How I Avoided Buying A Bad Business — And How You Can, Too…
When I’m not busy investing and trading in the market (or writing about it), I like to spend some of my spare time hunting for other business opportunities. Ideally, I’d like to find one that will either provide passive or semi-passive income.
In an ideal world, my goal would be to have a small business that I can one day hand off to my two boys while they are in high school.
Not too long ago, I was looking into a small business involving vending machines. If you think about it, it’s exactly the kind of business that fits into these categories. It can provide semi-passive income, and it’s something that my two boys could take over to help them learn some entrepreneurial and life skills while pocketing a little money for college.
However, I nearly made a major blunder by overpaying for it. Fortunately, my background in the markets helped me avoid that mistake.
Today, I want to tell you a little bit about it because the experience provides some key insights into not only purchasing private businesses — but also when it comes to trading stocks.
Time For Some Napkin Math…
First, let me just say that I’m no expert in the vending machine business. In fact, I know very little about it. My only experience with vending machines was in high school when I would order the inventory, stock, and manage our school’s machines.
That doesn’t make me an expert. But at least I knew the broad strokes of it. Besides, I am good at research, analysis, and valuation. So I decided to dig further…
The vending machine space is attractive to me because it’s an overlooked industry with good margins. And it doesn’t require a lot of time.
A well-placed vending machine will gross anywhere between $250 and $500 a month. Margins typically run about 50%, so net income will be between $125 and $250 per month or $1,500 to $3,000 yearly.
This is by no means a “get rich quick” business, but it’s easy to scale and doesn’t require much time. My goal would be to place 10 machines, which means my little vending machine business would generate annual gross sales of $30,000 to $60,000 and net sales of $15,000 and $30,000.
Let’s say it averages $20,000 in net income every year for the next 15 years (when my kids are in high school, can drive, and can take over). Then I’ll have socked away about $300,000 from this business, which they can use for college, travel the world, or start another business.
The vending machine route that I was looking at buying was small. It had four snack machines- three already placed- with the fourth sitting idle.
On the surface, this business looked like a good entry into the space. The asking price was $19,900. As I mentioned, it had three machines already placed at apartment complexes and one idle machine.
While the broker who listed the business said it did about $8,000 in gross annual sales, when he sent me the preliminary financials, it showed they were on pace to only do $6,100 in sales this year.
In the vending machine world — much like the world of stocks — the route is only worth what it’s currently producing. Just because it did $8,000 or $10,000 in sales one year doesn’t mean we get to value it using those historical figures. Like how we price stocks… just because a company once made billions in sales but no longer does, doesn’t mean it should get that same valuation.
After much research, pulling “comps” of other vending machine businesses that were for sale, I found that these businesses routinely sell for anywhere between 0.75 times annual sales to 1.3 times sales.
This one was demanding an astronomical 3.3 times sales…
What I Learned From This Experience
As you can imagine, when I presented my findings to the broker and politely asked how he came up with the valuation, he was insulted. And I was bummed too… you see, I was excited about this potential little business.
But just like when it comes to investing, I had to keep my emotions in check. I couldn’t let the excitement and euphoria about this venture gloss over the facts. And the facts were that this guy was simply asking too much for this business. What’s more, the momentum of sales was moving in the wrong direction.
Fortunately, my research, analysis, and trading background kept me from allowing my emotions to bubble over and pay a massive premium for this business.
The point is that sometimes the best investment decision you can make is to say “no.” That not only goes for the investment but also for yourself. It’s a rare skill these days… but also one of the most useful for an investor to have.
I’m always looking for my next investment or business idea. And just like usual, I’ll stick to my rules of finding businesses that have momentum, cash flow, and a fair valuation. And I’m always keenly aware of the potential risks.
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