THIS IS MY 119TH BLOG ON UNDERSTANDING MONEY
TOOLS.
In this blog we are going to cover the basics of return on
investment that most people who get into business should understand. Why get into a business before you know
the basics of returns and what to expect from your business plan and proforma?
In previous blogs we discussed the simple and quick
compounded interest Rules of 7 and 10 based upon 72. Quickly, this means that if you expect your investment to
double in 7 years, it will be at a compounded interest of 10%. Similarly, if you expect to double your
money compounded in 10 years you will be making 7% on your money. The 72 I make mention to above is just
a bit more accurate as you divide 72 by the rate of return and that will give
you the number of years before you double your money.
One element missing here is inflation eroding the original
amount of money.
Let’s now discuss rates of return and internal rates of
return. For rate of return it is
quite simple. You merely divide
the profit (or perhaps loss) by the original amount invested. Let’s say you invest $100,000 for one
year and at the end of the year you sell for $125,000. That leaves a profit of $25,000. To convert that amount into return on
investment simply divide the $25,000 by the original investment of $100,000 and
you will get .25. Now, to convert
that figure into a percentage return on investment merely multiply times 100 or
move the decimal point two places to the right. You get 25%.
That is the return on investment, exclusive of the impact of inflation,
depreciation of an asset, etc.
In two businesses I have been closely involved in, the
oil/gas business and commercial real estate/land development we use “internal
rates of returns” (IRR’s), as it is closer to reality. Why is this? In both businesses you can invest significant money with
losses for a few years, and then hopefully make a great deal of money. Therefore, until you see all the
figures you don’t know what a return might look like on an annualized basis.
(Again, for simplification we are going to omit inflation, depreciation of the
assets, taxes and any depletion allowances the government might give as in the
oil/gas industry.) This is also
known as a discount rate or economic rate of return.
In calculating an internal return there is a formula to
follow which is not too complicated and you can put to memory: NPV=CF divided
by (1+ Interest Rate times N). NPV
equals net present value, CF is cash flow, Interest Rate is your objective rate
of return, and N is the number of years it takes you. Ouch! Let’s
make some sense of this. We have a
situation where we have a number of cash flows (CF’s) into the project being
negative in perhaps early years and positive later on down the line. The objective with this formula is to
bring the NPR (net present value) back to zero. NPV is on the left of the equal sign. Assume you want a 10% overall return on
investment.
Without a calculator this takes some guessing and
experimentation. Let’s say you
take $7,000 and start your business.
The first year you lose $2,000, the second year you lose $1,000, however
the third year you make $12,000.
That has returned a positive Cash Flow (CF) of $9,000. Now, going back to the formula I gave
you above you are going to also use the N, number of years, or in this case
three.
Let’s put this together. NPV is $7,000.
CF, or $9,000, divided by 1 plus 10% (.10) times 3. I’m far from being smart but I do know
that .10 times 3 is .30. Now take
1.30 and divide that number into CF or in this case $9,000. On my phone calculator it shows me
$6,923. Wow, that is close enough
for me to $7,000, and that gets me close to my goal of zero. Therefore, in the case above my
internal rate of return for my little business has been 10% for a three year
period including both losses and profit.
See you next time.
