Mergers & Acquisitions

Resources: M&A Encyclopedia

Comprehensive articles on every step of the process of buying or selling a business from the most exhaustive encyclopedia of M&A articles in the industry.

Business Valuation & Return on Investment (ROI)

One of the key factors to take into account when considering buying or selling a business is the return on investment (ROI). When valuing a business, ROI refers to the return on an investment divided by the investment amount. For example:

$100,000 return /$1,000,000 investment = 10% return on investment

Calculating ROI is quick and easy, enabling you to compare the potential returns on different investments so you can make an informed decision. While calculating the ROI can be useful, the ROI has several flaws, such as not accounting for time or leverage, which we will address later in this article. While ROI is rarely used to value a business, it’s helpful to understand what impact ROI may have on the value of a business and how returns can be impacted by multiple factors.

In the world of business valuation, ROI is the inverse of a multiple. If the multiple is 4.0, then the ROI is 25%. For example:

$1,000,000 EBITDA x 4.0 multiple = $4,000,000 price of business, or

$1,000,000 EBITDA / $4,000,000 price of business = 25% ROI

Common multiples for most small businesses are two to four times SDE. This equates to a 25% to 50% ROI.

Common multiples for mid-sized businesses are three to six times EBITDA. This equates to a 16.6% to 33% ROI.

This article:

  • Takes a look at other factors that can affect ROI, such as growth in the value of the business.
  • Outlines the limitations of ROI and several factors that ROI ignores,
  • Offers other methods of calculating returns when ROI is not applicable.
  • Examines many elements that can affect the ROI.
  • Offers advice on whether to consider SDE or EBITDA to determine the value of the business and the effects those decisions will have on the ROI.
  • Fully explores the many advantages and disadvantages of ROI, and how to use ROI intelligently to calculate the potential returns on a business.
  • Examine whether you should use SDE or EBITDA when calculating ROI, and alternatives to using ROI.

Read on for a complete overview of ROI and how it relates to valuing your business.


Table of Contents

  • What is the Purpose of Calculating ROI?
    • ROI is Used to Compare Investments
    • ROI is Used as a Quick Valuation Method at the Outset
    • ROI is Used as a Rule of Thumb
  • ROI Across Investment Classes
  • Advantages of Using ROI to Value a Business
  • Disadvantages of Using ROI to Value a Business
  • Is a Business Really an Investment?
  • What ROI Ignores When Valuing a Business
    • ROI Ignores the Value of Freedom & Opportunity
    • ROI Ignores the Effects of Capital Appreciation
    • ROI Ignores the Effects of Time (Annualized Returns)
    • ROI Ignores the Effects of Leverage (Cash-on-Cash Return)
  • How Do I Use ROI for Valuing a Business?
  • Should I Use SDE or EBITDA to Calculate ROI?
    • Use SDE to Value Small Businesses
    • Use EBITDA to Value Mid-Sized Businesses
  • Tips for Using ROI to Value a Business
  • Alternatives to ROI
    • Cash-on-Cash Return or Return on Equity (ROE)?
    • Internal Rate of Return (IRR)
    • Real Rate of Return

Typical Returns

The following chart shows typical returns (ROI) for small and mid-sized businesses and their corresponding multiples.

Business Valuation: Converting ROI to a Multiple
ROI Multiple Main Street Businesses Mid-Market Businesses
100% 1.0
50% 2.0
33.33% 3.0
25% 4.0
20% 5.0
16.66% 6.0
14.2% 7.0
12.5% 8.0


What is the Purpose of Calculating ROI?

ROI is Used to Compare Investments

The purpose of calculating the ROI is to compare investments to one another. Investors seek to maximize their returns and will always seek out investments with the highest ROI relative to risk. Calculating ROI on various investments simplifies the process of comparing investments to one another.

ROI is Used as a Quick Valuation Method at the Outset

ROI is typically used as a quick, “back of the envelope” method before other more thorough measures of return are used, such as the internal rate of return (IRR). Calculating ROI allows you to quickly evaluate and rank potential investments before deciding which ones to pursue in more depth. ROI can differ dramatically from business to business and from buyer to buyer for the same company, which is one of the reasons why the range of values can be so broad for a business.

For example, if a business is priced at $2,000,000 and generates $200,000 in EBITDA, you can run some quick calculations and determine that other investments are more attractive. The ROI in this scenario is 10%. Few investors would consider investing in a business that offers a 10% ROI when other lower risk, absentee investments are available, such as real estate or stocks. ROI is a handy tool to use before deciding to dig deeper into the merits of an investment.

ROI is Used as a Rule of Thumb

As a rule of thumb, ROI is a roughly practical measure that is not precise. For example, a tailor or carpenter may use their thumb to take quick measurements. Rules of thumb are just that … rules of thumb. They are not designed to be any more accurate than using your thumb when making a measurement. Using the ROI is a useful tool because it’s quick and easy. However, you must be aware of its limitations and know when to use the ROI when calculating returns on an investment.


ROI Across Investment Classes

ROI is primarily useful as a tool for quickly comparing investments within an asset class or across asset classes. Here is a comparison of returns on various asset classes.

 A Comparison of Investments
Investment Returns Liquidity Use of Leverage Risk
Bonds 1-4% High Low Medium
Stocks 6-10% High Low Medium
Real Estate 4-12% Medium High Medium
Businesses 1-100% Low Medium Very High

 


Advantages of Using ROI to Value a Business

Here are the primary advantages of using ROI:

  • Universally used: The ROI is simple to calculate and is used universally. Due to its broad use, the ROI allows one to evaluate and rank potential investments quickly.
  • Simplicity: The ROI is easy to use and is much simpler and faster than calculating the internal rate of return (IRR), for example.
  • Facilitates easy comparison: The ROI makes comparing an investment’s returns to other investments — such as real estate, stocks, bonds, or other businesses — quick and easy.

Disadvantages of Using ROI to Value a Business

Here are the primary disadvantages of using ROI:

  • Does not account for time: The ROI does not account for the impact of time. To do so, either use annualized ROI (simply divide the return by the number of years), or internal rate of return (IRR).
  • Does not account for the use of leverage: ROI does not always account for the impact of leverage on cash flows and, therefore, returns. To calculate the impact of leverage, either use “cash-on-cash return” or IRR. As leverage increases, the potential of gains or losses increases as well as risk. Also, the higher the interest rates, the greater the amount of debt service and the lower the returns. In other words, returns are higher when interest rates are lower if leverage is used, but lower interest rates tend to drive up the price of businesses, thereby offsetting the impact of higher returns.
  • Does not account for capital appreciation: ROI does not always consider the impact of capital appreciation. In most cases, only the ongoing cash flow is considered (EBITDA) and not the impact of growth on the value of a business.
  • Does not account for potential: ROI also does not consider the value of potential. If one is comparing two investments with similar rates of return, but one investment is highly scalable and has higher potential (e.g., a software business), then obviously, that investment may be more attractive.
  • Does not account for qualitative factors: ROI does not consider the impact of non-financial factors such as the value of freedom or the lost opportunity cost.
  • Does not account for risk: ROI does not consider the impact of risk on potential returns. If one is comparing two investments — real estate and a small business, for example — and returns are similar, but one investment is less risky (e.g., real estate), then the less risky investment is more attractive.
  • Does not account for inflation: ROI must be used carefully when comparing investments in time periods with significantly different inflation rates. To do so, use the real rate of return.
  • Is not appropriate for startups: Calculating ROI is impractical for startups. For startups, most sophisticated investors, such as venture capitalists, use discounted cash flow (DCF).

In summary, ROI is a helpful tool but should be used with caution. By being aware of its limitations and its intended goals, it can be a valuable tool whether you are a buyer, seller, or M&A advisor.


Is a Business Really an Investment?

This brings up the important question: Is a business an “investment?” The Oxford English Dictionary defines an investment as “the action of investing money for profit.” A business qualifies under this definition. However, note that the definition does not include investing one’s “labor” or “personal efforts.” It is defined as investing money, not sweat equity.

To calculate the returns on an investment, it is, therefore, necessary to remove the value of your personal efforts. In simpler terms, you should deduct the value of your labor, or your salary, from SDE to arrive at EBITDA, and then use EBITDA to calculate returns. The value of your labor should be based either on:

  • your lost opportunity cost (what you could earn elsewhere), or
  • what the market salary would be for the manager’s role in the business (assuming you will replace the manager).

For example, if you are a software engineer buying a coffee shop, your lost opportunity cost may be $150,000 per year, based on the thought that you could get a job in your trade for $150,000 per year. However, the market salary for the manager’s role (your role) at the coffee shop you are considering buying is only $40,000. To calculate potential returns, it would be more realistic to use your lost opportunity cost ($150,000) since this is what you could potentially earn elsewhere.

Special consideration should be given if there is a large disparity between your lost opportunity cost and the manager’s market salary. The business may be a poor investment if you can earn significantly more in a salaried corporate position ($150,000) than the manager’s salary ($40,000). This is precisely why the value of a business is dependent on who the buyer is.

A simple calculation of ROI for a small business would be:

$200,000 SDE x 3.0 = $600,000 asking price = 33.33% ROI

But, if we subtract the value of your labor based on the manager’s market-rate salary, the calculation would look like this:

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

$200,000 EBITDA x 4.0* = $620,000 asking price = 25.80% ROI

*EBITDA multiples are normally higher than SDE multiples.

Now, consider if we subtract the value of your labor based on your lost opportunity cost, then the calculation would look like this:

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

$50,000 EBITDA / $600,000 asking price = 8.33% ROI

The ROI is heavily dependent on the amount of the salary used in the calculation and, therefore, your personal situation. Let’s examine the following scenarios for a business generating $250,000 in SDE that is priced at a 3.0 multiple, or $750,000:

The Effect of Owner’s Salary on ROI
Based on $250,000 SDE x 3.0 Multiple
Salary $50,000 $100,000 $150,000 $200,000 $250,000
EBITDA
(SDE Minus Salary)
$200,000 $150,000 $100,000 $50,000 $0
Asking Price
(SDE Times Multiple)
$750,000 $750,000 $750,000 $750,000 $750,000
ROI
(EBITDA Divided by Asking Price)
26.66% 20.00% 13.33% 6.66% 0.00%

 

Again, the ROI varies based on the opportunity cost to the buyer, if the buyer will be actively working in the business. In other words, the business will have different values to different buyers. The lower the opportunity cost to the buyer, the higher the ROI.

*The scenarios above exclude gains in capital appreciation, or increases in the value of the business, which are discussed below.

If a small business is not an investment, what is it? What are you really receiving when you are buying a small business?

If you are buying a small business, you are buying a job.

The value of a job varies based on who the buyer is. Therefore, the value of a small business is highly dependent on who the buyer is.

The truth is that most small businesses would not continue to operate if it were not for the continued employment of the owner. For many small businesses, if the owner walked away from the business, the business would close in a matter of weeks or months. In these cases, one is not buying a business but rather buying a job.

Is buying a job bad?

No, not if it’s a good job, based on your definition of “good.” There is nothing wrong with buying a job if you can buy a better job than you could obtain for free. Many people can earn more from owning a business than from working at a job.

A Korean immigrant who is not fluent in English, for example, might have a difficult time finding a high-paid job, but could likely make six figures owning a small business such as a liquor store. This is why many small businesses in the United States are owned by immigrants. They can earn more from a small business than they can from a job. They are willing to “buy a job” (a business) because doing so allows them to earn more and makes sense financially.


What ROI Ignores When Valuing a Business

ROI Ignores the Value of Freedom & Opportunity

ROI also ignores non-financial factors, such as the number one reason people go into business for themselves — freedom. Studies show that one of the top reasons people go into business for themselves is because they value freedom. Few traditional jobs offer freedom. When was the last time your kid was sick and you left your job to go home, drink a cold beer, eat pizza and watch movies with your son in the middle of the day? With a small business, you have more freedom to do whatever you like, whenever you like, with whomever you like.

Freedom carries different levels of value to different people. This is why the ranges of potential values for a business are so broad. Small businesses offer many non-financial benefits, which are inherently difficult to value and carry significantly different values to different people. Valuing a small business is therefore highly subjective.

While, in theory, a job may be “free,” the real price of a job is a lack of freedom. This is precisely the driving force for most entrepreneurs, myself included. Many would rather buy a business that offers the opportunity for freedom than accept a job that costs nothing but does not offer the possibility of freedom. For those who value freedom, “free” may be too expensive a price to pay if it means a loss of freedom. Or in the words of Henry David Thoreau, “The price of anything is the amount of life you exchange for it.”

First off, this is the inherent limitation of any financial model. Financial models are just that — financial models. By definition, if you reduce your decision to a financial model, you have excluded qualitative factors, which are far more important for many people than all quantitative factors combined. Financial models ignore qualitative factors such as freedom. Of course, you can attempt to put a number on the qualitative factors, but can you place an exact dollar value on your freedom?

Second, few jobs offer the same level of opportunity (capital appreciation) as owning and operating a business. History is replete with rags-to-riches stories of entrepreneurs who have started or purchased a business and gone on to become incredibly wealthy.

For example, Ray Kroc purchased a small restaurant in 1954 and turned it into the multi-billion dollar McDonald’s empire.

Business Valuation & Return on Investment (ROI)

Ray Kroc’s first McDonald’s (Source)

Sam Walton, the founder of Walmart, opened his first store in 1962 in Rogers, Arkansas.

Business Valuation & Return on Investment (ROI)

Sam Walton’s first store in 1954. (Source)

Howard Schultz, the founder of Starbucks, opened the first Starbucks in Seattle in 1971.

Business Valuation & Return on Investment (ROI)

Starbucks’ first location in 1971

ROI Ignores the Effects of Capital Appreciation

What do McDonald’s, Walmart, and Starbucks have in common? They have all generated billions of dollars in capital appreciation for their owners. In most cases, the majority of an entrepreneur’s net worth is in the form of capital appreciation in their business.

When calculating ROI, it’s critical to consider the effects of capital appreciation, or growth in the value of the business. In most scenarios, the value of a business grows in relation to, but not directly proportional to, growth in its earnings. However, there may be a gradual growth in the multiple as well, which is technically called “multiple expansion.” Let’s examine a few scenarios:

ROI and the Effects of Capital Appreciation on the Value of a Business
Assumes a 5% Annual Growth Rate in EBITDA
Year Annual Growth Rate in EBITDA EBITDA Multiple Value of Business
(EBITDA x Multiple)
ROI
1 5% 500,000 3.00 1,500,000
2 5% 525,000 3.10 1,627,500 9%
3 5% 551,250 3.20 1,764,000 18%
4 5% 578,813 3.30 1,910,081 27%
5 5% 607,753 3.40 2,066,361 38%
6 5% 638,141 3.50 2,233,493 49%
7 5% 670,048 3.60 2,412,172 61%
8 5% 703,550 3.70 2,603,136 74%
9 5% 738,728 3.80 2,807,165 87%
10 5% 775,664 3.90 3,025,090 102%

 

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

ROI and the Effects of Capital Appreciation on the Value of a Business

Assumes a 20% Annual Growth Rate in EBITDA

Year Annual Growth Rate in EBITDA EBITDA Multiple Value of
Business
ROI
1 20% 500,000 3.00 1,500,000
2 20% 600,000 3.25 1,950,000 30%
3 20% 720,000 3.50 2,520,000 68%
4 20% 864,000 3.75 3,240,000 116%
5 20% 1,036,800 4.00 4,147,200 176%
6 20% 1,244,160 4.25 5,287,680 253%
7 20% 1,492,992 4.50 6,718,464 348%
8 20% 1,791,590 4.75 8,510,054 467%
9 20% 2,149,908 5.00 10,749,542 617%
10 20% 2,579,890 5.25 13,544,423 803%

 

Keep in mind that a 20% growth rate is obviously not sustainable for long. However, this illustrates the incredible effects of capital appreciation on ROI.

Let’s now calculate the effect of including cumulative EBITDA from the business when calculating ROI.

ROI and the Effects of Capital Appreciation on the Value of a Business
Assumes a 5% Growth Rate in EBITDA
Year Annual Growth Rate in EBITDA EBITDA Multiple Value of
Business
Plus Cumulative
EBITDA
Total ROI
1 5% 500,000 3.00 1,500,000 500,000 2,000,000 0
2 5% 525,000 3.10 1,627,500 1,025,000 2,652,500 77%
3 5% 551,250 3.20 1,764,000 1,576,250 3,340,250 123%
4 5% 578,813 3.30 1,910,081 2,155,063 4,065,144 171%
5 5% 607,753 3.40 2,066,361 2,762,816 4,829,176 222%
6 5% 638,141 3.50 2,233,493 3,400,956 5,634,449 276%
7 5% 670,048 3.60 2,412,172 4,071,004 6,483,176 332%
8 5% 703,550 3.70 2,603,136 4,774,554 7,377,690 392%
9 5% 738,728 3.80 2,807,165 5,513,282 8,320,448 455%
10 5% 775,664 3.90 3,025,090 6,288,946 9,314,036 521%

 

ROI and the Effects of Capital Appreciation on the Value of a Business
Assumes a 20% Growth Rate in EBITDA
Year Annual Growth Rate in EBITDA EBITDA Multiple Value of
Business
Plus Cumulative
EBITDA
Total ROI
1 20% 500,000 3.00 1,500,000 500,000 2,000,000 0
2 20% 600,000 3.25 1,950,000 1,100,000 3,050,000 103%
3 20% 720,000 3.50 2,520,000 1,600,000 4,120,000 175%
4 20% 864,000 3.75 3,240,000 2,684,000 5,924,000 295%
5 20% 1,036,800 4.00 4,147,200 3,720,800 7,868,000 425%
6 20% 1,244,160 4.25 5,287,680 4,964,960 10,252,640 584%
7 20% 1,492,992 4.50 6,718,464 6,457,952 13,176,416 778%
8 20% 1,791,590 4.75 8,510,054 8,249,542 16,759,597 1017%
9 20% 2,149,908 5.00 10,749,542 10,399,451 21,148,993 1310%
10 20% 2,579,890 5.25 13,544,423 12,979,341 26,523,764 1668%

 

Unless you can project the future value of a business, you cannot accurately calculate ROI. You can estimate, or project ROI, but it is just that — an estimate.

When attempting to calculate ROI on the acquisition of a business, it’s critical to take into account the impact of growth on the value of a business. Obviously, this impact will be less for low-growth businesses, such as retail, and greater for high-growth businesses, such as those in tech. Regardless, such a calculation will be a crude estimate, at best.

Calculating ROI on businesses is inherently more difficult than calculating ROI on other investments, such as real estate, due to the difficulty of projecting the future value of a business.

ROI Ignores the Effects of Time (Annualized Returns)

ROI does not take into account the impact of time on returns. Whether an investment takes one or ten years to generate a 20% ROI, the ROI is the same, regardless of the time frame. ROI is, therefore, most useful when comparing two investments over equal time frames.

Alternatively, the ROI can be annualized. For example, if the ROI were 50% over a period of five years, the annualized ROI would be 10%.

Other metrics can be used as well, such as the internal rate of return (IRR). However, the IRR is significantly more difficult to calculate and is not as accessible to the average investor.

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

ROI also does not take into account the impact of leverage (e.g., bank financing) on returns. Let’s examine several scenarios and their impact of leverage on ROI:

The Impact of Leverage on ROI & Business Value
Assumes a 10-Year Note @ 6% Interest
10% Down 25% Down 50% Down All Cash
EBITDA 1,000,000 1,000,000 1,000,000 1,000,000
Price of Business 4,000,000 4,000,000 4,000,000 4,000,000
Down Payment 400,000 1,000,000 2,000,000 4,000,000
Annual Debt Service 479,604 399,672 266,448 0
Cash Flow After Debt Service 520,396 600,328 733,552 1,000,000
Cash-on-Cash Return 130.10% 60.03% 36.68% 25.00%

 

The Impact of Leverage on ROI & Business Value
Assumes a 10-Year Note @ 8% Interest
10% Down 25% Down 50% Down All Cash
EBITDA 1,000,000 1,000,000 1,000,000 1,000,000
Price of Business 4,000,000 4,000,000 4,000,000 4,000,000
Down Payment 400,000 1,000,000 2,000,000 4,000,000
Annual Debt Service 524,124 436,776 291,180 0
Cash Flow After Debt Service 475,876 563,224 708,820 1,000,000
Cash-on-Cash Return 118.97% 56.32% 35.44% 25.00%

 

As the charts above illustrate:

  • ROI increases as leverage increases.
  • Returns are highly dependent on interest rates.
  • When interest rates rise, returns decrease.
  • The greater the leverage, the higher the debt service, which increases risk.

How Do I Use ROI for Valuing a Business?

When it comes to selling your business, using ROI is not the most relevant or useful metric for valuing your business. The primary advantage of using the ROI is that it is a quick-and-easy “back of the envelope” method that can be quickly performed.

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 further. ROI is used by buyers to compare two potential investments or to evaluate if it’s worth spending time researching an investment in more depth.

Let’s 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 ten 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%?

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

Here is how I performed this calculation in my head:

    1. I determined how risky the investment was so I could calculate the desired ROI. Given the extremely 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 on public stocks. I assumed an 8% return on public stocks and multiplied this by four to five to arrive at a return of 32%-40%. This high rate of return accounts for the fact that startups have about a 50% failure rate.
    2. I used the “rule of 72” (a formula that calculates how long it will take for an investment to double in value, based on its rate of return) to determine that the investment would double twice in four years (an investment would double every two years at a 36% rate of return).
    3. 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 $1,000,000.

This entire calculation took about 10 seconds to do in my head. This is the primary advantage of using ROI. It is quick and easy. In a typical lunch meeting with a private equity partner, I might perform a calculation like this a dozen times. 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 in one episode the judges calculate potential returns on investments. This is exactly how ROI is used in the real world – – as a quick, crude rule of thumb.

Here is a second example to illustrate when ROI is used in the real world:

Suppose a business owner wants $10,000,000 for their business, and they net $2,000,000 per year. So far, we have a 20% ROI. But now, suppose that the business is a wholesale business and the buyer must purchase $5,000,000 in inventory, which is not included in the price. The ROI is now 13.33% ($2,000,000 / $15,000,000 = 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, then 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 $1,700,000, 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% would not suffice, given that returns on public stocks are often 8%-10%.

But if the owner claimed the EBITDA was $2,000,000, 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?

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, or the stability and predictability of cash flows.

ROI is a useful tool during conversations, especially given that, in most conversations, you are slowly peeling back the layers of the onion as you learn more about the business or investment. ROI is used in a circular fashion. You calculate the ROI. If it looks good, you probe deeper. As you probe and dig deeper, the returns change as you uncover additional factors that can affect the returns or the risk of the business, so you continue to calculate the ROI in your head as the conversation progresses and your knowledge of the business increases.

In reality, as you probe deeper, you may be using a modified version of the ROI. However, the objective is the same: to quickly calculate the return on the investment so you can compare the investment to others, or quickly determine if the investment — and hence the conversation — is worth pursuing. The ROI is used as a rule of thumb for quickly comparing the returns on investments.

Be careful using the ROI when evaluating the purchase of a small business. The ROI is simple to calculate but it neglects several important variables. Before calculating ROI, we recommend considering the following:

  • Ask yourself why you are attempting to calculate ROI — what is your purpose?
  • Determine the criteria for your decision — both quantitative and qualitative. If your criteria are primarily quantitative, then no mathematical formula will address the qualitative criteria.
  • Ask yourself if you are making an investment or buying a job — if you are buying a job, then ROI may not be the best metric to use.
  • Determine if SDE or EBITDA is the more appropriate measure of cash flow.
  • Calculate the value of your personal labor.
  • Consider how much freedom is worth to you and if you should take this into consideration when making your decision. If freedom is valuable to you, search for a business that offers the maximum amount of freedom.
  • Consider your lost opportunity cost.
  • Calculate the effects of opportunity, or capital appreciation — if this is important to you, search for a business with tremendous growth potential.
  • Consider the effects of time when calculating returns.
  • Run various calculations to see how leverage may impact your returns.
  • Consider using alternatives to ROI, such as cash-on-cash return or the internal rate of return.
  • If you are buying a business as an investment, compare the ROI to other investments, such as stocks, bonds, or real estate.

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


Should I Use SDE or EBITDA to Calculate ROI?

When calculating ROI, should you use SDE or EBITDA to calculate ROI on a business?

Use SDE when valuing small businesses.

Use EBITDA when valuing mid-sized businesses.

What’s the difference? It’s simple. SDE includes the owner’s salary and EBITDA does not include the owner’s salary. For example:

Business Valuation & Cash Flow: Calculating SDE vs EBITDA
SDE EBITDA
Net Income $500,000 $500,000
Owner’s Salary $200,000 (included in calculation) $200,000 (not included in calculation)
Total $700,000 $500,000

 

Use SDE to Value Small Businesses

SDE includes the owner’s salary because most owners work full-time in a small business, so a new buyer will also likely work full-time in the business. SDE is used to value small businesses in which the new owner will work full-time in the business post-closing. For example, an individual who buys a small business and nets $100,000 per year, replacing a full-time manager who was paid $50,000, will earn $150,000 per year ($100,000 net income + $50,000 salary). It doesn’t make any difference to the buyer if the income is coming from profits from the business, or their salary — all that matters is that they are “putting about $150,000 per year” in their pocket. This example shows how SDE includes the profit from the business plus the owner’s salary.

Use EBITDA to Value Mid-Sized Businesses

EBITDA does not include the owner’s salary because most mid-sized businesses are run by a management team and will continue to do so post-closing. EBITDA is used to value mid-sized businesses in which a management team and non-owner CEO operate the business post-closing. For example, if a private equity group (PEG) buys a business, they will hire a CEO to operate the business post-closing. If the net income from the business is $1,200,000 after paying the owner $200,000 per year, then the EBITDA is $1,000,000 (the SDE is $1,200,000) because the company purchasing the business will hire a new CEO at an annual salary of $200,000 per year.

When calculating ROI to compare investments with one another, it makes sense to use EBITDA because EBITDA is the cash flow left over after paying yourself a salary to operate the business. Someone will have to run the business post-closing and it’s unlikely you will work for free. Therefore, you should pay yourself a salary to manage the business and deduct this from the available cash flow when calculating ROI.

It’s important to understand that using SDE to calculate ROI results in a higher ROI than using EBITDA. This is because the owner’s salary is included in the cash flow, so the cash flow is higher, resulting in higher returns. Any business that requires a new owner to work full-time in the business will demand a higher return to cover that cost, and will command a lower multiple, or a lower ROI. Likewise, mid-sized businesses sell at higher multiples (lower ROI) than small businesses because a management team manages the business and a new owner is not always required to work in the business post-closing.

Tips for Using ROI to Value a Business

Ensure Cash Flow is Accurate: Note that all measures of return (ROI, IRR, etc.) are dependent on an accurate measurement of cash flow. When calculating ROI, you must be sure you are using an accurate cash flow figure. Never accept someone’s claims of cash flow at face value. Just because someone claims their EBITDA is $5 million does not mean their EBITDA is actually $5 million. Special attention should be paid to making adjustments to the owner’s salary, especially when multiple family members are involved in the business, or if the owner’s salary is highly subjective and not comparable to current market rates.

Account for Differences: The rate of return is only useful when comparing two investments with similar criteria. For example, the ROI would not be useful comparing investments with the following different criteria:

  Investment A Investment B
Time Frame 1 year 5 years
Leverage 0% Leverage 80% Leverage (or 80% of the investment is financed)
Potential Similar investments generate returns of 4-6% Potential annual returns of 25%
Risk 0.1% Failure Rate 50% Failure Rate

 

When comparing two investments, they should share the following similar criteria:

  • Time frame
  • Leverage
  • Potential
  • Risk

If they don’t, then adjustments should be made to account for the differences.


Alternatives to ROI

ROI is a helpful tool if you are aware of its limitations. However, at times you may wish to account for factors ROI does not consider, such as the impact of time or leverage. Several alternatives exist for calculating returns that consider other factors. Each alternative has advantages and disadvantages.

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

Cash-on-cash return is only necessary if you are employing leverage, or financing a portion of the transaction. If you are paying all cash, then cash-on-cash return and ROI will be the same. Otherwise, use cash and cash return to evaluate the impact of leverage on returns.

For example, calculating cash-on-cash returns is used when assessing returns on real estate, which can be readily financed, but this method is not used when investing in the stock market. Calculating a cash-on-cash return can also help you decide the appropriate mix of debt and equity when purchasing a business. Running multiple scenarios can help you compare multiple capitalization strategies to determine the ideal financing structure to maximize returns while mitigating the impact of risk.

Internal Rate of Return (IRR)

The IRR is perhaps the most comprehensive measure of calculating returns, and accounts for both the impact of leverage and of time. However, it is difficult and time-consuming to calculate. IRR is heavily dependent on the amount of time an investment is held. IRR is most commonly used by private equity and venture capital groups when calculating returns. Other more advanced versions of IRR also exist, such as the modified internal rate of return (MIRR).

Real Rate of Return

The real rate of return calculates returns after accounting for the impact of inflation. If the value of a business grows 8% in one year, but inflation is 4%, then the real rate of return is 4%. The real rate of return is often used by personal financial advisors. However, it is not often used when assessing acquisitions unless the inflation rate for the time periods of the investments being compared is significantly different.