The last posting, we left off pretty light at equity, debt and capitalization. I think of these as the foundations of concepts that effectively shape the overall argument of return and finance as a whole. To continue on that thread…..:
Return on Equity
This is a concept that often confuses new business owners or individuals that have never dealt with finance before. Return ON equity is very different from return OF equity. Return OF equity is giving someone back the $100 they invested in you. Return ON equity is the percentage rate of return that they should earn given that they have invested their money in your business as opposed to having that money available for other purposes. For all you economics majors out there, it is is compensation major for opportunity costs (adjusted for risk – but this is a whole different lesson for a different time). So for every dollar someone invests, don’t be surprised if the request for what they get back is higher than $1.
So…. as far fetched as this may seem for non-finance people, money has an expiration date like food or milk. That is not to say that money goes bad or can no longer be used after a certain date, but money does in fact lose value over time. There are various factors that contribute to this with inflation being one of the major contributing factors. When an investor looks at the value of $1 as opposed to $1 a year from now, depending on different variables, that $1 a year from now is worth less than $1 today. Due to this fact, when calculating returns for investors this discount rate needs to be taken into account.
This is exactly what it sounds like, valuing your business. We see so many headlines everyday of start-ups and businesses going public or being acquired at hundreds of millions of dollars and you probably have wondered how this valuation came to be. The purpose of this post is not to tell you how this is calculated, but to give a general idea of some of the things that are probably large contributors:
- Yearly earnings generation – based on the nature of the start-up there are different earnings metrics that may be more useful benchmarks, but at the end of the day how much $$ does the start-up make?
- Potential earnings generation – for non cash flow positive businesses, the prospect of future revenue is a huge valuation driver (given that there is nothing current to go on).
- Industry competitors – other guys doing the same thing your doing in exactly the same way? probably not the best situation to drive up your valuation. This is when you ‘pivot’.
- Value of Data – a more elusive metric, but a huge driver in the internet age is the value of your data and what advertisers and the like can do this data.