Private Equity Masterclass: How Billionaires Buy Companies 50% Cheaper Than Everyone Else

"RAISE CAPITAL LIKE A LEGEND: https://go.fundraisecapital.co"

In this first installment of the Making Billions Academy, host Ryan Miller teaches a powerful financial concept used by private equity pros to instantly assess deals: Tobin's Q. 

This ratio compares a company's market value to its replacement cost, helping investors determine if a business is overvalued or undervalued. You'll learn the simple formula, see practical examples, and discover how this timeless logic can help you avoid overpaying for assets.

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[THE HOST]: Ryan Miller is an Angel investor, former VP of Finance, CFO of an insurance company, and the founder of Fund Raise Capital,  https://www.fundraisecapital.co where his strategies helped emerging fund managers and deal syndicators to report raising over $1B following his strategies.

Transcript

Ryan Miller  

My name is Ryan Miller, and for the past 15 years, I've helped hundreds of people to raise millions of dollars for their funds and for their startups. If you're serious about raising money, launching your business or taking your life to the next level, this show will give you the answers so that you too can enjoy your pursuit of Making Billions. Let's get into it. 

Ryan Miller  

Just because you're paying a premium doesn't mean it's bad deal, doesn't mean it's a good deal. It just means you probably need to do more homework, same with undervalued. Is it undervalued because we're gonna catch a falling knife. Nobody wants to do that,  either way, you're just saying it's undervalued. It's overvalued, how bad do you want to dive into this thing? 

Ryan Miller  

This is the first installment of Making Billions Academy or MBA, for short. I'll be coming on and teaching financial concepts around investment funds, syndicating deals, portfolio management, private equity, venture capital, raising capital and much more. This episode has me illustrating a financial concept designed to help you find context to the prices you pay for shares, be it public or private. So if you want to see the diagrams, just head over to YouTube and search Making Billions podcast and search for Tobin's Q, as in the letter Q. So without further ado, I give you the first Making Billions Academy. Here we go. 

Ryan Miller  

Most investors overpay for businesses, but private equity pros, they use a simple ratio called Tobin's Q to instantly know if they're buying at a discount, or if they're about to get burnt. So today I'm going to show you what it is, where it came from, and how to use it to win deals better than before. So let's talk about where it came from. Tobin's Q was developed in 1969 by a Nobel Prize winning economist James Tobin. His insight was, in an efficient market, the market value of a company should roughly equal its replacement cost of its assets. So if Q was low, companies were cheap to buy relative to the rebuild cost, smart money would acquire instead of build. And if Q was high, companies were considered expensive, and investors would only pay up if there was strong competitive notes. 

Ryan Miller  

See, this wasn't just theory, economists used it to track entire markets, like when the US market traded at Q ratios near one in the 1970s that was considered cheap. But eventually hit two and above in the.com bubble, which was considered overvalued on a price basis. See legendary investors like Warren Buffett have learned on similar logic, buy assets below the intrinsic or replacement costs and private equity roll up shops, they do the same they use the same logic every day to avoid overpaying. So we're going to cover that, so let me explain Tobin's Q, it's real simple. So on there we have Tobin's Q, which is effectively just Q equals enterprise value divided by replacement costs, pretty simple, right? So we're just trying to, effectively trying to figure out, can I build this company or the assets that give it value? Can I build it for cheaper than I could just buy the whole company for or could I buy the whole company cheaper than I could build it? That's all we're really trying to answer, that's it's that simple. And so when you have Q, meaning the the ratio between the value of the company and the replacement costs. We're just trying to get a sense of should I walk away, so this is a tool to shortlist, right? So so that there's really three levels to consider. The first one is, if Q is less than one, then it would can be considered undervalued. And if it is equal to one, it's considered kind of a fair market value, or the price you pay is actually what it's worth. So you would pay, well, the same price it would cost you to replace everything. And then obviously, number three, if you haven't figured it out, as if Q is greater than one, it means you're paying a premium and if you're paying a premium, then you need other rationalization. 

Ryan Miller  

So it's not necessarily walk away, but it is a way to dive in and say, do we really want this, if we really do, is that premium worth it? Let's dive into other strategic assets, or other things that they may have, like special long term contracts or some type of competitive moat, you can do a lot of those things on building these out and really getting the price to justify it. So let's, let's drive that home with an analogy, you can think about it in three ways, right? So let's say you're buying a used car. Just an easy analogy, you could buy it for 20k when the new costs are 30k effectively that would mean Q is less than one, and that would be considered undervalued, right, it's a good deal. Another one is real estate, you buy a building for 10 million, but the rebuild costs are about 12 million. So that gives you an advantage. And let's say, in business you want to buy, say, an HVAC company for 3 million bucks when the rebuild costs are 4 million. Guess what, you're ahead, that's all this is telling you to do. 

Ryan Miller  

So now I'm going to make this real easy for you to figure this out, just so you have another tool in your mental toolbox to identify companies that may be a good fit for you or for your portfolio, so let's dive in. When we go to calculate enterprise value, it's effectively this. Is how we calculate it, okay? So we want to do the equity purchase price, equity purchase price, plus the debt, minus the cash, right? This is what I call napkin math, right, you could sit at a pub with some investors or someone. You're just jotting, it's not that sophisticated. Definitely don't make any investments just off this alone. But it's just something to say, what are we what are we dealing with? Real quick, is there a quick way that we can really just start to understand this? Okay, once you get this number, that's the true cost to acquire. So let's calculate enterprise value. So enterprise value, as we've already established, is essentially the purchase price plus the debt minus the cash. Okay, so in an example to figure out the true cost to acquire let's say you pay the equity purchase price is, let's say 4 million bucks, okay, it can be whatever. And let's say they got a million dollars of debt on their balance sheet, so 1 million and let's say they have some cash of about 200k. Okay, so effectively, pretty simple third grade math, now we can extrapolate that we have a enterprise value of about $4.8 million. Okay, so we got a purchase price, we got that locked in.

Ryan Miller  

The next part is effectively the replacement cost, so this is where we're going to compare these two. So on replacement cost, it's a little bit trickier, but not tricky at all. So here's, here's what replacement cost, how to calculate that. So effectively, it's just your adjusted PP&E, or property, plant and equipment. This is considered your long term assets that give value to your company. So adjusted property, plant and equipment, plus networking capital, which is effectively just the capital used to pay the bills and make payroll and everything that's in the business, plus any reproducible intangibles, okay, so intangibles, okay. So with that formula, we can back into roughly just a loose estimate on what the replacement cost is all on the long term assets. So one of the property, plant and equipment that's that's already displayed, and so we want to figure out what is that today. And so the best practice to do that is you want to adjust historical costs by inflation or by vendor quotes, those are those tend to help, right? So inflation is a little bit of an estimate, but vendor quotes will say, yeah, if you pay me, this is what you get, so those tend to be better. So little bit of groundwork, but figuring out what is replacement cost of, you know, these generators or this factory floor or these CNC machines, whatever it is that you're doing, you're saying, I need to understand your long term assets, and what's that value so? So let's give an example. So a million dollar machine bought, say, 10 years ago, may show a current price at $400,000 book value, and that's after depreciation, but today it costs 1.2 million to replace. So that's where the vendor quote comes in. So one of the shortcuts that some people use is when historical cost isn't available, sometimes it's not many PE folks will apply the book value times 1.2 to 1.5 okay. So you can do the book value, which is historical cost minus accumulated depreciation, and so you can effectively back into it as an estimate, and you can say, if I just do book value times, let's say 1.5 now that can work as a proxy and why is that? 

Ryan Miller  

Well, it's because book values are usually understated due to depreciation, so that's why we want to bring it back to say roughly what would it be so once we account for that depreciation. So let's say it's a 5% for 10 years in the depreciation, we want to add that back. So that compounds to about 50% or 2% for 10 years 20% so usually the 1.2 to 1.5 when you multiply that by book value, that really helps with replacement costs. But remember what I said the pro move here. You always want to do a sanity check against vendor quotes. So personally, I just use vendor quotes, but if that's difficult to do, or something that's outdated or for whatever reason, I just showed you the way to back into it. But typically you just get vendor quotes to say, cool, tell me if I want to buy a new generator from you, what would that cost today? That way you can really get a lot more of an accurate pricing on Tobin's Q of whether you want to move ahead or not. 

Ryan Miller  

Now, the next thing that you want to look at is network and capital. Okay, so on networking capital, it's pretty simple, it's just accounts receivable plus inventory minus accounts payable. That's it. Accounts receivable, the balance there, plus inventory minus accounts payable. So this is the cash that's really tied up in running the business, otherwise known as networking capital. 

Ryan Miller  

The final one here is, effectively we want to go to reproducible intangibles. So the reproducible intangibles, those only include what you need to rebuild. So let's say customer relationships, any licenses, software, SOPs, you want to avoid vague brand value, sometimes we call that goodwill, it's maybe baked in there. You want to avoid that stuff. So together, those will give you a realistic sense of what it would cost to recreate a company from scratch, right? So hopefully I haven't lost you yet it's relatively simple. If you have access to their basic three statements, their financial statements, you can, you can figure this out and really back into a reasonable price to say, should we dive in, or is there some, we got 100 deals. We got to make a short list, how do we get rid of 90 of the 100, or whatever it is? 

Ryan Miller  

So let's actually talk about a do versus don't, okay, so let's talk about a deal that you should do first. So that means that Q is less than one. So let's say you got blue collar HVAC. We like these guys sort of saying, hey, I want to buy a bunch of HVAC companies, roll them together, and then maybe I'll have a I'll own my whole city and all the HVAC, and that's going to be me, and I'm going to be just like the monopoly guy. So what we want to do is we want to add it up. So typically, when you go buy a company, you say, show me your financials after you sign an NDA. And let's say they want 2.5 million in equity, okay, and you notice on their balance sheet that they have debt of, let's say 500k or 0.5 million debt. And then, if you remember, there's also the cash, let's say it's, I don't know, 200 grand, so 0.2 million. Okay, so, so what that means is we have 2.5 + 0.5 - 0.2, which is effectively gives you an enterprise value of 2.8 million. Okay, so, so far, enterprise value of 2.8 million, okay, that's effectively what the purchase price should be. But we want to figure out is that a good price, so not necessarily looking at the price and what I can afford, but to say, is there enough value in the business to justify buying it for 2.5,  2.8.  

Ryan Miller  

Now, remember, the second one that you want to do after we figured out the enterprise values, we want to figure out replacement costs. Okay, so replacement costs, replacement costs are effectively, let's just say, on their financials, they have a PP&E of 2 million bucks, okay, 2 million and we then, let's say we multiply that by 1.2 million, so it wasn't appreciated, too bad. So it's a roughly 2.4 million. So whether a vendor told us 2.4 or, in this case, we backed into it, so we have PP&E, we said, yeah, roughly, sure, we don't have to go to bonkers yet. So let's just say they're long term assets, the property, plant and equipment is valued are about 2.4 million, right napkin math. So the second one is networking capital and networking capital, let's just say, is about, I don't know, 700,000 right? And then the intangibles, as we've described before, we put that at an estimate of, is about, we'll say 300 grand. Okay, so we're now getting to a place where we can start doing this. So now the final boss move Q equals, remember, enterprise value divided by replacement cost, which effectively is 2.8 million divided by 3.4 which gives you a Q of 0.82. That, since that's below one, now you're in you're in good position, so you're now buying a business for less than you can rebuild it. So this deal is worth leaning into, I'm not telling you to buy it on that case, but that's definitely something to say. There might be something here from a loose napkin math or thumb to the sun estimate. We're saying, yeah, we probably are onto something here. So let's dive in and make sure we like everything else, the leadership or the lack thereof, or whatever it is, but we're just saying from a pricing standpoint, it looks pretty good. 

Ryan Miller  

So now let's talk about a deal you should avoid, okay. So let's say there's a local IT service company, and the seller wants 5 million in equity. Okay, so again, back to enterprise value, they want 5 million in equity, and then we want the debt of, let's say, a million bucks. So plus a million and there's no cash, okay, but if there is, you just subtract that. So just for easy one, that gives us an enterprise value of 6 million bucks. Okay, great. So technically, thumb to the sun, this company is roughly worth about 6 million bucks. But we don't know if 6 million is a good deal yet, until we figure out the second part. So if we have replacement costs again, so we have property, plant and equipment of about 1.5 million, and let's say we estimate, we don't have vendor quotes, I'm giving you the hard stuff, vendor quotes are easy. Let's say I don't know, 1.3 so then that would give me a PP&E of about 2 million bucks, my math is right. So about $2 million for property, plant and equipment. 

Ryan Miller  

The next one is networking capital, so let's just say they have networking capital of a million bucks. Let's say that's all we saw, right? Real simple, easy company, anything you're buying for 6 million is probably fairly simple operations. So then, obviously, that gives us, actually, you know what, let's add some intangibles. So intangibles of ISO one, okay, just real easy. So then that gives us a replacement cost of 4 million bucks a buck. So 4 million bucks on replacement costs. So now Final Boss move, as we want to say, Q is equal to enterprise value divided by replacement costs, therefore Q is equal to six divided by four, therefore Q is now equal to 1.5 which is effectively saying you're paying 50% more than you could just rebuild this company and all of its assets, right? So that may be, like, get rid of it, I didn't like it that good anyway, whatever that is, but it's just saying, like, what I would do in that scenario. So pro move is to say, is there another reason because this does seem like it fits strategically. So let's really dive in. It's expensive, and that's fine, I'll pay the price for it as long as it's justified. So at least it's telling you the price is coming in a little bit hot, and so we just want to make sure that we understand, is this price worth it? Is the juice worth the squeeze? And so unless there are sticky contracts or true IP defensibility, you're probably overpaying. And if you can't even determine that, then, yeah, if it was me, I'd probably walk away. 

Ryan Miller  

So let me give you a teaching moment here. So there's really a difference, right? So deal number one, to discount the assets cover your downside, and deal number two, you're paying a premium, you're paying for promises. See, private equity, it's about discipline, not about emotions and Tobin's Q is one of those tools that keeps you disciplined. So now let's talk about some of the pitfalls where Q can mislead you see Tobin's Q, although it is powerful, it's not perfect. So here's where it could mislead you. Number one is asset light businesses. One might be like SaaS or consulting firms, they'll show a high Q because code or network effects aren't really fully counted, and that doesn't always mean that it's overpriced. So you see what I mean. So we're just saying it is a tool, not the one tool to rule them all, but it at least gives you a very quick analysis to say, what are we dealing with? So if it's an asset, light service business or it code Tobin's Q, may not be the perfect tool for you, but any I know HVAC and car washes and a lot of these, these other businesses that have factories, CNC, I know a lot of people that are buying these. So that would be a Tobin's Q would be a better fit. 

Ryan Miller  

The other one is where you just they, they have a run to fail, right? So run to fail is a strategy where you're just saying, we'll just ride these assets in the ground. So if you're an oil and gas company, you have these pump jacks, and we're like, we're not going to replace it every 5 years. We're just going to run it until it fails, and then we'll buy it then. So even though the life is 5 years, we might be able to get 8 out of it. Some people do it on the exact replacement schedule. Other people do it whenever it dies. So if you, if you've got these companies that have a run to fail asset replacement policy, then you're going to have a lot of old assets on the books, right? And so when you have these old assets on the books, then PP&E may be understated, all right. So old assets equals understated, PP&E, right? We covered that of depreciation and all of that. And so you just that for sure, is where I would lean in on vendor quotes, right? And I would say number three is overstating intangibles. So this is where a lot of gray area comes in. You got to be careful. So if you're buying a company, you want to understand what are the tangible assets typically, that's PP&E, typically, and then what are some of the long term intangible assets on the other side of that equation? And so valuing intangibles can be a bit of a challenge, and sometimes, just my opinion, it's more art than science, and so you only want to count what you truly need to replicate in about 12 to 24 months. So those are a few of those areas where maybe Tobin's Q isn't the best fit, or at least you use it with caution, knowing it calculates something, but is it, am I seeing what I think I'm seeing, or is it telling me something else? So false negative or false positive? 

Ryan Miller  

So I'd say, you know, as we're coming closer, I just want to bust some myths on this. So one is that I hear a lot is Q is only for academics. Well, I've been in school for, I don't know, a decade or more, I could tell you that is totally wrong. It's been used for decades by real investors and PE firms. The other myth is, Q is outdated. Wrong again, the logic of comparing purchase price to replacement costs, that's timeless. Another myth is Q is too hard to calculate. Well, hopefully by this point, you know, it's not that hard to calculate. You just saw enterprise value divided by replacement costs, done, easy. So you don't really, you don't need to be a PhD to use Q, you just need to be disciplined, that's really the crux of it all. 

Ryan Miller  

The last thing I want to talk about is just, let's do a quick reference and wrap this up, okay. So as we mentioned before, deal Q, or just sometimes Q is effectively enterprise value. Divided by replacement costs. We talked about how to do that, enterprise value, enterprise value is the equity price plus debt minus cash. Then number three is the replacement cost, which is effectively adjusted PP&E, which adjusted PP&E is effectively bringing it back, saying, okay, on your books, you show the depreciated value. And not everybody does a table. Some companies will provide a value of depreciation on a separate note, and you can figure that out of how much they've depreciated each of their assets. If you don't have that, then you can roughly figure out, you know, how much depreciation or inflation? How much did you depreciate a year? And you can solve for x, right? So times by between 1.2 to 1.5 is roughly the calculation to adjust PP&E back then you have plus networking capital plus intangibles. So now remember the thresholds that we have here are, if Q is less than one, it's typically undervalued. If Q is equal to one, it's typically fair market value, meaning you're getting what you paid for, no more, no less. And then if Q is greater than one, it's typically premium and you either walk away or you lean in and figure out some reason why, right, just because you're paying a premium, doesn't mean it's bad deal. Doesn't mean it's a good deal, it just means you probably need to do more homework. Same with undervalued. Is it undervalued because we're going to catch a falling knife, nobody wants to do that, this thing's going down. We're not going to be the one of the last ones off the Titanic, meaning we're not we're going to take this thing down. So either way, you're just saying it's undervalued, it's overvalued. How bad do you want to dive into this thing, right, both, both require you to do that. Just to close this thought out Tobin's Q, it was born in academia, validated by Nobel Prize winners and used by some of the greatest investors of all time, and now you have those tools to apply as well in your next private equity deal. So before you invest, just make sure you use this with caution, use it to filter good deals from bad ones. And if you're ready to raise capital and actually start buying businesses, then you can go to fundraisecapital.co where we take our community of investors like you from raising nothing to reporting back that they raise over a billion dollars from investors that were following my strategies, and I show you how to get those investors to get that done. So getting good deals, purchasing with intelligence and raising capital are a few of those things you will need in your pursuit of Making Billions.

Ryan Miller  

Wow, what a show, I hope you enjoyed this episode as much as I did. Now, if you haven't done so already, be sure to leave a comment and review on new ideas and guests you want me to bring on for future episodes. Plus, why don't you head over to YouTube and see extra takes while you get to know our guests even better, and make sure to come back for our next episode, where we dive even deeper into the people, the process and the perspectives of both investors and founders. Until then my friends, stay hungry, focus on your goals and keep grinding towards your dream of Making Billions.