Investing in a business is a risky venture. It can take many personal sacrifices to build a business and achieve success. These efforts are generally accepted and profits expected but few people appreciate the ownership of their business itself as a ‘wealth engine’. Learn more about this concept to empower your business decision-making and maximise the value you’re gaining from your business.
Business as a wealth engine is a simple concept. You have invested capital in your business (equity or net assets). You get a return on your investment from the business’ profits. This is represented by your NPAT (net profit after tax). Your return on equity (ROE) is measured as NPAT/Equity.
You will take some of the profits out of the business (dividends or distributions) and you will reinvest the remainder of the profits into the business. This increases the amount of capital invested in the business and then requires a higher NPAT to maintain the previous return on equity.
How powerful this wealth engine is can be demonstrated in the following example.
- Assume you have $1m invested in your business and that your cost of capital is 10% (the cost of equity relates to the level of risk involved in your business)
- Further to this, you plan to invest 75% of your profits back into your business each year for 10 years at which time you sell your business at a price that reflects the return on equity it is producing
Depending on the return on equity that you achieve over that period, we can determine the net present value (NPV) of the cash flows your business will generate in that period. (NPV is value of dollars earned in a future period discounted to represent what they would be worth in your hand today)
Consider three scenarios where your average ROE over a 10-year period is 10%, 15% or 20%. The net present value (NPV) of the cash flows over the 10-year period (i.e., the cash flows are discounted at the cost of capital rate to state the cash flows in current year dollars):
- If the average ROE is 10%, the NPV of the cash flows is -$172k (negative)
- If the average ROE is 15%, the NPV of the cash flows is $540k
- If the average ROE is 20%, the NPV of the cash flows is $1.62m
Another way to visualise this is to understand how much cash your business will generate over the same period
Scenario 1: You will recover $1.1m on top of your initial $1.0m investment, however, given the risk of the investment, you would have been better to invest your money elsewhere
Scenario 2: You will recover $3.2m on top of your initial $1.0m investment. Given the risks involved this is a fair return
Scenario 3: You will recover $6.3m on top of your initial $1.0m investment. This is a much more desirable outcome
A key strategic focus for business should be to plan to achieve a return of equity of around 20% (depending on risk profiles). The power of your business as a wealth engine should be harnessed to provide you with a return on investment that makes your hard work worthwhile.
This is where an experienced virtual CFO can work with your business to ensure that your strategic settings and your operational performance levels support the achievement of appropriate ROE levels.