Ever since I disclosed my net worth broke eight figures strange emails have been coming in. Another milestone was passed without fanfare. Past experience had me used to the lack of excitement financial milestones caused.
A theme among many emails revolved around my rate of return. I never really thought of it that way. It was just a thing that happened because I saved a large percentage of my income and invested the bulk of my excess money in index funds. One commenter said he was impressed because my rate of return over the last 20 years was 11% while the S&P rose only 8.5% per year on average. I don’t know if it’s true; I never broke the numbers down that way. All I care is that it grew to a lot.
What the emails and comments forget when they calculate my rate of return is that I added funds over the last 20 years. If I reached my million dollar goal when I was 32 and never dropped another dime in the kitty my internal rate of return would be impressive. Instead, I added excess funds every year. If I analyzed my real return including the additional invested fund my internal rate of return would be less impressive.
There is something else strange about my net worth everyone forgets. I own a business and business ownership has a strange way of building net worth fast. The first million arrived a lot sooner for this broke farm boy than expected. Sure, liquid equity investments were a large part of the seven figure net worth 20 years ago. But I owned real estate and a business too.
Real estate had subpar returns for me. The money was okay, but not great, especially when you consider risks and the time and work involved. The mutual funds did well, as expected. The late 90s were great years for the market and I don’t need to remind you the market has been running higher for eight or so years now. The real surprise, the real sleeper, was the business. It wasn’t planned at first, but once I understood how powerful a business can be at increasing net worth I used all my accounting skills to make good use of the advantage.
Warren Buffett Enters the Room . . . Again
I have followed Mr. Buffett for a long time. One thing that always amused me was his knowledge of the tax code. His stellar growth at Berkshire Hathaway is only amazing because people don’t see how he did it. His stock picks have been solid, no doubt. But it doesn’t completely explain his massive outperformance.
Early in Buffett’s career there were many significantly undervalued stocks. That environment does not exist today. Try to find a listed stock with more cash and equivalents than the price of the common stock itself. Doesn’t exist today.
When the market rallied and kept rallying the awesome deals disappeared. Guys like Buffett don’t sit back and sip Mai Tais all day when the well runs dry; they look for more opportunities. Buffett’s massive knowledge of investing and accounting allowed him to do something few are capable of.
Here is Buffett’s secret. When a corporation, Berkshire Hathaway perhaps, buys enough shares (a large enough percentage) of another corporation, the buying corporation includes their percentage ownership of the profits into their own reported profits. The thought is if the buying corporation owns that much of an interest they will effectively gain their portion of the profits even if the profits are not distributed as dividends.
When Buffett buys a stock he buys a lot of it. Now you know why. He wants to hit a magical percentage of ownership so he can include those profits into his own even if there is no current distribution. Later he gets to claim the capital gain, too. The companies he wants to buy must be good deals. He must also consider the ramification on the book value of Berkshire Hathaway.
Increase Your Net Worth $2 for Every $1 You Earn
The little trick Warren Buffett uses to increase the book value of his company is educational. There is a magnifying effect in play. You get extra zing if you do it right. The small guy has it easier if he knows what he is doing.
Going back to my disclosed net worth, the real question or comment should not have been about growing my net worth from ~$1.2 million to ~$12.6 million in 20 years. The real questions should have involved issues of getting to the first $1.2 million. How did a broke farm boy from the backwater of nowhere tuck away a million dollar net worth in 14 years? Since nobody asked, I’ll answer the question.
To start, the family farm finalized the bankruptcy a few months after I graduated from high school. I didn’t go bankrupt. My life savings was meager, but there were a few dollars rolling around my bank account. Remember, in 1982 bank deposits paid double digit interest rates (and a free toaster if you opened an account with $100, or was it $1,000; I always forget).
Even so, I did not have a head start on my way to a seven figure net worth. I started working in my dad’s business for peanuts. Spending was as close to zero as you can get without being zero. (You in the back, sit down! I know that comes to one cent.)
Saving all my income and investing it in bank deposits paying 12% and dropping some in growth & income mutual funds for the rest started the nest egg growing. A side gig preparing taxes which paid more than my real job sparked the early growth stages of my stash.
Things still weren’t awesome. I took a few years off to read nonstop. Then I met Mrs. Accountant and my hyper frugal ways (did someone say dumpster diving? —we called them McDonald’s runs back then) would no longer work. I had a one-year stint as a custodian at a parochial school before my real big break. I didn’t know it at the time, but quitting my day job after a full career of somewhere around 14 months was the best thing that ever happened to me. And my net worth.
Skyrocketing Net Worth
Do you like games? I do. Let’s play.
Thought experiment: Assume you start your own business, a season tax preparation business, perhaps. You visit the local apartment association and speak a time or two to build your client list. Just for argument’s sake let’s say you bring in 200 clients (don’t want to work too hard) and each client on average pays you $500. (They have rentals so the returns are not the cheapest.) Your revenue for the year is $100,000.
Tax preparation firms have 40% – 50% net margins if they manage properly. Just to make our game easy enough to figure in our head we will say our business owner has a 50% net profit margin. As a result $50,000 ends up in his pocket as profit.
First question: What is the net worth of our hero if she has nothing else to her name? $50,000? Hold that thought.
Our business owner is frugal, but wants to supercharge her net worth so she adds another 200 clients at an average fee of $500. She now has $200,000 in revenue and because she manages her company so well 50% of revenues end up in her pocket. Her income increased $50,000.
Next question: How much is she worth now?
Most people would say if she spent absolutely nothing on herself she would have a $150,000 net worth—a $50,000 profit from year one and $100,000 profit from year two. If you said that you are wrong. Her net worth is $350,000 to $450,000!
The Numbers Game
Okay WA, you lost your mind now. She has a business for two years, earns a combined profit of $150,000, spent absolutely zero of the profit investing it all and has a net worth of $350,000 or more? That doesn’t make sense! What’s the punch line? Stock market tripled in a year? She played options? Won the lottery?
None of the above. She played the safest game in town.
I’ll give you a hint. The first year her net worth was already $150,000! Still blows your mind our business owner starts a business, does a hundred grand in sales and has a net worth more than her revenue!
[Stop teasing me! There are other blogs I can read you know.
Okay, okay. I’ll spill the beans.]
Every business is worth something on the open market. In this case we have a tax preparation firm. Tax firms generally sell for 1 – 1.5 times revenue. Therefore, our business owner generated $100,000 of new revenues in year one. The value of the new revenues is 1 – 1.5 if sold on the open market, plus the profit she got to keep from owning the company the first year.
In year two she doubled sales, hence the value of the firm. Of course I am assuming a conservative value by using the lower end of the range.
When I was 32 my small tax prep business did around $300,000 in revenues. Real estate added ~ another $200,000. Without the business and real estate investment values added to my net worth I would have had to wait a bit longer to hit the seven figure mark. Maybe I would have enjoyed it more if only the cash was counted. Doubtfully.
The Power of Knowledge
In my life business ideas revolve around my firm. Over the years I have sold off pieces of my company only to engage a new idea, expanding the business in a different direction. I never failed to attract at least 1.0 times the revenue of the piece sold.
Armed with this knowledge I am able to increase my net worth with a multiplier effect. I never consider a client worth only what they pay me or the profit on the account. If a new client comes in with $10,000 of work I know I will generate $4,000 to $5,000 of profit for my favorite human AND increase the value of my company by $10,000 or more. In my mind I have a massive annuity and a nice check at the end if I sell.
This why my net worth grew so fast and why I said real estate underperformed. This doesn’t happen with investment properties. If you raise rent $10 a month the value of the property may increase, but it will be negligible. Real estate is worth what the market says it is. Businesses are worth a multiple of revenues, profits, assets or a combination.
This is why it is not that hard to be wealthy. This is why it is not hard to build a million dollar net worth. Starting from zero today and knowing what I know I could reach seven figures in five years tops. That isn’t bragging either; it’s a simple fact.
And now that you know the facts you can do the same.