Congratulations~ you are a small business owner and now maybe also a millionaire! There was once a lottery called “Millionaire for Life’ which paid the winner $1000 per week for 25 years. What if your business made $1000 net profit a week? Would that make you a millionaire?
The value of a business is related to the quantum and probability of future cash flows. Wait! What?! What does that mean, exactly? In the lottery, we know that the quantum of cash flow is $1,000 per week, $4,000 per month, $52,000 per year and $1,300,000 over the next 25 years. What’s the probability? When you win the lottery: it is 100%!
Annuities are payments over time
A business can be thought of like an annuity. An annuity is a stream of payments payable to the owner into the future. The weekly stream of payments of $1,000 in the lottery is the annuity.
The future cash flow of the business is like the payment in the lottery. A business is similar except that the value of each payment can vary. In the lottery, you know that you will get $4,000 month. In a business, each month’s payment (cash flow) is unknown but can be predicted or forecast.
In the lottery, you are certain to get the $4,000 a month. The risk in a business is that the predicted (forecast) cash flow is unknown. But a business owner can make predictions based on their knowledge of their market, their customers, their suppliers and their competition. A good business owner makes assumptions about what the future holds for them.
Long term value creation
Companies that can show success over time in gaining sales and controlling expenses have greater value. Companies that can show a history of positive cash flow will generate a greater value over those whose history is shorter or is more variable.
One looks to the past to forecast the future. The longer the history, the greater the support for the assumptions that yield the forecast cash flow. The closer the assumptions are to reality, the lower the risk of the probability of the future and the greater the value.