“Where do investment returns come from and what do insurance premiums have to do with buying SMBs?”
An investment return derives from a change of value. What you bought is either worth more or it is worth less, leading to a positive or negative investment return. What causes that change in value? At its most simplistic level, two things:
Change in expected future earnings power
Change in multiple someone is willing to pay for what you own
Earnings are under my control post-transaction. I work to increase sales, be more efficient with expenses, and implement processes to increase cash flow.
The multiple paid is up to me pre-transaction. I do not know what someone will pay me for a business in 10, 20, or 30 years. Again, I have no intention of selling. So then why does the multiple paid matter to me? Underwriting Risk.
Underwriting Risk is a term used by insurance companies.
It is the risk of suffering losses from written policies due to unforeseen changes in forecasts made at the time they wrote the policy.
Huh?
Basically, things did not go the way they had planned, and thus they are going to make less or lose money. How do insurance companies minimize underwriting risk? The easiest way is through price adjustments. They charge more for the policy and the risk they are taking.
When I buy a company, I am forecasting a series of future events. Events that will pay me an acceptable rate of return for the risk that I took. Those events can have unforeseen changes that lead to a lower return or loss of capital. Underwriting Risk. How do I minimize underwriting risk? The same way the insurance companies do, price. The lower the multiple I pay, the less right I must be to receive an acceptable rate of return.
While I factor the multiple paid into my projected investment returns, to me it is more a function of minimizing risk. The lower the multiple I pay; the less things have to go according to plan for my thesis to work.