Improve Your Financial Literacy by Understanding Business Valuation

Robert Kiyosaki, international bestselling author of Rich Dad, Poor Dad, has been stressing the importance of financial education and improving one’s financial literacy for decades. In his Yahoo Finance article “Paying the High Price for Bad Advice”, Kiyosaki talks about the high price people pay when they are low on financial literacy and can’t tell the difference between good financial advice and bad financial advice. According to Kiyosaki, the best financial investment one can make is not stocks, real estate, gold, or businesses. If you lack financial education, which is not taught in schools, you will likely lose money no matter what you invest in. Therefore, the best investment beginning investors can make is an investment in their own financial education.

The words of Kiyosaki are resonated by Cameron Herald in his passionate TED talk “Let’s Raise Kids to Be Entrepreneurs”. Not everyone has the temperament or desire to be an entrepreneur, but there are lots of kids who do not excel in the traditional academic environment who would find the idea of running a business exciting and engaging. In his TED talk, Herald shares a number of ideas that will help foster financial literacy in kids.

While Herald emphasizes the importance of fostering financial literacy in kids and Kiyosaki stresses the importance of financial literacy in adults, their messages are the same. Financial literacy is a subject that is missing in schools, and millions of Americans make poor financial choices everyday. If we want to live in a prosperous country with a strong economy, improving everyone’s financial education needs to be a priority.

While there are many topics to be learned and discussed under the general umbrella of financial education, one tends to be overlooked – the topic of how to value a business. How many business owners can tell you how much their business is truly worth? How many investors have the ability to analyze a company and tell you with confidence the value of the company? Business valuation may not seem like a topic that is of the highest priority, but learning the principles of business valuation will lead people to make smarter investment decisions. Think of it this way. If you know how to value a small business, you will make better financial choices in all of your life even if you never manage to buy a business.

The valuation process of a small business is not complicated. First, you start by looking at the company’s profit and loss statement. Right off the bat, this is a habit all smart investors get into. How many stocks have you purchased where you actually looked at the company’s profit and loss statement? If you are like most people, you probably bought the stock based on its current stock price rather than the company’s value, which can only be obtained by studying its financial statements. As illustrated by Rob Berger in his Forbes article, Warren Buffet focuses on the value of the company rather than the price of the stock.

The next principle in small business valuation is understanding how the company’s profits and the sale price of the company are correlated. The higher the profit, the higher the sale price. If the company doesn’t make any money, it isn’t worth much. Why is this principle important? Well, it is important because it forces the investor to justify the purchase price. How many times have you purchased an investment without taking into consideration how much income it will generate for you? Everyday, people buy what they think are “investments” that don’t generate any income whatsoever. Maybe it’s a car, or maybe it’s a house. They may hope the value will go up over time, but the value could very well go down. Financially savvy investors do not buy investments based on the hope that the value will increase over time. They want to know how much cash flow the investment will generate today, and calculate a purchase price based on a multiple of the cash flow. The business valuation process used for valuing small businesses is a perfect mechanism to teach people not only how to value a business, but also how they should think about all types of investment opportunities.

Last but not least, learning about business valuation encourages people to take control of their financial destiny. When you put your money into a stock or mutual fund, you are essentially giving up control of your money to some company’s CEO or fund manager. You have no idea what really goes on in the company, or how the fund manager is really managing your money. Most mutual funds charge a fund management fee and the fund managers get paid very well regardless of whether or not they make or lose money for their investors. On the other hand, learning about business valuation implies that you are looking at buying a business. When you buy a small business, you become an entrepreneur. You are in charge of the business operations, and whether the business makes or loses money is up to you. You are empowered to take control of your financial destiny. You are no longer hoping your stocks to go up in price. If you want to increase the value of your business, you know exactly what to do – you need to increase the profitability of your business. And there is only one person who can do that, which is you. What an empowering mindset! Even if you never buy a business, learning about business valuation will empower you to make better financial choices and investment decisions in all areas of your life.

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