- The Small Business Mentor
- Posts
- How to Make 50% Returns
Welcome back to The Small Business Mentor!
A quick message before we jump in:
If you haven’t already, be sure to check out the Small Business Mentor Podcast wherever you listen to your podcasts
If you’re reading this online, subscribe HERE and join thousands of business owners and professionals receiving these emails every week.
This is the last of three posts about my podcast guest and business hero, Greg Crabtree.
Let’s dive in…
Owning a small business is one of the best returns you can get in business. Greg Crabtree has found that the minimum return that an owner will receive on his investment in a small and profitable small business is 50%.
Let’s compare that to other asset classes:
US Stocks: 8-10%
Bonds: 3-4%
Real Estate: 4-8%
Crypto: Whatever
50% looks pretty damn good.
So a small business making 10-20% net income/profit, is getting a minimum of 50% return on the money invested in the business. And that’s the minimum. Some are making 100, 200, and even 300% returns. Wow!
Ok. here are some caveats. It’s making that 50% on MONEY INVESTED IN THE BUSINESS. That investment is roughly equivalent to the shareholders equity line on your Balance Sheet.
“Uh oh,” I can hear you saying as your eyes roll. “We’re talking about Balance Sheets?” Stay with me.
How to Measure Your Return on Investments (ROI)
Shareholders equity is what is left over after you subtract Liabilities (Accounts Payable, Debt, etc.) from all your Assets (Cash, Accounts Receivable, etc.).
This is the money you invested in your business. You either put it in by writing a check to start and fund the business and/or you kept money in over time to fund operations: working capital and the like.
If you use a lot of debt in the business and want to account for that, you’d use Return on Invested Capital. That’s a slightly different calculation as you need to account for the tax advantages of tax deductible interest.
We aren’t finance professors here so let’s just assume for our purposes we are talking about measuring your ROI on your pre-tax net income divided by the shareholders equity on your Balance Sheet.
This is a rough and ready version. Technically what we are measuring is Return on Equity (ROE) but again this isn’t a corporate finance class.
A 50% Return Is Great But…
The one issue is it can be hard to invest more in your business and get the same return. If your shareholders equity is $1m and your pretax profit is $1m, you are getting a 100% ROI.
But can you put another $500k into shareholders equity and get $1.5m in pretax profit?
If you can, this is the best use of your money that you can find but the reality is only a few companies can handle that kind of increased investment all at once.
Instead, what if you invest the $500k and end up making $1,050,000 in net income? Isn’t that good too?
You still got the 100% return on the first $1m in invested capital and you got a 10% return on the incremental $500k ($50,000/$500,000=10%).
10% is about what you get in US Stocks. So good, right? Wrong.
US Stocks are a lot less risky than your $1m net income company. I think Apple and NVIDIA will outlast you. You are also diversified across the entire economy if you invest broadly in something like the S&P 500.
You need to get that 50% ROI to compensate for all the risk you are taking. Even a 20% return from your business isn’t enough. You’re better off putting that money in the market.
The chances that your company hits a rough patch and goes belly up or makes more like $500k in net profit for a while are too high.
Knowing this 50% return benchmark is crucial in two key circumstances:
Reinvesting in your business. You should hold the decision to hire a new employee, buy a new piece of machinery, or whatever investment it is to the same 50% return.
Can the sales guy or gal you hire for $80k pay for him or herself and produce another $40k in profit? Let’s take the example of a company doing $500k in profit on $3.33m in revenue. They are right at 15% profitability.
If they hire that sales guy, they need to earn back his salary and make an incremental $40k in profit. Assuming the company will continue at a steady state, they hire the sales guy for $80k all in. That reduces their potential profit to $420k.
To justify the investment, they need to make a total of $540k in profit. That difference is $120k of profit. At a 15% profit margin that equals $800k in revenue.
Do the same thing for a marketing expense or piece of equipment. Will it create a 50% return?
Buying small businesses. When you own a business debt free, you could be making a 100% return but when you buy it for 10x Net Profit, you’re getting a 10% return assuming no growth.
That’s why you’ll see multiples more in the 3-5x range or even 2x range for really small companies. On a steady state basis that’s a 20-50% return. At 20%, you are probably better off in public markets unless you have some way of quickly increasing the net profit of the business.
This is of course why people want companies with a demonstrated record of growth across many years and even an economic cycle.
The Issue of Time
Those examples raise the issue of how long do you wait to see if you got that 50% return. If it takes the sales person 10 years to make that extra $40k, then she obviously wasn’t worth it.
Back to the finance professors. They will tell you to discount the future cash flow of the investment back by the appropriate discount rate based on the risk of the investment. Blah, Blah, Blah. No one is going to figure out their company Beta and then do a discounted cash flow (DCF) model.
Greg just says that you need to hit that return within 12-24 months. Again, we are using a rough metric here. Small businesses are risky and you need to get your money back in a reasonable time frame.
There you have it. ROI is a key metric in business. Start using it.
Keep growing,
Alan
P.S.
P.P.S.
1 Lots of people use EBITDA instead of the net profit. They will be the same unless you have a lot of equipment or real estate that is depreciating or if you are paying a bunch of interest. You can use either.
2 A small business is also extremely hard to sell. At a 10% return, it’ll take 10 years to return your investment. Same with the stock of a public company, but you can return your capital with the push of a button. Not so with a small biz.
Reply