7 Ways To Measure Business Value | Ep 702

This episode of "The Game w/ Alex Hormozi" delves into understanding and accurately measuring business value, countering common misconceptions and inflated metrics often encountered.

1. Contract Value Misrepresentations: Many businesses inflate their worth by extrapolating short-term contracts.
2. Lifetime Revenue Overestimations: Total revenue figures over the business's lifetime can be misleading without context.
3. Business Valuation Nuances: Market-based valuations can vary greatly, and understanding the underlying metrics is crucial.
4. EBITDA and Profit Insights: Knowing the difference and significance of EBITDA versus actual profit is vital for accurate business valuation.
5. Net Free Cash Flow as a Key Indicator: This metric is crucial for understanding the real economic benefit a business generates.

1: Introduction to Business Valuations

Alex introduces the topic and sets the stage for a detailed discussion on business valuation metrics. Alex Hormozi: "Business is risky, and understanding true value is essential for success."

2: Misleading Metrics and Realities

Exploration of common misleading metrics like contract value and lifetime revenue. Alex Hormozi: "These metrics often do not reflect the true financial health of a business."

3: Practical Valuation Techniques

Discussion on practical metrics like EBITDA and net free cash flow. Alex Hormozi: "Understanding these metrics can significantly impact investment and business decisions."

1. Verify Contract Terms: Always check the actual cash received versus contracted amounts.
2. Assess Revenue Context: When evaluating a business, consider the timeframe over which revenue is reported.
3. Understand Valuation Metrics: Learn the difference between top-line revenue and actual profit.
4. Focus on Cash Flow: Prioritize metrics that reflect true cash generation like net free cash flow.
5. Consider Owner Earnings: Evaluate what the business owner is actually able to take home as a measure of success.

“You can bet on yourself, but there are so many more stories of guys who bet everything on themselves at the casino and walked away empty handed.” Today, Alex (@AlexHormozi) shares the key aspects of business valuation, debunking common misconceptions and highlighting seven critical metrics: contract value, lifetime revenue, business valuation, yearly revenue, profit or EBITDA, net free cash flow, and personal net worth. At the end, he ranks which of the metrics are best to use and why you should not be looking at the others to determine the value of a business.

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.

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Alex Hormozi
A lot of times you're not going to sell. A lot of times, businesses fail. There are tons of risks. That's why business is one of the riskiest things to get into. Most businesses do not succeed.

That's just, those are just the stats, right? And 99 times out of 100, business never actually sells.

The wealthiest people in the world see business as a game. This podcast, the game, is my attempt at documenting the lessons I've learned on my way to building acquisition.com into a billion dollar portfolio. My hope is that you use the lessons to grow your business and maybe someday soon, partner with us to get to $100 million and beyond. I hope you share and enjoy.

I'm going to show you seven ways to measure business value and how you're probably being deceived by most people you see on the Internet simply because you're not understanding the words and terms they're using. All right? So by the end of it, you'll understand who's b's, who's legit, who's real, who's fake. And if they haven't given you enough information to make the decision, exactly what questions to ask. All right, so let's dive in.

So, the first of the seven types of ways that people will measure value is that they will extrapolate a single month of contract value into eternity, or at least over a year. And so, for example, what that looks like is someone, you know, selling a yearly contract at an event. They sell 100 people at that event, let's say for $30,000 a year, right? And they say we're doing $3 million a month. Wow.

Right? Crazy. But the reality is they sold $3 million of contracts that are unenforceable to people on monthly income streams are monthly cash flow. And so 100 people at $2,500 a month is what will get you to that $30,000, right? Roughly.

And so if you were, what it really means is they did $250,000 at that event, but they said, I'm doing $3 million a month. Right. Even though it was a one time event that is not going to recur. And they based it on contract value and not payments collected. And so the first way to see through this stuff is to say, well, how much money was actually collected and how reliable are the contracts that you're actually selling?

If you have highly secured contracts with companies that are legit, or you have them secured against assets, meaning that the likelihood that they continue is high or you have a net negative churn company, meaning the contract increases in value, over time. Based on the business economics that you have, like Salesforce, for example, when you sign a contract with Salesforce or you signed a contract with HubSpot, which is another CRM, most of those clients increase how much they spend over time. And so that would be legit in that instance. But the vast majority of people who are saying this to you are not being legit. And so first thing to look out for at the very end, I'll give you my rating for each of these ways of doing it.

All right? The second is lifetime revenue. So this is when someone says, you know, we've done x amount of total revenue collected in our business. Now, a lot of times we'll say, I have a, I mean, I see an ad right now that I run all the time. It's like how I built a $50 million business, but they mean how much revenue they've collected over the lifetime of the business.

Alex Hormozi
And so for context of how ridiculously inflated this will be, a McDonald's employee will collect a million dollars in revenue as income. Honestly, that's even better because it's income, it's not even revenue. But like, just to show you how ridiculous and preposterous this is, a McDonald's employee will collect that over the entire lifespan. If you worked at McDonald's your whole life, right? And so if you use this metric, then it's incredibly inflating and it's great for ego and it sounds good to impress people who don't know what you're talking about.

Okay? And so you may have seen one of my videos that said 122 million in revenue for me. And I do that a because the headline is more compelling than saying, you know, we've done mid thirties for the last three or four years. But, and I, you know, I'll play the game too. But understanding what that comes from, and so that's why I try and be as honest as possible, is like, well, this is what we did in revenue.

This is what we did in profit, so that I can just be transparent with everybody so you know at least what to look for. And so when someone says we have a $50 million business or $100 million business, ask them, are you talking about yearly revenue? Are you talking about profit? Like, what are you talking about specifically when you say that number? And a lot of times people are like, well, I meant, I guess that's how much total revenue we've done since we started.

Now mind you, most entrepreneurs, especially newer entrepreneurs, will conflate or they will mix revenue with cash collected. Those are two very different things. Revenue is contract value, but cash collected is really reality. And so they'll use this term, and for the purposes of this, when I say revenue, I mean cash collected, what was processed and received by the business. So the second way that people describe their value is how much total revenue they've done over a lifetime.

So you may actually have seen, you can see this at work I got for doing 100 million or passing $100 million in total revenue in three years, three and a half years, I think, since we started with Clickfunnels, which is software that we use for landing pages, and they recognize that people were top performers. But again, that's revenue. It doesn't mean. It means cash collected, but that doesn't mean that we're doing that per year. Now, this year is a breakout year.

And I'll tell you what we do at the end of this year, because we will be close to that number. I don't think we'll cross 100 million this year, but we'll be really close. So anyways, number three is business valuation. So this one is one where it's based on the market's value of the business if it were sold. So this is another way of kind of inflating the business that you have.

Now, this isn't necessarily an unfair way of valuing a business, right, based on its own value. But the thing is, is it all depends on who's the one who's ascribing the value. What are they, what are they using to create that value? I hear all the time, like, I think I'd be able to get 15 times top line. You don't know squat, right?

The market will pay what the market will pay, all right? And so for most businesses that are small businesses. So anything that's under $5 million a year in revenue, most of those guys are getting two to three times EBITDA, which is another measurement I'm gonna get to in a second, which is the earnings before interest, tax amortization and depreciation. Right. And so those are business metrics that is going to have a multiple ascribed to it.

So if you're a mid market, which would be like ten to $100 million in revenue per year, then you might have a six to eight times multiple. If you get above $100 million, then a lot of times you can get into the twelve s cetera. And most of the time that's done on EBITDA in a very, very, very rare number of circumstances, will they do it on top line revenue. All right? And that is in a fast growth company that has high amounts of capital that need to be reinvested in it, that they believe are going to give it a strategic advantage for high gross profits in the future that they're reinvesting capital into.

All right. And so that is where I saw somebody recently saying that they had, you know, they sold their business for 100 times EBITDA. Right. What that really means is that, like, and this is where, this is what I want everybody to be thinking, well, either they had a really, really crazy business, or more likely, they were making almost no profit in their business and just got a high valuation because of, or not even necessarily a high valuation. If they, if they're doing, you know, $10,000 a year in profit on a $5 million business, then if they sell for $5 million, they get 500 times EBITDA, which is ridiculous.

Right. But people do that because it sounds impressive. Right? So that's why we're going through this. So you can cut through the b's and hopefully get better sources of information, which is kind of my goal here, is that you can measure, you can measure other entrepreneurs value based on the true value that they've been providing.

Alex Hormozi
All right, so the next one here is yearly revenue. All right, so this is how much revenue a business is doing yearly. Now, we're getting a little bit closer to reality here. Now, again, revenue versus cash collected, it depends on the type of business. If you have a service business that's based on recurring revenue and contracts, then you're going to have contracts that are factor into that.

If you had an e commerce business, for example, which is purely transactional, then the revenue and cash collection are going to be very close to each other. Right. And so, and revenue would also not take into account refunds, chargebacks, things like that, which then gets into net revenue. I won't get into it. There's a zillion terms.

And just as a side note here, the reason there are so many terms is because measuring value is something that is one of the hardest aspects of investing in business in general, is that people want to figure out what is this thing worth? And so that's why they have lots of different metrics that they look at. And so for you, as a keen entrepreneur or investor or person who wants to grow within the business world, understanding all of these metrics and how they work together to assess or get as close to true value as possible are, these are going to be tools in your skillset. And some of these are better and some of these are worse. And I'll get to my ratings in a second.

All right, so yearly revenue is the next, which is just how much are you doing every year in terms of top line right now? The next one is profit or EBItda. Now, these two things are not necessarily the same, but I'm going to say EBITDA being earnings before interest, tax, depreciation, and amortization. Right. For most businesses, this is where coming back to the business valuation, if you're mid market, you're getting six to eight.

If you're kind of smaller, then you're at two to three, sometimes four if you're doing really well or you have some sort of competitive advantage. And so, again, that may sound soft to you in terms of those numbers, but the reality is that a lot of people just look at the outliers, which catch all the news in the press. But most businesses, businesses are sold every day at one x two x three x EBITDA all the time. Just no one wants to talk about it. This is even closer to reality.

If I'm looking at a business owner or somebody's trying to posture with me, the eggplant measuring contest of entrepreneurship, if they're starting to talk to me about these numbers, I'm like, hey, bro, what are we doing bottom line? What are we doing bottom line per year? This is what I want to know. Right. Real quick wise, you guys already know that I don't run any ads on this, and I don't sell anything.

And so the only ask that I can ever have of you guys is that you help me spread the word so we can help more entrepreneurs make more money, feed their families, make better products, and have better experiences for their employees and customers. And the only way we do that is if you can rate and review and share this podcast. So the single thing that I asked you to do is you can just leave, review. It'll take you 10 seconds or one type of thumb. It would mean the absolute world to me.

And more importantly, it may change the world with someone else. And so that leads me naturally to the next one, which is, okay, well, you've got a certain amount of EBITDa that's coming up. But depending on your type of business, you might have to reallocate all that money back into the business to just maintain your competitive advantage, which Charlie Munger, Warren Buffett, they talk about how their least favorite type of businesses are businesses that require lots of additional capital right now, as they've become gazillionaires, they have to find businesses like that because they have to put their capital to work. But the thing that created their wealth was finding businesses that did not require a lot of additional capital. That created lots of, survey says, net free cash flow.

So how much owner earnings, how much can you extract from the business? All right, that's what this NFCF here is, net free cash flow, right? And I've talked about this, but this is after I've reinvested profits in the business to maintain and grow our competitive advantage. How much can I, as the owner, take out? The reason this is so important is because a lot of times you're not going to sell.

A lot of times businesses fail. There are tons of risks. That's why business is one of the riskiest things to get into. Most businesses do not succeed. Those are just the stats, right?

And 99 times out of 100, your business never actually sells. You might do an asset sale or a garage sale, but doesn't actually sell for what you think it is. Which is why for me as an entrepreneur, you want to de risk by extracting cash flow. And many times this is one of the values of the business. And so if I'm talking to an entrepreneur and they tell me this, then I'm going to probably ask, well, what are you taking home in owner earnings?

What are you extracting from the business? What are you taking out as dividends? Because I want to know what's reality, right? And that leads me to the last and the bottom one here. And then I'll give you my ratings on these, which is what's your net worth, right?

This is what entrepreneurs, you know, everyone's shying away from talking about. A lot of guys that you see on your newsfeed, those guys message me and say, hey, man, I want to do x, Y and z. I want to start investing, et cetera. And they've got half a million dollars to their name and they talk about how they've done $10 million in revenue, right? Right.

Lifetime. And so again, you could just, I'll give you a funny example for you. So if someone says, hey, we've done a million dollars in revenue, look at our award, right? That's over a total lifetime, right? That could be over ten years.

So if you did a million dollars revenue over ten years, it means you're doing $100,000 a year in revenue, right? And if you're doing 50% margins on that, right, that's a $50,000 a year owner income business, which is just the median income in the United States. And there's nothing wrong with that. But in terms of taking this person as an authority, I would be hesitant to take their advice because candidly, they're probably just spending what they're making on living. Because if that's how they're trying to position, just take that with a grain of salt, you know what I mean?

And the reason I'm going through this is because the best thing you can do is learn from others. But to make sure that you're actually learning from others, learning from people who are good information sources is important. And there's tons of people who know way more about business. But I just try to share the stuff that has worked well for us in creating, you know, for me, an ultra high net worth, which is over 30 million. And there's two aspects of net worth, all right?

You have your net worth that comes from your investable assets, which is what you've extracted, right? We've extracted, paid your taxes on and then been able to reinvest and grow. And the second is the percentage of the businesses that you own. Business or businesses that you own, all right? Which is why having a fair and reasonable valuation is important, because what's the true market value of the business that you have?

Now, if someone says, like, my business does like $10 million a year and they do $2 million of EBITDA, right, $2 million a year, and they're getting a five times multiple on that because it's truly a business and doesn't require their face. If it requires their face, then they're not going to get that multiple. So it's important to understand these variables that create and measure value in a business. Because if you're looking for people and you're trying to listen to advice, then make sure you're getting it from the sources that are true and real. Again, two different ways that combine to create net worth is going to be your after tax wealth that you've extracted from the business and be able to reinvest on the side and grow on your own and the percentages of the businesses that you own and the value around them.

All right, so let's get to the good part, which is yay or nay? Is this something that I'd be looking at in terms of whether I'm going to value this person's opinion based on this stat alone survey says contract value? No, I would not do that. And that is because this can be wildly inflated, especially if you extrapolate on one month's contract value for the rest of the year. It can be wildly inflated.

All right, so number two, lifetime revenue survey says, no, I would not use this as a way of measuring how good someone is at business because you want to know how long was that? Over 20 years. Was it over 40 years? Because that's what a McDonald's employee can earn over that amount of time. All right?

So don't be impressed by this number. Ask more questions, which you should hopefully do as we go down this. All right. Business valuation survey says yes, but caveat on this. You want to know what kind of multiple are you assuming and what is that off of, top line or bottom line?

And why can you defend that? Right? So this is asking good questions so that you can actually get closer to true value, which is why all these Metrics even exist to begin with, is so that people can ascribe and measure value. All right, next one. Yearly revenue survey says a partial answer because it goes with number five, which is yearly profit.

All right, the difference here, if someone's doing $100 million a year in top line revenue and they're spitting out just a little bit of profit, that may be okay, right? If you're doing $500,000 a year in profit. I knew a company that was doing 20 million a year in profIt, doing 500,000. SOrrY, 20 million in revenue, $500,000 a year in profit, and they got sold for 168 million. Right.

Now, that's a super valuable business, and it's because the bankers and the people who bought it saw that they had reinvested everything. Right. Into growing the business. Right. And so understanding the relationship between these two things, if I have another business that's doing $500,000 a year and a million dollars a year in top line revenue, then it's going to be a far less valuable business.

So understanding that they might be making some strategic decisions about how they're reinvesting the business, et cetera, or some capital costs that might have cost them, but they see what it's going to yield them in the future, etcetera. All right? Now, this is especially true with software businesses, FYI. All right, which that particular business was a software business. Next one.

Survey says yes, on net free cash flow. This is Uncle Warren, this is Uncle Charlie Munger. This is their primary metric for measuring business. They try and figure out what is the net free cash flow after I reinvest everything. This is an excellent way, excellent way to figure out the value of the business, because if you can do your net free cash flow and then you multiply it, then you're going to get very close to what an investor might be willing to pay for the asset, excluding some sort of crazy monopoly thing that they're trying to get with some sort of category king situation in a marketplace.

All right? And then finally, net worth. How do we see this on the valuing of an entrepreneur's eggplant? Right? Survey says, yes, I think this is an excellent measure of value because this is what is left after all the chips.

Alex Hormozi
All the chips have fallen, all the cookies have crumbled, all the roosters have roosted. This is what's left after everything, right? Because if you, you know, if you like, I've had 13 businesses and I now own eight more. So I've had 21 businesses, right? So I've had a lot of these things.

And the thing that remains is you, your net worth as an entrepreneur. And if you look at the Inc 500, sorry, the Fortune 500, and you look at it 50 years ago, what you'll see is that there's only two businesses that are still on the Fortune 500 from now from 50 years ago. GE and Ford. That's it. That's it.

Right? And so when you think about that, a lot of times what business becomes is you create something. And then as an entrepreneur, you want to be able to create enough personal wealth throughout the trajectory of the business. That's like, literally all businesses, Fortune 500, and only two of them, right, are still there. And so thinking about that, that should hopefully shift your perspective, which is why I'm so big on extracting dividends while the business is growing.

Alex Hormozi
And I know that that might not be as popular in the Silicon Valley world, but a lot of those guys don't live in reality. And for the everyday business owners, everyday entrepreneurs that are hustling out there, trying to make a buck, trying to feed their families, it's important to de risk because you can't put all your eggs in the single basket. That is my opinion. Sure, you can bet on yourself, but there are so many more stories of guys who bet everything on themselves at the casino and walked away empty handed. All right?

And so it is my belief that if you were generating a profit, you should be purposely taking some out every month, even though the, like, for me, the vast majority of my net worth is in my business valuations still, I still have, you know, over whatever, a lot in, in investable assets. Um, that categorizes me as ultra high net worth. All right? And so, again, ultra net worth, just so you know, from the definition standpoint, is investable assets. It's not based on total value.

All right? And so these are the seven ways that I wanted to highlight for measuring value. If you see someone and they say, I am worth this, or my business is worth this, or I built an x million dollar business, ask these questions. Is that lifetime revenue? Is that contract value that's been extrapolated?

Alex Hormozi
Is that your business valuation? Based on what multiple? Is that based on a top line multiple? Or is that based on a bottom line multiple? What's the net free cash flow?

What are you taking out as dividends every year? And then finally, if someone will share it with you, which I'm actually not that opposed to sharing net worth numbers. I know some people are. I don't really know why. I figure if you make enough money, over time, people will always end up finding out what your net worth is, which is basically the entire Forbes list.

And so, anyways, these are the ways that you measure value. These are my two second snap judgments on them. And if you have your astute cap on, then you probably figured out that a lot of these things go together, right? And it's not just one number. It's understanding the interplay between them so that you can ascertain what the true value of a business and or the entrepreneur that owns it is.