Hi everyone and welcome back!
If this is your first time on the blog I recommend heading over to the Introduction, and Return on Investment post. This article will incorporate key ideas already mentioned and it’s important you have a good understanding.
Today, we will be focusing on Investing For Growth. The topic is fascinating because human beings place a large value on growth – or the future value of a business. There are a couple of reasons for this:
1. Higher profit is clearly worth more than less.
2. Humans have an innate willingness to develop and improve their surroundings and environment – dopamine hits fuel short-term development goals which, over a long period of time, results in larger, more developed societies and organizations.
3. Credibility: larger companies bring greater perceived credibility.
4. Status and prestige: Being bigger feeds our egos and attracts more attention.
5. Humans have an innate desire to be safe and in control. Being bigger, or the desire to be big, taps into these feelings – the larger we are the more stable and in control we are.
As a result, the idea of growing one’s business taps into these same alluring factors. But before we tackle the meat of this topic, we need to solidify the fundamentals. As my mother always told me, to grow big and strong you need to eat your beans! Let us begin!
From the Return on Investment article, we established, and can now all agree, that more revenue does not mean a better business. Finance and business quality is not a pissing contest. It is all about how you use it – and by it, I mean your money!
Let us revisit Charlie, and his famous biscuit business – remember the one that earns a 20% ROI! Over the past 5 years, Charlie’s stores generated a 20% ROI from an initial $500,000 investment, or $100,000/yr in profit that flows straight into his bank account. It is important to emphasize that this 20% ROI is special because the profit you received is high relative to the size of the initial investment. Most people cannot find investment opportunities of this quality – but our Charlie has a business that does just that.
Charlie has a couple of options: A) Do nothing and, all else equal, receive the $100,000 in profit he earns every year and spend it for personal uses. B) Invest the money into government debt yielding ~4%. C) Invest the money into a passive market ETF which historically has grown at 7%-9% a year. Or D) Use the profit to reinvest back into his business. What should Charlie do? Your finance brains should be kicking into action – it depends on what has the highest risk-adjusted ROI.
To answer this question, we need to assess what ROI Charlie can expect to generate on every additional dollar that he reinvests back into his business. Put another way if Charlie invests one extra dollar into his business, what is the return he can expect? The technical name is Marginal Return on Investment, or “MROI”. MROI is very impactful to the valuation of a business because it determines how fast we can grow the profits of our business.
How to Calculate MROI
MROI differs from ROI as it focuses additional investments made. See below the formulas for ROI and MROI and look how they vary. MROI focuses on the increase in profit in Year 2 compared to the additional investment made.
Let’s use an example
Stage 1: Charlie Makes an initial investment in a store.
Stage 2: Reinvests one year of profits into the store at a 40% return.
Charlie reinvests $100,000 of profit into his business (the Additional Investment) by creating a pick and mix stand. The new stand was able to generate an extra $40,000 in profit the following year. We can calculate the return on the “marginal” investment made – i.e. the additional investment.
After the investment, we can recalculate the ROI of Charlie’s total investments using the total profits in year two divided by all investments made into the business.
The Final ROI of Charlie’s investments is higher than the initial investment made in buying the store at 23.3% vs 20%. Why?
Charlie’s marginal investment, the $100K of profit that was reinvested, was more productive than the investment in the store – the MROI was 40% which pushed the Final ROI higher.
MROI in Practise
Hopefully the math broken out is helpful to understand. But how do we go about finding the MROI of an actual business?
To find the likely MROI of a business, we should start by examining the business’s financials over the past 5 years and exclude any non-reoccurring events that obscure the underlying performance (e.g. large, and/or irregular one-time sales or costs). While history doesn’t repeat, it rhymes. When investing in a business, past results are the best indicator to help us estimate the most likely range of possible outcomes. Humans are bad forecasters because we have psychological biases affecting our judgment so it’s prudent to use tangible evidence. Moreover, if we believe that prospective opportunity is similar in nature to our previous business than we can start to get comfortable that a similar outcome may occur.
Now, if past performance is accurate and Charlie can reinvest at a 20% MROI and grow the profits of his business then he is sitting on an extremely valuable business. The value comes from the ability to reinvest profit earned each year at a 20% ROI which is vastly superior to the options A, B and C – either by expanding existing stores or purchasing new ones. As a result, Charlie’s original investment will still give a 20% ROI ($100,000 on the initial $500,000), but the profit reinvested will also earn a 20% ROI ($100,000 profit will earn and extra $20,000) hence fast growing profits.
For one $500,000 store that reinvests all its profit at different rates for 25 years. See the impact to ROI over time, converging closer to MROI.
Reinvesting money at high MROIs is incredibly valuable because it takes advantage of compounding profits at a fast rate of growth. Remarkably $100,000 turns into $9.5M, or 95x times your initial investment after 25 years. The economic benefit of owning a high MROI business is enormously beneficial because the economic benefits accrue directly to YOU!
BUT, BUT, BUT there are two important considerations before we can start dreaming about our wealth compounding at such high rates:
- What % of our profit can we reinvest in our business?
- If we can only reinvest $10,000 in our business at an MROI of 20%, and the remaining $90,000 returns a 5% MROI then the value of “potential growth” is not very high.
- How long can we continually invest in our business at the same level of MROI?
- Assuming we can invest 100% of our profit at an MROI of 20%, how long can this continue? i.e. 5 years or 25 years makes a big difference ($250K vs $9.5M respectively).
Investing $100,000 of profit in Year 0 at a 20% MROI is likely going to be much easier than investing Year 25’s profits of ~$9.5M at the same 20% MROI because 1) Competition will catch onto how profitable you are and try compete for your profits 2) You will have invested in the “low hanging fruit” first and the industry will have matured after 25 years leaving less high ROI opportunities 3) Larger opportunities are needed to reinvest all of your new profits – million dollar projects are needed as hundred thousand dollar opportunities don’t move the needle anymore further reducing the viable opportunity set of investments to be made.
The largest impact on the value of your business is your opportunity to invest at high MROIs for a long time. But a high ROI is hard to sustain for a long time and gets more difficult the larger one becomes limiting the “reinvestment runway”. As a result, growth assumptions, MROI and runway to reinvest at these rates, are very impactful to a company’s value and must be thought of carefully, and to be honest, a touch pessimistically because market forces are stronger than many anticipate.
Today’s piece focused on ensuring we understood the fundamentals of investing for growth. The next half of the Investing For Growth article will dive deeper into 1) Why investing at high MROIs for a sustained period is difficult 2) Situational factors helping you assess how to invest for growth 3) A 10-question checklist that one should consider before investing, or reinvesting in your business.
Work Referenced
Greenblatt, Joel. The Little Book That Still Beats the Market. Hoboken, N.J., Wiley, Chichester, 2010.
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