What I want to detail in this article are two things. How to:
- look for, buy, and then make a 600% return on a business investment/purchase inside 24-months, and,
- compare returns and make business decisions using an internal rate of return (IRR) calculation. IRR is something every small business owner should understand.
You wouldn’t know that we’re in the midst of a pandemic and recession by looking at the stock market. The S&P is trading at multiples well above early January numbers.
Much of this year’s stock market gains in the S&P can be attributed to the performance of the top five stocks which include Apple, Microsoft, Amazon, Facebook, and Google—all well-known tech names.
Had you bought these five stocks at the beginning of the year, you would be looking at a cumulative gain north of 40%. Had you bought Apple in 2015, and held it until today, you would be looking at a 420% return.
Unfortunately, picking the next Apple, Microsoft, Netflix, and so on, is a bit of a crapshoot. You’re going to win on a couple and likely lose on more. In the end, hopefully, your gains exceed your losses.
How to Buy an Online Business and Make a Quick Return
On a somewhat related note, a couple of weeks ago I mentioned that I was looking at buying a company and that I had caught myself before I made a mistake. I’d suggested that buying the company would have been a mistake from a personal standpoint, but from an investment perspective, I believed that I would be able to make a 1000% return on my invested dollar inside of two years.
I’ve since received a number of emails asking what type of business investment could provide a 1000% return inside of two years, so I will endeavor to provide an example of my investment thesis and the process to go about gaining that type of ROI.
In the article, I mentioned that I had made an offer for a small B2B business. Here’s what I wrote in the article:
“I spent many hours doing due diligence including six months of growth planning, hiring plans, and even some potential staffing interviews. As part of my due diligence, I revamped the marketing, website, landing pages, spoke with some potential customers, and—believe it or not—received a commitment from one of those customers to proceed with my offering when ready.”
In this particular case, the business was valued based on 36 times monthly earnings multiple. The types of businesses I am looking at—online dot coms—are all valued based on monthly profits rather than the traditional multiple of five times yearly EBITDA.
The multiple varies from a low of 25 times to as high as 42 monthly EBITDA (or even greater), depending on the type of business, the nature of the revenues, attrition, brand, staff, and a host of other variables.
So, for example, if the company had revenues of $9,000 per month, with expenses of $3,000, the business valuation calculation is done as follows: the monthly profit of $6,000 X 36, which is $216,000.
Ideally, you are looking to buy a business where you can find a significant incremental upside in revenue, and this is what I managed to find with this particular business. In this case, I understood the potential upside in revenue, mostly because I was able to quickly pinpoint the changes that need to be made to the website, landing pages, ad campaigns, sales reps, pricing models, and business processes.
I believe that with the right changes, and the addition of one or two full-time salespeople, I would be able to increase revenues quite significantly. Now, moving back to the example I referenced above, it would be possible (again, these aren’t the actual numbers) to increase the monthly revenue from $9,000 to $45,000 per month. Assuming a similar EBITDA margin, the monthly bottom line would be $30,000.
Now fast forward two years later. It’s time to sell the business.
Again, assuming a similar sales multiple of 36 times monthly profit (remember that’s the multiple I used when I bought the business), the business’s value would be 36 X $30,000, which is $1,080,000.
Given the initial investment of $216,000, my profit on business disposition would be $840,000. Assuming I was able to profit about $450,000 during the life of the business, my total profit is $1,290,000.
My starting investment is $216,000. That’s what I paid for the business.
The end result, after the sale of the business two years later, including accumulated profits (before taxes), is estimated at $1,290,000.
The total return from day 1 to month 24, considering all of my assumptions, is approximately 600%. My IRR is estimated at 117% (more on IRR below).
How to Compare Investment Decisions Using Internal Rate of Return (IRR)
One of the problems many people have when confronted with whether to proceed with an investment decision is the difficulty in assessing the potential rate of return and then comparing that rate of return with other comparable investment options.
If you buy a stock today for $100, and sell it tomorrow for $200, then you made a 100% return on your investment. Alternatively, if you buy a stock today for $100, and sell it in five years for $200, although you still made a 100% return on your investment, you need to factor in the time value of money. In other words, $200 in five years isn’t the same as $200 tomorrow.
Now, let’s complicate this situation slightly. Let’s assume that the stock you buy for $100 today pays a 5% dividend per year for the next five years. For math simplicity purposes, let’s assume the dividend stays at 5% throughout the life of your holding, and that you collect the 5% dividend in the last year prior to sale for $200.
Here’s what the math looks like:
You start with $100 in year one, receive the dividend for five years, and sell the stock in year 5.
In this situation, the IRR is 19%.
Internal Rate of Return (IRR), quite simply, is the percentage return earned on a per-dollar basis for each period the dollars are invested.
Keep in mind, the above is a very simplified explanation of IRR with many applied assumptions, namely that the borrowing costs are embedded in the yearly return, and that the dividends themselves are reinvested at their own compounded IRR rate.
It is possible, using a modified version of the IRR formula, to include the borrowing costs and reinvestment rate. This formula is known as MIRR, or modified internal rate of return.
When to Use IRR:
I use IRR on every investment decision, and any decisions to proceed are based on the return assumptions over a period of time.
Once you know your IRR (or make some assumptions about possible returns), it is possible to compare various investments and measure the implied risk and potential reward.
IRR can be calculated with a simple formula inside Excel or Google Sheets with the following formula: =IRR(start field:end field)
You should also keep in mind that the IRR return assumptions are only as good as the accuracy of the input variables. Garbage in, garbage out. But, and at a minimum, knowing how to compare various competing investment options will help you decide whether to proceed with an investment or not.
What’s a Good IRR?
If I’m investing in a blue-chip dividend stock, I’m willing to accept a much lower IRR than a risky business proposition, but here are my basic benchmarks:
- Fundamental IRR investment (blue-chip dividend) = 7% to 13%
- Enhanced IRR investment (momentum stock, more inherent risk) = 13% to 19%
- Opportunistic IRR: (more unknowns) = 19% +
With regard to the business decision I discussed earlier in this article, I referenced a 117% IRR, which if achieved, is fantastic. I’ve written before about real estate opportunities with greater than 100% IRR, which you can read about here: Here’s How To Buy An Apartment Building And Make A Whopping 110% In Three Years
As with anything, and investments especially, a lot can happen between start to finish. In the situation where you’re looking to invest in an opportunity, you should of course find something that suits your skillset and capacity from a technical, personal, and business perspective. If you’re taking a significant risk, then you should expect a corresponding return; otherwise, you might do just as well by investing in a stock like Apple.
If you enjoyed this article, you might also enjoy: How to Become a Decamillionaire, Grow your Net Worth to $10 Million, and Join the 1% Club
And this one: How Do You Know When It’s Time to Sell Your Business? It’s Not All About the Money.
You should also consider subscribing to my blog. I publish one article a week on small business and wealth creation. You can subscribe here.
Also, I published a book during the summer of 2018, “The Kickass Entrepreneur’s Guide to Investing, Three Simple Steps to Create Massive Wealth with Your Business’s Profits.” It was number 1 on Amazon in both the business and non-fiction sections. You can get a free copy here.
