My mom used to tell me stories of these boy geniuses who figured out the secret of stock market, and made millions of dollars playing the stock market. So right out of college in my early 20’s, I tried to learn “investing”. I read books on day trading, talked to my friends on Wall Street, and watched CNBC religiously. I lost thousands of dollars, which felt like millions back then. Worst of all, I still had no idea what truly makes a company great.
Maybe I am just not a good investor, I thought. I couldn’t make sense out of all the ratios and financials. I just couldn’t connect the dots.
Fast forward a few years, I started my first company with Erik. Turns out, running and growing a business from the ground up is the best education on learning what makes a company great — duh, silly me.
“I am a better investor because I am a businessman, and a better businessman because I am an investor.”
— Warren Buffet
I am telling you this story because like me, a lot of entrepreneurs still haven’t connected the dots. In the early 2000’s, the media praise the success of web startups based on monthly unique visitors and total registered users. But suddenly one day, they became vanity metrics. The focus then turned towards revenue growth which led to the unicorn boom. Then Fidelity writes down majority of their unicorn investments which led to the overarching question: how do you measure the value of a company?
The answer is free cash flow.
Why is this so important to understand? I’ve seen too many great entrepreneurs pay little attention to their company’s finances. Yes — engagement metrics, growth metrics, unit economics, sales funnels are all important. But, how do they impact the value of your company? You must connect the dots.
“Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.”
Now, let’s translate that to plain English.
Free cash flow is the amount of money a company has left over after it pays its bills. It’s what’s left over of the money the business has actually collected when it’s paid out all of its expenses. To calculate free cash flow, add up everything that comes in. Subtract everything that goes out. Free cash is what’s left over.
The value, or the worth of your company, is essentially how much cash the company has on hand + the company’s assets (intellectual property, real estate, etc.). Your valuation is the market’s belief in your ability to increase the company’s assets. So how do you grow your assets?
You can increase your company’s assets by investing the left over free cash. You can build a new product, you can acquire another company, you can buy back stocks, etc. This is the money you can use to make more money for the company — and a business exists to make money.
Hence, the greater the company’s ability to generate free cash, the higher its valuation.
With that in mind, every business decision you make, think about how it helps you increase free cash flow in the future. Whether it’s raising the next round of funding, or hiring a sales force, or building a product feature — does this decision help you increase free cash flow down the road?
p.s. It’s important to note that free cash flow and profit are not the same. A business can go bankrupt even if it’s profitable. I will explain this in another post.
