Category: Business

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Business

Measure Everything: Digital Advertising

Today I’d like to talk about what I see as one of the biggest advantages of digital advertising: it’s efficiency as a form of advertising.

By digital advertising, I mean advertising that is delivered by a computer or other such electronic device, such as Google Adwords or Facebook. By efficiency, I am talking about getting the most increase in revenue for the least cost of advertising.

While digital advertising isn’t for every business, it’s probably the most efficient type of advertising you can buy for businesses selling online. Not because it’s the best way to advertise or has the highest sales conversion rate, but because it’s the most measurable. Here’s why:

When you use digital advertising, you can drive customers directly to a page on your website, which means you can store a cookie on their machine to record that they arrived at your website from a specific advertising campaign. Coupled with the information from the advertising broker (Google, Facebook, etc.) you can work out how much profit your advertising campaign generated per click that you paid for. For example, you pay for 100 clicks (adverts that people click on, priced per click), which generates 5 sales, giving you $100 profit ($20 per sale). You can then work out in a very exact way, the value of an advert. In this example, you know that if you pay less than $1 per advert / click, your advertising is worthwhile. If you pay more, it’s not worthwhile.

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Business

Do I Need To Repay The Wage Subsidy?

A few weeks ago I wrote an article about the economic future of NZ, in which I praised the government’s reaction to COVID19 and the associated financial policies arising from it. Specifically I said that I liked the wage subsidy as an implementation of Helicopter Money.

Why I liked it so much, is because it directed money straight to all businesses (small and large), and forced those businesses to ensure their staff were looked after. Trickle- Down Economics, anybody? I think this is better than Quantitative Easing because the money goes straight where it’s needed (though arguably there are better ways to implement Helicopter Money).

Every business owner I talked to, had applied for and got the wage subsidy. Comments on the no-questions-asked ease of acquiring the subsidy, along with the soft eligibility requirements of “…a 30% decline in predicted revenue…” and soft wording on repaying it, stating that you can repay it if you become no longer eligible, all suggested that the wage subsidy was actually Helicopter Money.

Now it seems that numerous large law firms are repaying the wage subsidy and the wage subsidy page on the Work and Income website is dominated by large red text talking about repayments.

So the question for employers is do i need to repay the wage subsidy? I don’t have the answer to this, but I suspect that the fact that the law firms are repaying it might be a clue.

In some ways it’s no surprise that the government is asking for the money back. In fact, I stated that there would be a need to replenish the coffers in the very same article in which I praised the wage subsidy policy. I’m just a little disappointed in the way the Work and Income website phrased the repayment, because for me, to say that you are eligible if you predict a 30% drop, then say that it has to be paid back if you are no longer eligible, I would have thought that having had predicted the 30% drop made you eligible.

Additionally I think that in the case of a growing company (especially those who have recently done capital raises or increased investment to fund growth), it’s quite possible that revenue could be up from last year, but 30% less than predicted. This could validly cause an increase in staffing costs that is not sustainable as returns didn’t fit the anticipated financial modeling, and such a company could be in need of the wage subsidy.

I think there’s scope for arguing a position here, but I suspect that increased need to replenish the coffers in the coming year may result in the IRD comparing past and present returns for those who kept the subsidy, and correspondingly auditing those who didn’t report at least a 30% drop. I expect that this will result in a lot of unpleasant words like “fraud” being thrown around.

It is my understanding that in cases where tax law is based on your opinion (such as whether you’re a share trader or share investor), the opinion of the taxman overrides any thoughts the business owner may have had on their intentions.

To leave on a positive note, while we may not have got any Helicopter Money, the alternative methods of replenishing the coffers are less attractive.

If you are wondering whether you need to repay the wage subsidy, you may wish to talk to your lawyer, accountant or ring the number on the Work and Income wage subsidy page that offers advice on whether you need to repay (though I expect in the case of any ambiguity, a ruling would not be in favor of these business).

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Business

Managing Risks In A Project Implementation

Managing risks in a project is very different to managing risks in a business. This article covers some of the ideas around managing risks in a project, more specifically, with a view to managing the implementation aspect of the project, rather than the project as a whole – because this is a large subject. I’ll try to keep this a little generalized so it’s relevant to all types of project implementation in business.

Managing risks is not about avoiding failure in a project implementation, but instead, accepting that things can go wrong and being prepared with a plan if that happens.

The first step in managing risks in a project implementation is to come up with an implementation plan. You’ll want this to be very clear so there’s no ambiguity about the steps. It should be written in such a way that someone else (with the appropriate skills) can implement your plan. This doesn’t mean that it should be so basic that a monkey could do it, but you need to be able to know exactly what was done if you or another suitably skilled person were to read the plan 5 years later.

The reason for this is because you (or someone else) may need to find out exactly what was changed after the project has been implemented. An example of why this is necessary is that there could be a problem that wasn’t considered which pops up a few weeks after implementation, and you’ll need to know exactly what was done. Another example might be that you need to rebuild your whole system (exactly) years later, and you’ll need to know what was done to replicate the whole thing.

Next you’ll need to identify the stakeholders. The stakeholders are the people who will be affected by the implementation of your project. This is so you can keep people informed, schedule work and communicate outages.

The next step is to list all the risks around your project implementation. Once you have this list, you should decide which risks you are going to have a plan to mitigate, and which risks you (and relevant stakeholders) are going to accept. You’ll need a rollback plan as a catch all in case your project implementation and risk mitigation plans fail, and to catch any risks you have not considered. Your risk mitigation and roll back plans should be at least as detailed as your implementation plan, because when it hits the fan, stress will make implementing your roll back plan harder and you’ll be more prone to mistakes. You should also plan what triggers cause your mitigation plans to be implemented (for example, the rollback plan might be triggered if the implementation is not completed and continuing with the implementation would not leave enough time for the rollback plan if the implementation were to drag out any longer).

The next task is around resource allocation. As part of your planning, you need to ensure that you have resources (human or otherwise) to implement your project, including those required to cover any risks you have chosen to mitigate.

Finally, you’ll need to make a plan to support the project post implementation. This means planning for future usage of resources (human or otherwise), and considerations for supporting the project after it’s implementation.

If you’ve worked in risk management before, you might recognize that this article is quite general. That’s because (coming from an IT background, where risk management is detailed and specific) I’ve tried to keep it as generic as possible so it can spur thoughts of approaching risk management for projects in all aspects of business. This same line of thought can be applied to implementing a server replacement project, the deployment of new PPE in a factory, or the deployment of a new office in another region (though this would obviously touch on the issue of risk management at a business level).

I hope this helps start the conversation about risk management and gives you some thoughts about how to go about managing risk in whatever line of business you are in.

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Business

Model Everything: Capitalized Costs

Welcome to the first of my Model Everything series of articles. In this article I will be talking about the financial term called Capitalized Costs and how it can be used to model the profitability of ventures better.

What Is A Capitalized Cost?

A capitalized cost is essentially a cost that is displayed as it’s amortized value of the period of time, rather than a one off cost.

For example, if you buy a server for $20,000, and you expect to amortize that cost over 4 years, the capitalized cost would be marked as $5,000 a year over 4 years instead of a one off cost of $20,000.

Actually, it would probably depreciate differently over that period, but that’s another discussion.

Financial Modelling With Capitalized Costs

I like to capitalize costs when exploring the profitability of a venture because it prevents the delusion of profitability when there is none. In other words, you may not be making the profit you think you are because your capital expenditure costs are not included.

For example, you buy a server for $20,000 to host a web based product. Your first year isn’t profitable because you had hardware to buy. The second year is profitable and so is the third and forth year. you think you’re doing well until your fifth year when you realize that you have to re-buy the hardware you bought in year one because it’s old and needs replaced. Suddenly you’re not profitable again. Has the business really been profitable all those years?

Modelling profit using capitalized costs lets you work out the true cost, though I would recommend depreciating the cost evenly throughout the years for the purpose of simplifying your modelling (but obviously depreciating the assets as much as you can for tax purposes outside of your modelling).

Summary

You need to model the amortization into your cost planning, and that’s what cost capitalization does.

Nothing lasts forever, so it’s better to view everything as if it was effectively rented each year when trying to work out if a venture is profitable.

I hope that gives some food for thought and is useful.

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Business

Common Mistakes Startups Make

I Am Starting A Business So I Need A Website

This is something that I used to hear all the time from people starting businesses, back when I used to run an IT company. They would come up with an idea, or have the beginnings of a business but didn’t feel that they had a proper business without a website. I believe that this is a logic fallacy stemming from the line of thinking that because successful businesses have a website, you need a website before you can be a successful business.

Now I’m not saying that you shouldn’t have a website. To be clear, I absolutely think you should have a website for your business. However (unless your business is focused around web business), you should be aware that it’s probably one of the least important aspects of a business.

The second thing about websites that I’d like to dispel is the idea that a website will get you lots of free business. It won’t. For a website to get traffic, you need to advertise the website. You also have to build a method to convert sales. This is beyond the scope of this article, but the takeaway is that a website is not what makes a business.

Religion, Babies, Politics And Pets

What do religion, babies, politics and pets have to do with business? Absolutely nothing, and it should stay that way! A big mistake that people make when producing public facing materials for their business is to include these things. I can tell you that there is no faster way to half your customer database than by pressing a political or religious allegiance. It’s just not necessary and will cause you to lose customers.

Another common mistake people make is to pick the thing they love the most in this world and expect that others will have the same positive feelings when they see baby pictures all over their website or their cute dog on their marketing material. Don’t do it! Resist! It’s a great way to instantly lose credibility and make you look like an amateur.

Not Measuring Effectiveness

Not measuring internal success of a business is a very common mistake. People often let the jubilation of all the sales coming from that big trade show hide the fact that it just wasn’t efficient – the event cost $3,000 to attend and you made $5,000 profit, but you forgot to add in the $3,000 of staff time to prepare and attend the event, support costs of the new sales, amortization of the event equipment, etc. When you consider all the costs associated with those new sales, the venture was not profitable.

Another common mistake is not measuring the cost of advertising. How do you know that the radio advert you paid for returned a profit? Did those new sales come from the radio advert or a Google search? People often pass off the cost of advertising as soft benefits and say that you can’t measure the value of having the brand out there. Another argument is that sales often come from multi touch points so you can’t measure the value of any particular media. For example a customer heard a radio ad and decided to buy when they saw a flyer from the company they felt they knew because of the radio ad.

There’s certainly some truth in this, but you should be doing your best to measure it. Ask customers where they’ve heard of you; give them discount codes that relate to particular adverts; if you’re big enough, create a new phone number, website or URL to monitor the success of that new TV ad. Organize your advert campaigns so different media over lap and measure the success of a campaign that includes multiple media types rather than a particular advert.

Measuring the effectiveness of your adverts is important because this will make your business more efficient. If your business is more efficient, your products can be cheaper, and if your products are cheaper you can be more competitive, put more money into efficient growth and be more resilient in a downturn (imagine your competitors indiscriminately cancelling TV, radio and web ads because they’re trying to save costs, while you know exactly what’s earnings accreditive and shouldn’t be cancelled).

No Financial Modelling

You see an opportunity to grow the business at the cost of raising capital from an external source. You could get an investor. You could get a bank loan. You could do nothing for a year and grow organically.

This decision is often made with feeling rather than with maths. For example, people don’t want to get more debt so they get an investor and lose a percentage of their business. Some people don’t want to lose a share in their business, so they do miss out on the growth.

Financial modelling is the best way to work out what course of action would result in the largest gain in the value of your share in the business. Financial modelling should be used throughout the business, including working out how a change (voluntary or otherwise) might effect the business.

As time goes by, I’ll add more articles about these subjects with more detail on each subject. Stay tuned.

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Business

If Your Business Isn’t Growing, It’s Shrinking

A friend said this to me a while ago and I thought that it’s such a great piece of wisdom that it’s worth sharing and unpacking:

If your business isn’t growing, it’s shrinking.

Upon hearing this, my first thought was the third option: the business can be neither growing nor shrinking, but stationary; but of course that’s where the wisdom in this simple sentence is. If your business is stagnant with no growth, you’re basically waiting for someone to disrupt the industry and take your market share.

The take-home comment on this is to think about how you can grow your business so it’s more resilient. Investigate horizontal and vertical growth to reduce the risk of relying on your core business and increase the agility of your business so you can respond to new threats. It also highlights the need to continue to invest in R&D to grow your market share and keep on top of the game.

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Business Investing

How To Do A Business Valuation

There are a number of different ways to value a business, and although there are a few recognized methods, business valuations are as much of an art than a science.

This article discusses the types of valuation available, when to use each type and links to other articles showing how to do each respective type of business valuation. By the end of this article you still won’t know how to do a business valuation because there are many significant subtleties that are unique to the business you are valuing, but you’ll have a good start from which to grow your knowledge.

Choosing The Right Type Of Valuation

The outcome of a valuation will depend on the type of valuation chosen, the values used in the valuation and the reason for the valuation. That’s why the first step in valuing a business is to choose an appropriate method of valuation.

The Football Field Approach

The Football Field approach isn’t really a type of valuation, more of a method of helping to choose a valuation type. Ironically, given that choosing the type of valuation is the first thing to do, a Football Field can only be done once you’ve done every other type of valuation available.

This isn’t my favorite way to choose what type of valuation to use, but it’s something that I do because it helps get your head around the valuation and give some sense of how the chosen valuation method fits in with alternative ways to value the business.

When I do a Football Field, I perform each type of valuation that can be done on the business thrice; once with a pessimistic view, once with an optimistic view, and once with a view of what the most likely outcome is. Then I place them all in a graph so I can see how each type of valuation compares.

You can then use this to see any commonalities between the different types of valuations and where the upper and lower values are.

Valuation Methods

Here follows a synopsis of various valuation methods, their appropriateness to different types of business and a link to a more in depth description of how to value a business using the respective method.

Discounted Cash Flow (DCF) Analysis

A DCF Analysis is primarily used by accountants to calculate the value of a business in terms of its total worth across a 5 year period. This valuation method is typically used when determining the monetary value of a business for the purpose of arbitration or contractual value. For example, it may be used to calculate the equivalent cash value of a shareholders stake in a company if that shareholder were to be subject to a Call or Put Option.

A DCF Analysis is less frequently used as a method to calculate the market value of a business because (while it may factor opportunity cost or depreciation of the value of money invested in the return in the business – AKA the “Discount”) it typically doesn’t consider a margin of profit for the buyer to entice a purchase.

That said, a DCF Valuation does provide the benefit of factoring in future growth of a company and therefore may be argued as a suitable way to value high growth companies; hence I use my own version of a DCF Analysis when valuing growth companies, which includes a margin of profit – a model that alters based on the exit strategy for the investment.

A DCF is probably the most complex method of performing a business valuation and is not relevant when profit is low compared to revenue (or if profit is negative), as there is value in such a company that is not apparent through the profit (such as goodwill, IP, etc.).

Here’s a Wikipedia article on how a DCF Valuation works.

Comparable Market Analysis

The Comparable Market Analysis (AKA Comparables Market / CM Valuation) involves finding historic sales prices of comparable businesses and using these to deduce what the business might be worth.

The Comparable method is typically used where there is a lot of sales data available in an open market – such as in a stock market or business broker.

The Comparable Market Analysis is heavily influenced by market sentiment and can result in wildly different valuations depending on when it’s done. This can lead to a Greater Fool scenario and also be subject to market manipulation. In the absence of these issues and a short investment time-frame, this is arguably one of the best valuation methods because it tells you what the business is worth at that time.

The problem I have with this type of analysis is that it doesn’t consider the return an investment can give you relative to the performance of the company in the absence of a sale or change in the market conditions, and it relies of the analysis of others.

Therefore, I posit that this type of valuation is most appropriate for stock market traders (but not stock market investors) and business brokers who have access to historic sales data and have some control over the market.

Discounted Dividend Model (DDM)

This is basically a DCF valuation based on dividend return instead of NPAT, which gives the perspective of value of a business based on the return to the investor in the absence of a sale. Truthfully I don’t use this method and don’t know much about it. There’s a really nice Wikipedia article on DDM if you’re interested to learn more.

I suppose this method could be useful for a retiree who wants to calculate Return On Investment (ROI).

Price-to-Earnings (PE) Ratio

The PE value of a company is calculated by dividing the Market Capitalization (MC) of the company by its earnings (Net Income – dividends). This can be done as a backward PE (where the last reported annual figures are used to calculate earnings) or a forward PE (in which the forecast earnings are used in the calculation).

More information on Price-to-Earnings ratios is available here.

Also, check out my own proprietary method for calculating PE.

Multiples Of Revenue

This is a common method of valuing businesses for sale by business brokers. It’s sort of a lazy method because it doesn’t attempt to calculate the value of a company in any depth. It doesn’t consider the effort required of the company to be profitable or the value of the assets that the company holds (though often business brokers will add the value of stock to this number). There are other methods of valuing a business that business brokers use, many of which consider a salary component for the owner, though these methods are beyond the scope of the type of investing I do; hence will not be discussed here.

The benefit of using multiples of revenue is that it does place some value on the company that is relative to its capacity to become profitable if that is not currently the case. Also the value of the goodwill, IP and other aspects could (lazily) be considered to be relative to the revenue of the company, which otherwise may not be recorded in the company’s profit.

This type of valuation is also often used when valuing companies whose customer base is on an Annual Recurring Revenue (ARR) pricing scheme.

I like this valuation method when based on multiples of ARR, but prefer to derive my own valuation method based on the component of a company’s ARR that has the capacity to be profitable (I blend elements of DCF in this method).

This is because I only want to invest in companies that are capable of being profitable so they can offer multiple exit opportunities (sale, Put Option, dividend return, etc.). Also, while theoretically a company could give a positive return on investment if the valuation is based on multiples of ARR, while the cost of growth is less than the multiple of ARR growth, this could lead to a Greater Fool scenario with no other exit than a sale.

Summary

There are a lot of methods to value a business, and I’m sure there are more than I have listed here, and after reading this you can probably appreciate why it’s important to chose a type of valuation that’s relevant to the purpose of your valuation.

Whether you’re valuing your business for sale, looking for investment or trying to decide what the business is worth so you can buy out a business partner at a fair price for all parties involved, there are many valuation methods to chose from. Though given the number of scenarios of requiring a business valuation and the variable nature of finding value in different businesses, there’s no single method for every case.

This is why I suggest that if you are an investor, you should come to your own conclusion about the method of valuations that you use, or make your own valuation methods as I have.

Addendum: An investor should also consider soft aspects of value in a business (such as IP or value in directors). An investor should also watch out for creative accounting and consider the reliability of forecast profit projections. There are a number of things to consider when valuing a business that are not discussed here, and they are learned with experience; hopefully this article sets you up with the basics to get started and my analysis of stocks on this website will help fill in the gaps and grow your knowledge on the subject of valuing businesses.