTER 1 Buffett and the Fundamental Business Perspective
Warren Buffett as Your Small Business Consultant
Return on Equity, Return on Investment—the Preview
Apples to Apples
Investing from the Business Perspective
A Spiel on Capital Gains
Turning Capital Gains into Cash Flow
Buffett as a Cash Flow Powerhouse
The Cash Flow Trifecta
CHAPTER 2 The Importance of a Consumer Monopoly or Toll Bridge
Briefly Stepping through the Quantitative Mirror
And What It Is Not . . .
What? The Consumer Monopoly and My Small Business
Taking on the Big Boys Is a Big Mistake
If You Can’t Beat ’Em, Join ’Em—Why a Franchise Makes Sense
Track Records and Subway Cars
Purchasing an Existing Business
The Toll Bridge
How to Build a Consumer Monopoly
Branding
Some Branding Pointers
How to Build a Toll Bridge
The Best Combination—A Consumer Monopoly Toll Bridge or a Toll-Nopoly
CHAPTER 3 Strong, Consistent, and Growing Earnings
Through the Eyes of Warren Buffett
Earnings and the Consumer Monopoly
And What We Do Not Want to See . . .
Why This Is So Important
Where to Start—The Income Statement
Income Statement Forensics
I Am Purchasing an Existing Business, This as Opposed to I Am Robot
I Am Starting a Small Business
How to Project
Now for the Hard Part
Marketing Research
The “Splitting the Pie” Method of Marketing Research
A Small Trial Run or, Just Open the Doors and See What Happens—Hello World!
Reverse Engineer the Financials
Take a Friendly Noncompetitor Out to Lunch
Analyzing Larger Public Companies
Bottom Line
Application for Small Businesses
The Initial Rate of Return on a Stock—The Initial Rate of Return on a Business
Discounting
Six Degrees of Hypersensitive Separation
So What? How Does This Apply to My Small Business?
Take Away
CHAPTER 4 Emphasizing a High Return on Equity
Painting the Picture of Return on Equity
And Now Some Examples
Return on Equity Industry Averages
Another Reason Return on Equity Is So Doggone Important
To Rent or Not to Rent, That Is the Question
Some Definitions
Breaking Up Is Hard to Do
Similar, Yet Different
Of Assets, Cash Flow, and Financial Independence
What Warren Wants to See—The Entire Reason We Are Covering This Topic
Across the Universe of Investments
How to Become Joe-Like
An Afterthought on Financial Ratios
Uses of Funds
Assumptions
More Detail on the Ratios
CHAPTER 5 Retained Earnings—The Fuel for the Engine of Compounding Returns
Death of the Compounding Engine
Let Me Have a Dollar
Of Retained Earnings and Llama Farms
But . . . We Are Supposed to Be Discussing Small Business, Correct?
Looking at a Phenomenon
Retained Earnings, So What?
Taxes, Taxes, Taxes . . . and Death
Up in the Sky, It’s a Plan, It’s a Bird, It’s . . . Super Buffett
Retained Earnings in Relation to Business Valuation—the Proof in the Pudding
One Other Thing to Keep in Mind
How Warren Buffett Determines the Price
How the Heck Does This Apply to My Small Business?
How the Heck Do I Apply the Historic Earnings Per-Share Method to My Small Business?
Valuation as It Relates to Retained Earnings
Low Research and Design, Low Required Investments in Maintenance and Upkeep . . . Low I Tell You, Low
CHAPTER 6 The Tumor of Long-Term Debt
Debt: Friend or Foe?
Wrapping Your Brain around Debt versus No Debt
This Is a Two-Way Street—The Reverse Effects of Leverage
My Poor, Poor Income Statement—Damn You, Debt!
Good Debt Versus Bad Debt
Warren Buffett versus Good Debt versus Bad Debt versus Your Small Business—Who Wins?
How to Wire the Debt Prescription into a Small Business
But What If I Am Starting a Business?
Stocks Versus Real Estate Investing
In Conclusion
CHAPTER 7 Keeping Up with the Joneses
Hamburgers, Cokes, and Animated Mice . . . Oh My!
Just What Is Inflation?
So What? How Does This Apply to My Small Business?
The Opposite Is Also True
An Either-Or World
Fixed Debt Can Be Your Friend—Hello, Friend
Inflation Is Not Your Baby Daddy
Commodity-Type Businesses
CHAPTER 8 With Healthy Net and Gross Margins
Before You Can Have Net Margins, You Must Have Gross Margins
So What? What Say You, Warren?
Gross Margin Is Really Not That Gross
Two Important Things
And Now, a Bucketful of Consumer Monopoly Margin
CHAPTER 9 Building a Small Business That Warren Buffett Would Love—Finishing the Landscape
The Spirit
Finis! A Landscape Framed
Epilogue
The Business Plan—Well, Yeah, There Is an Outline, but This Is Not War and Peace
Goals and Milestones—You Said You Were Going to Live Up to Them, How Did You Do?
Implementation—It’s a Pretty Document . . . So What?
About the Author
Index
Copyright © 2012 by Adam Brownlee. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Brownlee, Adam, 1978–
Building a small business that Warren Buffett would love / Adam Brownlee.
p. cm.
Includes index.
ISBN 978-1-118-13888-5 (cloth); ISBN 978-1-118-22550-9 (ebk);
ISBN 978-1-118-23889-9 (ebk); ISBN 978-1-118-26355-6 (ebk)
1. Small business—Finance. 2. Investments. 3. Buffett, Warren. I. Title.
HG4027.7B76 2012
658'.022—dc23
2011046752
Introduction: Painting the Picture of the Ideal Business
Someone is sitting in the shade today because someone planted a tree a long time ago.
—Warren Buffett
Ah, but I was so much older then, I’m younger than that now.
—Bob Dylan
They’re Gr-r-reat!
—Tony the Tiger, mascot of a consumer monopoly company that Warren Buffett loves
A consistent truth exists across all small businesses: Each one is different. A hamburger stand drives down operational costs through inexpensive, rapid-fire delivery; a service business builds sustainability through solid, enduring relationships; a technology firm evolves through bleeding-edge innovation and development. It would be catastrophic for a tax service provider to ram his clients through in 60 seconds just as it would be suicide for a hamburger stand cashier to play a round of golf with customers as the drive-thru line backs up. No matter how disparate the business model universe may be, another consistent truth exists: Every great business is built upon the same core fundamentals.
There Is a Template
The core of a strong business is not a mystery, nor is it a complicated mess. It is found in the wisdom of Warren Buffett, which is a virtual blueprint to create superior business results and build a powerful small business engine. If you follow this blueprint, digest its meaning, and learn its intricacies, you can build an economically superior small business, one that Warren Buffett would love.
You Hold in Your Hands the Blueprint
If you asked Warren Buffett what he looks for in great business, this is what he would say:
- I want to see a consumer monopoly …
- With a strong track record of earnings.
- With a healthy return on equity.
- With the ability to reinvest those earnings at a high rate of return.
- With little or no debt on the balance sheet.
- With the ability to increase prices with inflation.
- With a healthy net and gross margin relative to other businesses and industries.1
These statements embody the principles that Warren Buffett used to turn an initial $105,000 investment into a $40 billion fortune; and if the principles are wielded appropriately, they can be used to transform a small business into an economic powerhouse. This, folks, is our road map.
The Context—Focus on the Fundamentals First
Instead of hacking at the proverbial leaves of a bad business—a missing marketing plan, anemic revenues, low inventory turnover—let us first examine for cancer at the root via the Buffett principles. If a tumor is found, let us determine if intense fundamental therapy as prescribed in the following chapters can save the business, and if not, then it is time to move to higher ground and seek out a better business model. Remember, parameters such as return on equity, and debt to equity allow us to compare across multiple business models. If the current business is terminally ill after delivering year after year of poor returns, then it is time to take a bold step.
Let us first check that we are in the right forest before cutting down the trees.
Who Says? Warren Buffett Does
Don’t take my word for it; take Warren Buffet’s. I could affront you with a spaghetti tapestry of professional credentials but why bother? Warren Buffett is available and his track record is much more stupendous than mine. He grew his initial investment of $105,000 into a $40 billion fortune over 40 years.2 I cut my grass yesterday.
Let us start at the fundamental fountainhead as prescribed by Mr. Buffett before moving onto tactical measures such as forecasting financial statements or business plan development. Let us build a small business that Warren Buffett would love.
It Is Easier Said than Done—A Preview
Regarding Buffett’s second principle, “with a strong track record of earnings”: It is painfully obvious that a healthy business needs a strong track record of earnings in order to be viable. A business without earnings, which represent everything left over on the income statement after all expenses—cost of goods sold, payroll, utilities, taxes, and so on—have taken their bite, is like a lawn mower without a lawn mower blade. It may be fun to circle the yard a few times, but after a while the grass needs cutting. A for-profit business is “in business” to generate earnings, which in turn, when divided by the initial investment or equity, leads to a return. The bottom line on the income statement—earnings—represents the pulse of a business, and Buffett seeks out strong, steady 10-year earnings track records. The entrepreneur should strive to generate strong earnings track records. If this is not a priority, then perhaps your time is better spent circling the yard on a bladeless lawn mower.
Earnings lead to another empirical Buffett fundamental rule, return on equity. Return on equity can be thought of as the common size ratio used to illustrate the productivity of the equity in the business and can be used for comparison purposes. Think of it this way: If you put premium gas (equity) in a jalopy (business), the overall performance of the car will be poor, regardless of the gasoline grade. If on the other hand you put the gas in a new Corvette, all things equal, the car performance should be much better. (You can hug corners, get stuck on speed bumps.) Return on equity is used to distinguish a business jalopy from a Corvette, and is found simply by dividing earnings by the amount of invested equity.
For example, a fourplex generating $10,000 in yearly earnings, with $100,000 of invested equity, is producing a 10 percent return on equity ($10,000/$100,000). This rate of return is superior to a CD at the local bank that is coming in at 4 percent.
In the context of cash flow and financial independence, the smaller the return the greater the capital needed. For example, at a rate of return of 5 percent and monthly expenses of $3,000, it will take $720,000 of investment capital in order to generate $3,000 per month and be financially independent. At a rate of return of 10 percent, the required investment is only $360,000. Quite a difference … like half!
A Business Plan Is Written Once
Remember this also: A business plan is typically written once, but fundamentals are timeless and diamonds are forever. Sure, it is necessary to revise and update the business plan as economic conditions and business strategies dictate, but accurate business coordinates on a compass, as found in the investment principles of Warren Buffett, again are timeless. Let us first build this rock solid framework before adjusting the nuts and bolts.
Bad Pizza Joint … Bad
I have worked with numerous struggling businesses lacking solid underlying fundamentals that could use a healthy dose of Buffett. Case in point: I recently met with the owner of a local pizzeria whose business has very little differentiation from the local mega chains. Net, net, his operation is embroiled in head to head competition with the likes of Domino’s and Pizza Hut. The owner of the small shop works night and day and is very passionate about his business. Still, over the past five years, Domino’s has spent an estimated $1.4 billion in national advertising in the United States.3 Although I am always fond of the underdog and tend to root for him, this is just one battle the small guy cannot win—at least not on this battlefield.
What he can do, in following our plan to build a business that Warren Buffet would love, is create consumer-monopoly differentiation and distinguish his business from the mega chains. Currently his model is very similar to the delivered, standard quality pizza of Domino’s. For our small guy, this results in head-to-head failure. Even loyal fans will eventually capitulate, making the switch based on Domino’s systematized, superior delivery framework with its built-in, machete price slicing offers. As it stands, our pizza guy does not have a chance (Mama Mia!) and must differentiate his model lest he sits stagnant in a slowly spiraling vortex of death. Perhaps he can implement a Hawaiian luau theme complete with a tomato sauce-spewing volcano that erupts every hour on the hour. An Elvis impersonator can perform a couple of numbers (Live! Via Satellite!) before gorging himself on a fried peanut butter and banana pizza just to show the customers how good it is.
I kid a little, of course, but this concept is founded on the same consumer monopoly concept that Warren Buffett loves to see in a business. Coke is Coke because the company has built up an enduring consumer brand over the past 120 years, and if the cans, bottles, and two liters disappeared off the shelves of the local supermarket warehouse tomorrow, most people would take note. The same can be said for the local Hawaiian themed pizza shop that spews pizza sauce every hour while a fat guy in a jumpsuit obliterates a Chicago pan to the tune of See See Rider. If that went away, customers would notice.
How to Paint
We have a road map courtesy of Warren Buffett, but what do we do with it? How can we take the principles of a consumer monopoly, with a strong track record of earnings, a healthy return on equity, with the ability to reinvest the earnings at a high rate of return, with little or no debt on the balance sheet, the ability to increase prices with inflation, and a healthy net and gross margin relative to other businesses and industries, and wire it into a small business in order to build a small business that Warren Buffett would love?
First we take a step forward, and then backward, and now we are cha-cha-ing!
Seriously, let us look to the small business revenue projection methods for inspiration.
The Small Business Revenue Projection Methods—Get Inspired!
The million-dollar question asked by most start-up owners is “How much will I make?” And the million-dollar answer: “If I knew, I would have a million dollars.” Revenue projections at best are an accurate forecast and at worst, a good guess. But, if revenues for a financial forecast can be filled in, can the picture of the entire business be painted as well?
The Five Brush Strokes for Revenue Forecasting
1.
Gather consumer spending data for the proposed product or service and divide this figure by the total number of competitors.
2.
Determine the breakeven point of the new business.
Can this be achieved?
3.
Survey the target market and ask them, “How much and how often will you spend with me?”
4.
Take a friendly noncompetitor out to lunch and ask for pertinent sales data.
5.
Conduct a small trial run.
No single stroke by itself paints a complete picture nor do the strokes combined guarantee complete accuracy. The more the merrier, though. These questions, in order, can be answered using public data—the forecasted business expenses—by asking the target market and by opening and operating the business on a small scale. Methods one, three, and four answer how much you should make, method two answers how much you need to make, and method five says “Hey, you are making money now; here’s how much you are making.”
Together, the answers should paint an overall powerful landscape that answers the question, “How much revenue can I expect to generate?” Remember, this is a forecast; no guarantees here, and certainly crystal balls that predict the future do not exist. If anything, at the center of our painted landscape is a close estimate of the number.
Using our virtual business paintbrush and the five colors mentioned previously, we have painted in from the top, the corners, and the bottom, filling in just about every space except the small space lying at the center. That small space in the center is the million-dollar question, and we’ve gotten very close to answering it.
The same painting methodology used in forecasting revenues can also be applied in building a fundamentally sound, economically strong small business. We are going to get out our brushes, our palette, paint, a giant canvas, and Warren Buffett (don’t worry, we have a hand truck), and then we are going to paint our bloody hearts out until all that we have left is a small, tiny spot in the center. Once we have painted a beautiful business landscape, we will hold in our hands the picture of a superior business and revel in the confidence that we have built a small business that Warren Buffett would love. Figure I.1 details the road map we will be following along our journey.
Notes
1. Mary Buffett, Mary and David Clark, Buffettology (New York: Fireside, 1999), 24–25.
2. Alice Schroeder, The Snowball (New York: Bantam, 2008).
3. Domino’s Income Statement. Retrieved July 23, 2011, from http://financials.morningstar.com/income-statement/is.html?t=DPZ®ion=USA&culture=en-US.