Business Valuation & Return on Investment (ROI)

When delving into the realm of purchasing or selling a business, a pivotal consideration emerges: the Return on Investment (ROI). As you assess the worth of a business, ROI becomes synonymous with the return on a venture divided by the invested sum. To illustrate:

$100,000 yield / $1,000,000 investment = A noteworthy 10% ROI

Deducing ROI is both swift and straightforward, allowing you to contrast potential gains across diverse investments, empowering you to navigate decisions with astuteness. Yet, while grasping ROI proves invaluable, it’s crucial to acknowledge its limitations. This metric overlooks critical elements like time and leverage, subjects we’ll explore further in this discourse. Although it’s infrequently employed for business valuation, comprehending the influence of ROI on a business’s value and its susceptibility to myriad factors can significantly augment your insight.

In the realm of business valuation, ROI presents itself as the reciprocal of a multiple. If the multiple stands at 4.0, the ROI equals 25%. To illustrate:

$1,000,000 EBITDA multiplied by 4.0 multiple = $4,000,000 business price, or

$1,000,000 EBITDA divided by $4,000,000 business price = 25% ROI

For most small businesses, typical multiples range from two to four times SDE, translating to a 25% to 50% ROI.

In the case of mid-sized businesses, common multiples hover between three to six times EBITDA, corresponding to a 16.6% to 33% ROI.

In this article:

• We investigate additional factors that can impact ROI, including the business’s value growth.
• We define the boundaries of ROI and highlight various factors it fails to consider.
• We present alternative methods for calculating returns when ROI isn’t applicable.
• We analyze numerous elements that influence ROI.
• We offer guidance on choosing between SDE and EBITDA for business valuation and how these choices influence ROI outcomes.
• We conduct a comprehensive exploration of the pros and cons of ROI, along with practical strategies for its intelligent application in gauging potential business returns.
• We assess the suitability of SDE and EBITDA for ROI calculations and explore alternative approaches.

Continue reading for a complete breakdown of ROI’s significance in business valuation.

Typical Returns

Behold the ensuing chart, which confidently displays standard returns (ROI) encompassing both small and mid-sized businesses, alongside their corresponding multiples.

What is the Purpose of Calculating ROI?

ROI is Used to Compare Investments

The essence of computing ROI lies in its power to juxtapose investments for discerning minds. In their quest to optimize returns, investors unfailingly gravitate towards opportunities boasting the most favorable ROI in relation to risk. The act of calculating ROI across diverse investments streamlines the intricate task of drawing comparisons and choices.

ROI is Used as a Quick Valuation Method at the Outset

ROI functions as a rapid and preliminary assessment, often likened to a “back of the envelope” approach, preluding the application of more intricate return evaluation methods like the internal rate of return (IRR). The process of calculating ROI extends the advantage of swift scrutiny and prioritization of potential investments, culminating in the judicious selection of avenues warranting more in-depth exploration. The divergence of ROI across businesses and buyers, even for the same enterprise, contributes significantly to the breadth of valuation ranges observed within the realm of business assessment.

Consider this illustration: a business tagged at $2,000,000, yielding an EBITDA of $200,000. With swift computations, you swiftly deduce the allure of alternative investments. In this context, the ROI stands at a modest 10%. Diving into a venture that offers a 10% ROI might find few takers among investors, particularly when more secure, hands-off opportunities like real estate or stocks beckon. In your toolkit of investment insights, ROI shines as a pragmatic preliminary step before embarking on a deeper assessment of an investment’s prospects.

ROI is Used as a Rule of Thumb

Consider ROI as your practical rule of thumb—a pragmatic gauge that doesn’t seek precision. Much like a tailor or carpenter relies on their thumb for rapid measurements, rules of thumb, including ROI, operate in the same vein—practical yet not precision-engineered. Just as your thumb isn’t geared for pinpoint accuracy in measurements, ROI doesn’t endeavor to be an exact science. Embracing ROI as a quick and facile tool is a strategic move. Yet, its limitations should be embraced, and its application should be wielded astutely in your pursuit of calculating investment returns.

ROI Across Investment Classes

ROI stands as a pivotal instrument, orchestrating swift comparisons among investments, be it within a single asset class or transcending across diverse asset categories. Behold a comprehensive juxtaposition of returns across a spectrum of asset classes.

Advantages of Using ROI to Value a Business

Highlighted are the key benefits that stem from embracing ROI:

• Widespread Applicability: The beauty of ROI lies in its universal relevance and effortless calculation. Its broad acceptance translates into a swift assessment and prioritization of potential investments.
• Simplicity Redefined: The brilliance of ROI shines in its user-friendliness, far outpacing the complexities of calculations like the internal rate of return (IRR).
• Seamless Comparisons: ROI functions as a seamless conduit for comparing investment returns with ease, be it against real estate, stocks, bonds, or other business ventures.

Disadvantages of Using ROI to Value a Business

Exploring the central drawbacks of ROI reveals crucial insights:

• Time Disregarded: One of ROI’s limitations lies in its oversight of temporal implications. To remedy this, consider employing annualized ROI (by dividing returns by years) or opt for the internal rate of return (IRR) for a more comprehensive temporal analysis.
• Leverage Unaccounted: ROI falls short in addressing the intricate influence of leverage on cash flows and returns. A countermeasure is to leverage the “cash-on-cash return” or IRR for accurate leverage impact evaluation. As leverage escalates, the potential for gains or losses intensifies, accompanied by escalated risks. It’s worth noting that higher interest rates amplify debt service, leading to diminished returns. While lower interest rates boost returns, they can inflate business prices, thus countering the perceived benefit.
• Capital Appreciation Overlooked: Often, ROI sidesteps the ramifications of capital appreciation. In most instances, solely ongoing cash flows like EBITDA are taken into account, sidelining the growth’s influence on a business’s value.
• Potential Value Overlooked: ROI’s scope doesn’t encompass the potential value of an investment. Comparing two ventures with similar returns may fail to acknowledge the allure of a highly scalable investment with greater potential, like a software business.
• Non-Financial Factors Neglected: ROI omits the impact of non-financial facets, including the worth of freedom or lost opportunity costs.
• Risk Unaddressed: Risks are left unexplored in ROI calculations. In comparing investments with similar returns, the less risky option might prove more attractive, emphasizing the necessity of considering risk.
• Inflation Unconsidered: ROI’s application must be judicious when contrasting investments across periods of disparate inflation rates. To rectify this, utilize the real rate of return for a comprehensive analysis.
• Unfit for Startups: Calculating ROI proves unwieldy for startups. Here, sophisticated investors like venture capitalists lean towards discounted cash flow (DCF) as a more fitting evaluation metric.
• Navigating ROI’s limitations uncovers a nuanced landscape essential for informed investment decisions.

To conclude, while ROI stands as a valuable instrument, exercising prudence in its application is paramount. A thorough grasp of its constraints and intended objectives empowers its judicious use, proving invaluable for buyers, sellers, and M&A advisors alike.

Is a Business Really an Investment?

This raises a pivotal query: Can a business be categorized as an “investment?” The Oxford English Dictionary defines an investment as “the action of investing money for profit,” a description aptly applicable to a business. However, it’s noteworthy that this definition solely encompasses the investment of monetary resources, excluding the investment of one’s labor or personal exertion—essentially, sweat equity isn’t covered.

To effectively compute returns on an investment, it becomes imperative to disentangle the worth of personal efforts. In simpler terms, this involves subtracting the value of your labor, or your remuneration, from SDE, yielding EBITDA, which subsequently serves as the foundation for return calculations. Determining the value of your labor can hinge on either:

1. Your forgone opportunity cost (representing potential earnings elsewhere).
2. The market salary relevant to the managerial role within the business (assuming you’ll assume the managerial responsibilities).

For instance, consider a software engineer acquiring a coffee shop. If the opportunity cost of not practicing software engineering amounts to $150,000 annually, while the market salary for the coffee shop manager (your role) stands at $40,000, it’s more pragmatic to employ your opportunity cost of $150,000 in calculating potential returns. This choice aligns with the notion that your potential earnings elsewhere hold greater weight.

Particular attention becomes imperative when a substantial gap emerges between your forfeited opportunity cost and the prevailing market salary for the managerial role. If the prospect of earning substantially more in a salaried corporate role ($150,000) eclipses the manager’s stipulated salary ($40,000), it can signal a business that might not yield a favorable return on investment. This underscores precisely why the value of a business remains contingent on the identity of the buyer.

Let’s demystify the ROI calculation for a small business through simple steps:

Starting with a straightforward calculation:

$200,000 SDE multiplied by 3.0 = $600,000 asking price = Impressive 33.33% ROI

However, when we factor in the deduction of your labor’s value based on the manager’s prevailing market-rate salary, the equation transforms:

$200,000 SDE – $40,000 salary = $160,000 EBITDA

$160,000 EBITDA multiplied by 4.0* = $620,000 asking price = Solid 25.80% ROI

*Notably, EBITDA multiples typically exceed SDE multiples.

Now, envision subtracting the worth of your labor relative to your forgone opportunity cost, culminating in this calculation:

$200,000 SDE – $150,000 salary = $50,000 EBITDA

$50,000 EBITDA divided by $600,000 asking price = Substantial 8.33% ROI

The return on investment (ROI) significantly hinges on the salary amount factored into the computation, tailored to your individual circumstances. Let’s delve into the subsequent scenarios concerning a company producing $250,000 in SDE, valuated at a 3.0 multiple—equivalent to $750,000. Rest assured, these calculations are grounded in confidence.

Certainly, here’s the revamped text in a confident tone:

The ROI fluctuates based on the buyer’s opportunity cost, particularly if the buyer actively engages in the business. Essentially, the value of the business is perceived differently by various buyers. When the buyer’s opportunity cost is minimal, the ROI escalates.

*It’s important to note that the mentioned scenarios do not encompass gains in capital appreciation or enhancements in business value, which we’ll discuss below.

When we ponder over what a small business truly is, it becomes clear that it’s an investment of a different kind. It’s essentially the acquisition of a role—a job.

However, the value of this job isn’t uniform—it varies according to the buyer. Consequently, the value of a small business is intricately linked to the buyer’s identity.

The underlying reality is that a significant number of small businesses would cease operations without the owner’s continued involvement. For many such enterprises, the departure of the owner would inevitably lead to closure within weeks or months. In these instances, the purchase isn’t so much a business as it is a job.

Is acquiring a job through this means undesirable?

Not at all, especially if it’s a favorable job based on your personal criteria for “favorable.” There’s no issue with buying into a job if the job you’re buying surpasses what you could secure for free. Numerous individuals can realize greater earnings through business ownership than through traditional employment.

Take the example of a non-English-speaking Korean immigrant. Finding a high-paying job might be challenging, but ownership of a small business, like a liquor store, could likely result in a six-figure income. This explains the prevalence of immigrant-owned small businesses in the United States. They’re able to generate more income from such ventures than from regular jobs. Their willingness to “purchase a job” in the form of a business stems from the financial sense and elevated earning potential it offers.

Rest assured, this perspective underscores the rationale behind business ownership’s financial viability.

What ROI Ignores When Valuing a Business

ROI Ignores the Value of Freedom & Opportunity

ROI considerations aside, there’s a realm of non-financial elements that deserve attention, prominently exemplified by the primary driver pushing individuals towards self-employment: freedom. Extensive research underscores the fact that a paramount motivation for embarking on entrepreneurial journeys is the inherent value attributed to freedom. Regrettably, conventional employment often falls short in delivering this coveted autonomy. When was the last instance you could swiftly leave your job to tend to a sick child, and then relish a chilled beer, savor pizza, and share movies with your son during daylight hours? In the realm of small business ownership, the luxury of unbridled freedom is your prerogative — to engage in what you desire, when you desire, alongside whomever you hold dear. Such is the unequivocal promise of this liberating path.

Diverse as aspirations may be, freedom takes on varying degrees of significance for each individual. This dynamic spectrum of values is what widens the potential valuation ranges for businesses, creating an expansive landscape. Small businesses, in their essence, bring forth an array of non-financial advantages that inherently defy precise quantification—these attributes hold uniquely varying worth in the eyes of different people. Consequently, the appraisal of a small business resides within the realm of high subjectivity.

While on the surface a job might seem “free,” the real cost of such a job often translates to a forfeiture of freedom. This very realization propels a substantial portion of entrepreneurs, myself included. Rather than settling for a job that’s costless but devoid of the prospect of freedom, many would opt to invest in a business that not only promises profit but, more importantly, offers the potential for liberating autonomy. For those who place a premium on freedom, the expense of “free” can far outweigh its literal cost, if it entails surrendering that precious freedom. As Henry David Thoreau aptly phrased it, “The price of anything is the amount of life you exchange for it.”

It’s crucial to recognize the inherent limitations of any financial model. Financial models are fundamentally numerical constructs. When decisions are distilled solely through a financial lens, they inherently sideline qualitative elements—factors that hold greater sway for many individuals than all the quantitative metrics combined. The realm of financial models neglects qualitative dimensions like the intangible essence of freedom. While it’s possible to attempt quantification of these qualitative aspects, pinning an exact dollar value on something as ethereal as personal freedom remains a formidable challenge.

ROI Ignores the Effects of Capital Appreciation

Think about McDonald’s, Walmart, and Starbucks. They all share a common thread—they’ve collectively amassed billions of dollars in capital gains for their proprietors. Typically, the lion’s share of an entrepreneur’s overall wealth is tied up in the form of capital appreciation within their businesses.

When it comes to computing ROI, it’s of paramount importance to factor in the impact of capital appreciation, denoting the growth in a business’s value. In most scenarios, a business’s value increases in correlation with its earnings growth, although not necessarily in direct proportion. Moreover, there’s also the potential for a gradual uptick in the business’s multiple, technically termed as “multiple expansion.” Let’s delve into a few scenarios for a clearer picture.

*Assumes a .10 annual (ex: 3.2 to 3.3) increase in the multiple (the higher the EBITDA, the higher the multiple).

It’s important to note that a growth rate of 20% is clearly not viable over the long term. Nonetheless, this example vividly demonstrates the significant impact of capital appreciation on ROI.

Now, let’s proceed to compute the influence of incorporating cumulative EBITDA from the business in the ROI calculation.

Unless you possess the ability to forecast a business’s future value, the precise computation of ROI remains elusive. While you can make an educated estimation or projection of ROI, it remains precisely that— an approximation.

When endeavoring to determine ROI in the context of a business acquisition, it’s imperative to factor in the influence of growth on the business’s value. Naturally, this influence will vary, being less pronounced for businesses with lower growth trajectories like retail, and more substantial for high-growth entities like those in the tech sector. Nevertheless, even with meticulous calculation, the outcome remains a rough gauge at best.

Calculating ROI for businesses inherently poses more challenges compared to other investments, say real estate, due to the intricacies associated with projecting a business’s future value.

ROI Ignores the Effects of Time (Annualized Returns)

ROI operates in a realm oblivious to the passage of time and its effects on returns. Whether an investment yields a 20% ROI in one year or stretches across a decade, the ROI remains constant, indifferent to the time span. Its true utility surfaces when pitting two investments against each other, confined within identical time frames for fair comparison.

Alternatively, we can harness the potential of annualization to gauge ROI on a yearly basis. For instance, if the ROI stands at 50% over five years, the annualized ROI computes to 10%.

While additional metrics like the internal rate of return (IRR) can also step into the spotlight, it’s important to acknowledge that calculating IRR poses greater complexity and isn’t as readily accessible to the average investor.

ROI Ignores the Effects of Leverage (“Cash-on-Cash Return”)

Additionally, ROI fails to consider the influence of leverage (such as bank financing) on returns. Let’s delve into multiple scenarios to understand how leverage affects ROI:

As evident from the charts above:

• ROI escalates alongside increased leverage.
• Returns are notably influenced by prevailing interest rates.
• A surge in interest rates corresponds to a dip in returns.
• Amplified leverage leads to heightened debt service, thereby elevating risk.

How Do I Use ROI for Valuing a Business?

In the context of selling your business, relying solely on ROI might not offer the most pertinent or valuable measure for determining your business’s worth. The key advantage of employing ROI lies in its swift and straightforward nature—it’s a handy “back of the envelope” method that can be swiftly employed.

Seasoned investors possess the knack to mentally compute ROI for a potential investment within mere seconds, enabling them to swiftly gauge if an opportunity merits their further consideration. ROI serves buyers well as a tool for juxtaposing two potential investments or for swiftly assessing the need to delve deeper into researching a particular investment opportunity.

Let’s take a practical scenario into account:

Imagine a friend presents an investment proposal related to their business. They seek to borrow $200,000 and commit to reimbursing you $300,000 over a decade. A swift mental calculation yields:

• Return = $100,000 ($300k – $200k)
• ROI = 50% ($100k / $200k)
• Annualized ROI = 10% ($100k / 10 years — without compounding)

A mere glance reveals that few seasoned investors would contemplate this investment after dedicating mere seconds to gauge its potential return. Why opt for a venture into a startup realm with a 10% ROI when historical returns on public stocks consistently range from 8% to 10%?

In a flip of its application, ROI can be reversed to compute the requisite repayment amount, grounded in desired returns. For instance, if public stocks yield 8% and this investment is perceived as four to five times riskier than established, public stocks, a robust 32%-40% annualized ROI would be necessary to offset the inherent investment risk. For an initial investment of $200,000, the aim would be to reap approximately $1,000,000 in a mere five years, effectively accounting for the risk factor.

Here’s how I promptly conducted this mental math:

• First, I gauged the investment’s level of risk to establish the desired ROI. Acknowledging the notably high failure rate of startups, along with the operational costs and intricacies of overseeing a minor stake in such ventures, the return needed to be at least four to five times the historical returns of public stocks. With an assumed 8% return on public stocks, multiplying this by four to five yielded the targeted return of 32%-40%. This substantial return factors in the startup’s inherent 50% failure rate.
• Applying the “rule of 72” (a formula predicting an investment’s doubling time based on its rate of return), I determined that an investment would double twice in four years at a 36% rate of return. This propelled the initial investment from $200,000 to $400,000 in year two and further to $800,000 in year four.
• Building upon this, I added 30% of $800,000 ($240,000) to reach $1,000,000.
• This comprehensive process unfolded in about 10 seconds of mental calculation. The beauty of utilizing ROI lies in its swiftness and ease. During a customary lunch discussion with a private equity associate, such calculations could easily be performed several times. It’s impractical to resort to a calculator each time and disrupt the conversation’s rhythm, so professionals in the field adeptly conduct these computations mentally, all while maintaining uninterrupted engagement. This skill is second nature for those in M&A, venture capital, or private equity.

Observe any episode of “Shark Tank” and you’ll note the frequent instances where judges assess potential investment returns. This mirrors how ROI functions in reality –– a quick, rudimentary yardstick for assessment.

Allow me to provide a second example, painting a vivid picture of ROI‘s practical application:

Imagine a business owner seeking $10,000,000 for their business, yielding a net of $2,000,000 annually. Initially, the ROI stands at 20%. However, things take an interesting turn when we consider that the business, being wholesale in nature, necessitates a $5,000,000 inventory purchase, distinct from the listed price. This adjustment shifts the ROI to 13.33% ($2,000,000 / $15,000,000 = 13.33%). At this juncture, it’s a situation requiring closer investigation—a point where delving into aspects like leverage impact, business risk, and latent potential becomes crucial.

Suppose the inventory can be financed at a 6% interest rate, resulting in a $300,000 annual interest on the inventory ($5,000,000 x 6% = $300,000). The recalibrated EBITDA after debt service now stands at $1,700,000, corresponding to an ROI of 17%.

If recent years witnessed dwindling revenues, gross margins, or profitability, the risk quotient for this business escalates. An ROI of 17% wouldn’t hold up in such circumstances, especially considering that returns on public stocks typically range between 8% and 10%.

However, if the owner claims an EBITDA of $2,000,000, it becomes paramount to meticulously scrutinize their EBITDA calculation. What exactly is encompassed in their calculations? Does it display an assertive stance? Are salary expenses included? Are any potential adjustments overlooked?

Other pivotal factors step into the spotlight as well: the impact of leverage on acquisition financing, annual capital expenditures (CapEx), the necessity for additional working capital infusion, and the stability as well as predictability of cash flows.

In conversations, ROI serves as a valuable compass, guiding the discourse through a gradual unearthing of insights. With each layer peeled back, you delve deeper, and as you do, the returns evolve in response to the newfound facets affecting either returns or business risk. Consequently, you perpetually gauge ROI mentally as the discussion advances, enriching your grasp of the business.

In practice, this exploration may lead you to adopt a tailored ROI version. Yet, the core intent remains unaltered: expediently assessing the investment’s return to facilitate comparisons or expedite judgment on whether the investment—and by extension, the conversation—is worth pursuing. ROI functions as an intuitive rule of thumb, facilitating swift comparisons of investment returns.

Exercise caution when employing ROI as a yardstick to evaluate the acquisition of a small business. While calculating ROI is straightforward, it fails to account for numerous pivotal variables. Prior to embarking on an ROI calculation, it’s prudent to keep the following points in mind:

• Begin by understanding your motive behind calculating ROI—what purpose does it serve?
• Establish the criteria that will guide your decision, encompassing both quantifiable and qualitative aspects. If your criteria lean heavily toward the quantitative, bear in mind that no mathematical formula can address qualitative considerations.
• Reflect on whether you’re entering an investment venture or essentially purchasing a job. If your intention is job acquisition, ROI might not be the most fitting metric.
• Weigh the appropriateness of utilizing SDE or EBITDA as the preferred cash flow measurement.
• Assign a value to your personal labor within the equation.
• Contemplate the worth of freedom in your evaluation and ascertain whether it should significantly impact your decision. If freedom holds substantial value, prioritize businesses that promise the highest degree of autonomy.
• Account for the opportunity cost you’ll incur.
• Factor in the effects of opportunity and capital appreciation—particularly relevant if these factors hold importance. In such cases, prioritize businesses with substantial growth potential.
• Acknowledge the time factor’s role in return calculations.
• Explore diverse scenarios to gauge how leverage could potentially shape your returns.
• Consider alternatives to ROI, like cash-on-cash return or the internal rate of return.
• If you’re treating the business as an investment, juxtapose its ROI against that of other investment avenues like stocks, bonds, or real estate.

Each of these considerations, among others, is pivotal as you weigh the prospects and costs tied to acquiring a specific business.

With this comprehensive approach, you can confidently navigate the intricacies of business evaluation.

Should I Use SDE or EBITDA to Calculate ROI?

In the calculation of ROI, which metric—SDE or EBITDA—should be employed to assess a business’s worth?

• Opt for SDE when valuing small businesses.
• Opt for EBITDA when assessing mid-sized businesses.

The distinction is clear-cut. SDE encompasses the owner’s salary, while EBITDA excludes it. To illustrate:

Use SDE to Value Small Businesses

SDE encompasses the owner’s salary, and this makes sense considering that the majority of small business owners are fully engaged in the operation. It’s a reflection of the fact that a new buyer is also likely to be immersed in the business on a full-time basis. SDE serves as the valuation method for small businesses where the incoming owner is set to assume full-time responsibilities post-closure. To illustrate, if an individual purchases a small business netting $100,000 annually and steps into the shoes of a full-time manager previously earning $50,000, their total earnings will amount to $150,000 annually ($100,000 net income + $50,000 salary). Whether the income stems from business profits or their own salary is immaterial to the buyer; the pivotal point is that they’re pocketing approximately $150,000 annually. This instance perfectly demonstrates how SDE encapsulates both business profits and the owner’s salary.

Use EBITDA to Value Mid-Sized Businesses

EBITDA deliberately excludes the owner’s salary, a deliberate approach in light of how most mid-sized businesses function. Such businesses are typically steered by a dedicated management team, a structure that persists post-acquisition. EBITDA serves as the valuation cornerstone for mid-sized businesses where the reins are handed to a non-owner CEO and a capable management team upon closing. For instance, in cases where a private equity group (PEG) acquires a business, they will onboard a CEO to orchestrate operations post-acquisition. If the business yields a net income of $1,200,000, factoring in the owner’s $200,000 annual compensation, the EBITDA stands at $1,000,000 (with SDE at $1,200,000). This alignment arises as the acquiring company will assign a new CEO with an annual $200,000 salary.

When comparing investments, it’s judicious to compute ROI using EBITDA, as it encapsulates the remaining cash flow after the owner’s salary is considered—reflecting the reality that someone will oversee business operations post-closure, usually not on a voluntary basis. Consequently, the ROI calculation should factor in the owner’s reasonable salary when deducing available cash flow.

A significant takeaway here is that utilizing SDE for ROI calculation yields a higher ROI compared to EBITDA. This stems from the inclusion of the owner’s salary in the cash flow, consequently elevating the cash flow and resulting in higher returns. For any business necessitating the new owner’s full-time involvement, a more substantial return is requisite to cover this commitment, subsequently leading to a reduced multiple or ROI. Likewise, mid-sized businesses command higher multiples (lower ROI) in comparison to small businesses, as they often entail a proficient management team and do not invariably demand the incoming owner’s active engagement post-acquisition.

Tips for Using ROI to Value a Business

Validate Cash Flow Accuracy: Keep in mind that all metrics of return (ROI, IRR, etc.) hinge on an impeccably accurate cash flow assessment. In the ROI calculation process, it’s paramount to ensure the cash flow figure employed is nothing short of precise. Trusting someone’s assertions about cash flow at face value is a pitfall to dodge. The fact that someone proclaims an EBITDA of $5 million doesn’t inherently render it true. Vigilance is required, especially when adjusting for owner’s salary, particularly if multiple family members play a role in the business or if the owner’s salary lacks objectivity, failing to align with prevailing market rates.

Account for Disparities: The return rate proves its mettle in comparing investments sharing akin criteria. For instance, employing ROI for comparing investments with disparate criteria like the following would be futile:

In the context of comparing two investments, it’s imperative that they align in the following key aspects:

– Time frame
– Leverage
– Potential
– Risk

When these elements are in harmony, a meaningful comparison can be drawn. However, when disparities emerge, it’s crucial to implement necessary adjustments to appropriately accommodate these differences.

Alternatives to ROI

ROI proves to be a valuable asset when its constraints are well understood. Nevertheless, there are instances when you may desire to incorporate elements that fall beyond ROI’s purview, like the effects of time or leverage. Fortunately, a range of alternatives are at your disposal for computing returns while factoring in these additional considerations. Each of these alternatives presents its own set of strengths and weaknesses.

Cash-on-Cash Return or Return on Equity (ROE)

Cash-on-cash return comes into play when leveraging or financing part of a transaction. If you’re making an all-cash payment, both cash-on-cash return and ROI remain identical. However, when leverage is involved, cash-on-cash return serves as the metric to gauge the effects of financing on returns.

For instance, cash-on-cash return is pivotal in assessing returns for real estate investments due to their potential for financing, unlike its use in stock market investments. This calculation also aids in determining the optimal mix of debt and equity when acquiring a business. By running various scenarios, you can compare diverse capitalization strategies and identify the financing structure that maximizes returns while containing risk impact.

Internal Rate of Return (IRR)

The IRR stands out as an all-encompassing gauge for return assessment, encompassing the influences of both leverage and time. However, its calculation demands effort and time due to its complexity. IRR’s efficacy is intricately tied to the investment’s holding period. Among those who frequently employ IRR for return calculations are private equity and venture capital entities. Moreover, the landscape includes more advanced iterations of IRR, including the modified internal rate of return (MIRR).

Real Rate of Return

The real rate of return stands as a robust measure, factoring in inflation’s impact on returns. In a scenario where a business’s value increases by 8% over a year, but inflation sits at 4%, the actual gain is 4%. While personal financial advisors frequently deploy the real rate of return, its application in acquisition evaluations is less frequent—unless a substantial variance in inflation rates between the investment periods being compared comes into play.