How To Use ROI for Valuing a Business

When it comes to selling your business, ROI isn’t the most relevant or useful metric for valuing your business. The primary advantage of using ROI is that it’s a quick-and-easy “back of the envelope” method. Sophisticated investors can calculate the ROI on a potential investment in their head in a few seconds, helping them determine if an investment is worth spending time on before pursuing it. 

Consider the following example:

A friend pitches you an investment idea in their company and asks to borrow $200,000 and then repay you $300,000 in 10 years. You can quickly calculate the following in your head:

Return = $100,000 ($300k – $200k)

ROI = 50% ($100k/$200k)

Annualized ROI = 10% ($100k/10 years – not compounded)

Few sophisticated investors would consider this investment after spending a few seconds calculating the potential return. Why would they consider a risky investment in a startup at a 10% ROI when returns on public stocks historically yield 8% to 10% and represent a much lower risk?

The ROI can also be used in the reverse direction to calculate the amount of the required repayment based on the desired returns. If the stock market yields 8%, and you consider this investment four to five times riskier than large, public stocks, you would require a 32% to 40% annualized ROI to account for the risk of the investment. If you invested $200,000, you would need to receive approximately $1 million in just five years to account for the risk. 

Here’s how I performed this calculation in my head:

1. First, I determined how risky the investment was so I could calculate the desired ROI. Given the high failure rate of startups and the cost and overhead of managing a small investment in a startup, I would need to receive a return of at least four to five times the historical returns generated by public stocks. I assumed an 8% return on public stocks and multiplied this by four to five to arrive at a return of 32% to 40%. This high rate of return accounts for the fact that startups have about a 50% failure rate.
2. After determining risk, I used the “rule of 72” to determine that the investment would double twice in four years. The rule of 72 is a formula that calculates how long it will take for an investment to double in value based on its rate of return. To use the rule of 72, you divide the interest rate by 72 to determine how long an investment will take to double. For example, at 12% interest, an investment will double in six years (72/12 = 6). An investment would double every two years at a 36% rate of return.
3. With these two calculations, I was able to determine that this took the initial investment of $200,000 to $400,000 in year two and to $800,000 in year four. I then added 30% of $800,000 ($240,000), to the $800,000 to arrive at $1 million.

The entire calculation took about 10 seconds to do in my head. This is the primary advantage of using ROI and multiples. They’re quick and easy to calculate. I might perform a calculation like this a dozen times in a typical lunch meeting with a private equity partner. It would be odd to pull out my phone every time to calculate returns and interrupt the flow of the conversation, so any seasoned professional learns to perform these calculations in their head, all without breaking eye contact. This skill is commonplace for anyone in M&A, venture capital, or private equity. 

Watch Shark Tank and count how many times the judges calculate potential returns on investments in one episode. This is exactly how ROI and multiples are used in the real world – as quick, crude rules of thumb.

Here’s a second example to illustrate how ROI is used in the real world:

Suppose a business owner wants $10 million for their business, and they net $2 million per year. So far, we have a 20% ROI. Easy enough. But now, suppose that the business is a local distributor, and the buyer must purchase $5 million in inventory, which isn’t included in the price. The ROI is now 13.33% ($2 million/$15 million = 13.33%). At this point, I wouldn’t be terribly interested, but I would want to dig deeper. I would want to consider the impact of leverage, how risky the business is, and the potential that exists in the business.

If the inventory can be financed at 6% interest, the annual interest on the inventory would be $300,000 ($5,000,000 x 6% = $300,000). We now have an EBITDA after debt service of $1.7 million, or an ROI of 17%. 

If revenues, gross margins, or profitability declined in recent years, I would consider this business risky, and an ROI of 17% wouldn’t suffice, given that returns on public stocks are often 8% to 10%.

But if the owner claimed the EBITDA was $2 million, I would need to closely examine how the owner calculated EBITDA. What exactly did they include in their calculations? Were they aggressive in their calculations? Did they include their salary? Did they miss any potential adjustments? Is the business growing?

I would also want to consider other factors, such as the impact of leverage on financing the acquisition, the amount of annual capital expenditures (CapEx), the need to inject additional working capital, and the stability and predictability of cash flows.

All of these considerations and more are critical when you evaluate the opportunity and costs of a particular business.

The primary advantage of using the ROI is that it’s a quick-and-easy “back of the envelope” method of calculating the value of a business.