It Sounds Complicated, But It Really Isn’t…and It’s What Business is All About
Predominance of Risk vs. Return. An overwhelming portion of everything in business - at least in the transactional sense - boils down to risk vs. return. What level of risk are you assuming and what will you be paid for assuming that level of risk? And every decision should be considered through this lens.
Understand Return on Investment. There are several measures of return on investment in business, but they all boil down to this: for a given financial investment, what return will I earn?
Here are the measures you really need to know: Internal Rate of Return (“IRR”), Multiple on Investment (“MOI”), and Payback Period. And generally, use them together, given that between the three, they consider the key variables of any investment: cash in, cash out, and the timing of those cash flows.
Internal Rate of Return. In simple terms, IRR is the rate at which your investment is growing. For example, if you invest $100,000 in an investment and receive $10,000 back each year for 4 years and then $150,000 back at the end of the fifth year, your IRR is 15.8%, meaning you earned a compounded annual return of 15.8% on your investment. Spreadsheets are ideal for calculating IRRs and the analysis should be used regularly. Hardly a day goes by that I am not calculating IRR for something.
It is important to note that the IRR calculation itself has some fundamental flaws (e.g., the calculation assumes that cash flows during the measurement period are reinvested at the IRR rate, which is not usually the case; it does not distinguish between durations of investments; it does not account for differing scales of investment). You should learn them so that you don’t use the calculation improperly. But IRR, despite its flaws, has become a standard business language and you must know it and use it.
Multiple on Investment. This simply tells you what multiple of your investment you earned. Did you double your money, triple your money? For example, if your investment of $100,000 earned the cash flows in the IRR example, your multiple of investment would be the sum of all cash flows to you, divided by your investment. $10,000 + $10,000 + $10,000 + $10,000 + $150,000 = $190,000. Divide that by $100,000 and your MOI is 1.9.
The drawback of MOI is that it contains no measure of time. What if it took 15 years to generate the cash flows in our calculation? That would be a horrible ROI, given your annual return would be extremely low. But it’s a good check on your IRR calculations. You may calculate a respectable 20% IRR on a contemplated investment, but the projected MOI is only 1.2, which informs you that it is a short-term transaction and you might do better by looking for a higher MOI over a longer time period.
Payback Period. Payback period is one of the standard business school teachings and I still like it. The method is generally used in capital budgeting analyses. It simply tells you how long it will take to recoup your investment. Obviously, the shorter the payback period, the better.
For example, if you are considering buying a $100,000 widget machine in your factory and you calculate that you can generate $50,000 annually in after-tax profits on that investment, you are looking at a two-year payback, which is very respectable. If the profits were $10,000 annually, and the payback period were then ten years, you might reconsider that investment.
Find the Appropriate Measures and Use Them. As mentioned above, there are a variety of measures that are used. In real estate for instance, while they use IRR and MOI, they also use cash-on-cash returns, capitalization rates, net operating income, and others. In other industries, it’s other measures. Learn them and use them.
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