Carl Menger is one of the founding fathers of Austrian Economics. One of his concepts is that the value of input goods is derived from the value of the final consumer good. A simple example would be wheat and bread. Wheat, in its natural form, is of little use. However, when mixed with other ingredients and a bit of labor, it becomes bread. Bread is a valuable consumer good.
The input (wheat) derives value from the value of the final good (bread). Wheat cannot be worth more than bread. So how much should the inputs it takes to make bread be worth? That will depend on how much you can sell the bread for. The final good determines the value of the inputs.
This is the same for businesses. What is the ultimate good produced by a business? CASH. That’s it. CASH. Everything else is just an input to produce that cash. So how do I value those inputs? By how much cash the business can produce and how sure I am of that cash continuing to flow.
Lots of inventory? High CAPEX? These are red flags for the company’s ability to produce cash flow. It is also why it is important to not get distracted by shiny inputs. Cool tech stacks, new ways of doing things, trinkets. They are all fun inputs. But if they do not lead to an increase in cash production, they do not add value and should not be paid for when acquiring a company.
This also made me think about businesses operating on valuable pieces of land. We see this all the time; A company for sale earning $1,000,000 in profits per year. But it is situated on a piece of land that is “worth” $10,000,000. So, the seller wants $14,000,000 for the business. $4,000,000 for the operation and $10,000,000 for the land. The problem is that the final product I am looking to buy, the cash from the business, is not worth $14,000,000. The inputs are mispriced based on the value of the final good.
Maybe if I was going to use that land for a different output, then I could pay the ask. But not in its current state and to create that value would require more work and additional inputs (development plan, financing, etc).
Focus on the ultimate output. Focus on the cash. The rest is just an input to get to that final product.