I think we can all agree that Warren Buffett, the CEO of Berkshire Hathaway and one of the richest men in the world, knows at least something about building and running businesses. After all, he’s not called the Oracle of Omaha for nothing when it comes to investing in companies, so if you’re able to build a business that attracts his attention, you’re probably – and we mean that in the most understated way – on to something. In the book “Building a Small Business that Warren Buffett Would Love“, author Adam Brownlee puts together some advice for small business owners on how to structure their companies with fundamentals that would impress that notable investor and philanthropist.
Sure, Buffett is most certainly only interested in big companies, but the fundamentals remain the same. Brownlee distills and identifies the common principles behind the many companies in the Berkshire Hathaway portfolio and presents them in the form of a road map that small business owners can follow in building their businesses. According to Brownlee, there are seven values that determine an ideal business:
1. A Consumer Monopoly.
Is your company in the business of providing a product or service that is a veritable staple in the lives of your consumers? If you can build a consumer monopoly that is also a “toll bridge” – or the only available option in town – you’re almost guaranteed that consumers will spend well and often enough to sustain and grow your business.
2. With a Strong Track Record of Earnings.
For a business to be successful, it must have strong, consistent and growing earnings over the long term. Here’s where learning to read a company’s income statement becomes useful – because that’s where a company’s track record is. An existing business or a franchise business will have that track record in place, while a startup is likely to have to develop and project earnings.
3. A Healthy Return on Equity.
A business is first and foremost an investment, and a healthy return on equity is simply the measure of how hard that equity is working for you. A business with strong fundamentals is one that delivers a strong return on equity – creating a healthy level of income with the least amount of equity possible.
4. The Ability to Retain Earnings.
The problem with many small businesses is that they tend to have a low ability to retain earnings i.e. income is often taken out of the business by the owner, and thus not reinvested into the company. If a business cannot retain its earnings, it loses the power of compounding, and growth is stymied.
5. Possessing Low Debt Levels.
We’ve heard the debate on the subject of good and bad debt, but the importance is really down to the ability of earnings to pay off its debt. Warren Buffett, Brownlee points out, is of the opinion that a business should be able to pay off its long term debt in one or two years straight out of its earnings.
6. And the Ability to Increase Prices with Inflation.
Inflation can kill businesses, especially those that cannot increase prices (or worse, keep its prices up). A business that is able to keep up with inflation while maintaining or buying back shares will be able to increase its earnings per share. Here’s where commodity businesses are at a disadvantage, especially it has to engage in price competition just to retain customers.
7. With Healthy Net and Gross Margins.
And of course, a business that is able to generate good net and gross margins shows earning power. And if it so happens that the business consistently posts strong net and gross margins that outperforms industry and global industry averages, that’s a business Warren Buffett can fall in love with.
Much of what’s in “Building a Small Business that Warren Buffett Would Love” sound like investment advice, because it really is. But it’s also useful for small business owners to understand such business fundamentals so they know how to build and grow their companies. Aside from the many income statements Brownlee uses plenty of simplified examples – many of which revolves around the running of a hamburger stand – to help readers understand issues such as debt, margins, return on equity, amongst others.
Ultimately, “Building a Small Business that Warren Buffett Would Love” doesn’t tell you how to run your business; what it does tell you is how well you have to run your business. If there’s nothing else that you can take away from the book, hey, we reckon you’ll at least learn how to run a hamburger stand.