Return on Investment
Since this is the first real post on my blog, I would like to reintroduce myself. My name is Matt, and I work for Constellation Software. My role is on the corporate development team where I assist in the research, evaluation and valuation of small businesses that want to sell to us. The crux of my job is to analyze companies and assess the potential to improve their operations. If we see the opportunity to make improvements we likely can make a good investment. Let’s dig in!
What about your business? Let me take a guess. Your business would be great if only you had a better sales team/strategy to grow revenues more… Or, your business would be taking off if you had some more cash to invest in R&D to enhance your product performance… Or you are just understaffed limiting your ability to grow your company… Or you are increasing capacity so your business will be able to handle all the volume you are going to get since your product is about to take off…
Be honest… do any of these justifications sound familiar to you? Yep… me too. Owners often try to grow sales because they believe bigger is better. If you are willing to give me five minutes, I am going to try and convince you that logic is not always true. In fact, growing revenue alone can be bad for your business! Yes, you heard me right, GROWTH ALONE does not necessarily good.
I know what you are thinking – who is this kid that is trying to explain what is, and what is not good business… young people always think they know what is best… Well, you still owe me four minutes and 30 seconds before you switch off. I promise it will be worth your while.
The most important principle in finance is Return On Investment (“ROI”). I know what you’re thinking: “What the hell does that even mean!?” It sounds like a complicated finance term, doesn’t it? Well, the concept of ROI is actually simple. I will explain it exactly how I did to my granny – and that is saying something! Get your stop clocks out please… and GO!
Return on Investment is the ratio, expressed as a percentage, of the annual profit earned divided by the initial investment made to generate that profit.
For example, if you invested $100 in a store and earned $30 in profit the ROI would be 30% (i.e. ROI = $30/$100). AND…TIME! That is it. Really!
Optimizing For ROI
It probably seems too simple to be true, but this small formula is incredibly powerful – in my opinion, by far the MOST important principle in finance. Now, just to fully comprehend why this formula is so profound let’s flesh this out with an example.
Our favourite businessman Charlie – you will soon see why – has a real knack for knowing how to sell biscuits. Since he was a kid, he has tried every single biscuit he ever laid his eyes on. Charlie now manages three stores selling his own brand of biscuits – Cinnamon Charlies. His stores generate a lot of profit and he doesn’t know what to do with it. Charlie wants to expand, the real question is – should he? To purchase the real estate, renovate, and stock the store with inventory, costs $500,000 for each individual store – the initial investment Charlie risks. Moreover, at each individual store, Charlie consistently earns $100,000 in profit i.e., cash he takes to the bank. Importantly, Charlie believes he can do the same numbers at a new location he has carefully scoped out. Think back to that ROI formula – should he do it?
I am not sure about you, but if that was me I would be saying “Hell yes. Take my money. That sounds like a great deal”. Think back to that formula we talked about. Charlie is earning a great 20% on the investment he makes for each store. Earning 20% annually on an investment is a rare, and special opportunity because you receive a large amount of profit relative to the money you invested.
Ok, so what if Charlie was choosing between locations. Location A (just described) was located on Bourbon Avenue, near the popular shopping high street in town but is still a few blocks away. Alternatively, there is location B, on Jammy Dodger Drive – the street with the highest foot traffic in town. However, as we all know by now, nothing in life is free and the real estate on Jammy Dodger Drive comes at a steep price – $4,000,000. For the location, Charlie reckons he can earn $120,000 in profit annually (3% ROI).
Which location would you prefer if this were you? (Hint: Please don’t say Jammy Dodger drive!)
Hopefully, you preferred option A… But why?
Crucially, the return on your investment is much higher. Charlie’s money is much more productive at location A as it generates a 20% ROI versus a 3% ROI. Charlie could invest $500,000 in Location A, generate $100,000 in annual profit, and still have $3,500,000 to invest in other stores or projects whose profits could far exceed the $120,000 profit offered from a store at Location B. Hypothetically, instead of building out a store in location B at the original price ($4M), Charlie could build out 8 stores that are similar to store Location A ($500,000 each x 8 = $4M) and generate $800,000 in extra annual profit (20% ROI). The return Charlie receives on the investment in opportunity in Location A is much better, and is a better use of his money.
Let’s make this even more simple, and say both stores initially cost $500,000 but the store in Location A has a 20% ROI and a 3% ROI at Location B. An investment in a store in Location A would give Charlie an extra $100,000 of profit annually but Location B produces only $15,000 of profit annually. Since both stores cost the same amount of money Location A is a NO-BRAINER. The same-sized initial investment in Location A makes $85,000 more money.
The key point is that a business or opportunity that generates a lot of profit relative to the initial investment needed is very valuable. Put another way, a business that needs a smaller investment to generate $100 profit is more valuable than a business that needs a bigger investment to generate $100 in profit. By optimizing your business’ ROI, the value of your company increases. It is the most important metric for indicating the quality of your business because it shows you how effective the company is at making money with the capital already put into the business.
The second key point that should be becoming more obvious is that the higher the ROI you invest your profits the faster your profits will grow. Using the $100,000 of profit we generated and investing it in another 20% ROI project turns next years profit into $120,000. The year after would be $144,000. The year after that $172,800 (Note: this holds as long as you can reinvest your profits at the same ROI every year – to be discussed in the next article).
ROI & Risk
Now we should take a step back. Some people may say, “Well what if we can’t get a store in location A. Why is 3% so bad? Isn’t it better than doing nothing?”
Well, yes, actually doing nothing is better than a 3% return. Instead of investing in the store in Location B Charlie can invest in U.S. government debt which gives you a ~4% return every year. Since U.S. government debt is almost certainly going to be repaid, the 4% is called the risk-free rate of return i.e. the return received for investing your money and not taking any risk. It may look like you are earning 3% by investing your money in Location B, but in reality, you are giving away the added 1% you could earn by buying government debt (1% = 4% from U.S. debt i.e. the risk-free rate – 3% ROI of Location B). By not investing at the highest rate possible, you are doing the financial equivalent of burning money – you just can’t see it! Your money grows slower than it could be. Look at the home page and remind yourself of what happens when you forego a few percentage points of compound interest over long periods. It is an expensive mistake.
Not only does the store in location B have a lower return than the risk-free rate – (3% vs 4%) it is also risky – there is no guarantee shoppers will buy your products. If there is the option to earn 4% on your money taking no risk, why even try building a store in Location B?
On the other end of the risk spectrum, as a business owner, you have money at risk. If you go bankrupt you can lose everything. As a result, you must be compensated for the risk you take of losing your money i.e the ROI in excess of the risk-free rate – in the finance industry, we call this “spread”.
Location A with a 20% return offers a 16% spread over the risk-free rate. i.e. Every dollar invested in Location A earns 16% more than the risk-free rate. With a 16% spread, one can say the risk to build a store is is justified given the high reward relative to the size of the initial investment. Clearly, the riskier the business or project, the greater the spread you should want to justify an investment. How this applies to your own business is a key point of consideration and must be thought of before making new investment decisions.
Conclusion
In my opinion, the most fundamental principle of business is to maximise ROI per unit of risk taken over the long term. To receive as many dollars as possible in profit from the initial investment made. It is not to: increase sales, increase market share, have the flashiest technology, or even to have the best product. All of these are great, but it does not mean you have a better business unless it improves your ROI. Similarly, you could increase your profits by substantially but if you invested too much (e.g. the Store on Jammy Dodger Drive) you are giving up future profits.
By now, I hope you agree that growing sales 100% is not always good. Because, but if you invest lots of money and get no extra profit then you are just as good as Charlie building a store on Jammy Dodger Drive.
Next Time
The eagle-eyed among you will have thought “Well, doesn’t all this ROI discussion depend on the ability to continue to invest in high-ROI businesses/stores/projects”? Yes, you are right. This is a crucial point, and is the subject of my next article! See you there!
Work Referenced
Greenblatt, Joel. The Little Book That Still Beats the Market. Hoboken, N.J., Wiley, Chichester, 2010.
No Investment Advice
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Nice post. I learn something totally new and challenging on blogs I stumbleupon on a daily basis.
It’s always exciting to read content from other writers and practice a little
something from other sites.
Great first article! Looking forward to reading the others! Cheers
Great first article. Simple but clear examples helped! Looking forward to reading the others! Cheers