If I Owned a Business...

STOCKS – really, it’s just owning a business with a bunch of people!

VALUE - the first thing we need to understand when owning any business. You will hear the term “intrinsic value” which basically means “true value”. In the world of business, intrinsic value is determined by a number of exercises.

The best way to explain it is by using something more relatable – owning your own business.

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You decide to start your own business making “widgets” to sell. I’m going to show this in steps using the basic “principles of Accounting” that states:

ASSETS = LIABILITIES + OWNERS EQUITY

Which means:

What you HAVE = what you OWE + what you OWN

Let’s start your business using $1,000 that you’ve saved up:

ASSETS ($1,000) = LIABILITIES (0) + OWNERS EQUITY ($1,000).

Since this is all cash, your value will be $1,000, right?

Next you will spend $500 on supplies to make your widgets:

ASSETS are still $1,000 but now $500 is cash and $500 is supplies so VALUE is still $1,000.

With the $500 in supplies you are able to make 50 widgets at a cost of $10 each (to keep things simple, we aren’t going to include any labor costs) and you sell them for $20 each.

Total sales are $1,000 which you add back into your account:

ASSETS ($1,500 – all cash as you used the supplies) = LIABILITIES (0) + OWNERS EQUITY ($1,500 – the $1,000 you started with plus the $500 you made on sales). As it turns out, widgets are VERY popular right now, the demand is high and you can sell them for $30 each. It makes sense to buy more supplies right? So you spend $1,000 to buy supplies to make 100 widgets. If they all sell at $30, your total sales will be $3,000 What is the value now?

ASSETS ($2,500 cash - $500 still in your account PLUS the $3,000 from sales LESS the $1,000 supplies you used) And there are still NO LIABILITIES and OWNERS EQUITY is now $2,500.

This is a business in it’s most simple form. But let’s pretend this is your business. The demand for widgets is high – it’s the Cabbage Patch doll of the 80’s; the Lightning McQueen Crocs of 2022; now would be a good time to go to the bank to borrow as much money as you can to make even more widgets. This won’t change the value of your company at the time, as the extra cash in your account will be owed to the bank; but it will increase the value once those widgets are made and sold and the profit goes into the account.

Let’s fast forward to see what can happen:

Scenario #1

Widgets are still very popular; demand is very high. You can continue to grow your business by using your own money and bank loans and the value will continue to increase. If you decide to sell your business, the price may be higher than the value as the projected future sales are positive; its very likely that someone will pay more than the intrinsic value for this business.

Scenario #2

Something more popular has come into the marketplace or competitors have started making widgets and selling them cheaper or the price of supplies has sky rocketed or widgets aren’t as popular as they were or a number of other things that may happen and have a negative impact of widget sales – now what? If you decide to sell at this point, what do you think will happen? The value is exactly the same as in Scenario #1, but the unknown growth and future sales will likely drive the price down from its value.

CONCLUSION:

VALUE is what a company is worth; PRICE is what someone will pay for it.

How does this relate to stocks? More on that next week.