Return on Investment (ROI) is generally referred to as the cash or profit gained from equity dollars invested. It is also referred to as Return on Equity (ROE). The return can be expressed as a dollar amount, or converted to a percentage by dividing the return by the equity deployed. Typically, returns are calculated on an annual basis and referred to as annual rate of return.

Dollars Received / Dollars Originally Invested = Rate of Return

Return can also be calculated on total capitalization (debt and equity). Such a return would be calculated as follows:

Dollars Received / (Equity Capital + Debt Capital Invested) = Return on Total Capitalization

Example: If $50 was received in year one as a return on $200 invested the rate of return would be 25 percent, calculated as 50/200 = .25 or 25 percent

These returns can be calculated after the fact, as above, or the formula can be used to calculate the amount that can be invested and still yield a required rate of return. For example, if a given investment is expected to earn $50 and the required rate of return is 25 percent, then the amount that can be invested is $200. Using basic algebra to rearrange our original formula for calculated rate of return, we obtain the following formula to calculate investment amount that will yield the desired rate of return given the expected amount of income:

Dollars Received /Required Rate of Return = Dollars Originally Invested
$50 / .25 = $200

When considering the discount rate or required return on investment, it is helpful to study the historical returns of various investments. The table below lists the average annual total returns earned on a variety of investments between 1926 and 2000. Each of the investments in the list is publicly traded (due to the lack of information available on private investments). If we consider the character of the investments listed and the returns of each, we can make some general conclusions as the required rates of return on investments that are not listed below, such as private (non-public) investments.

1 Source: SBBI Valuation Edition 2001 Yearbook. Returns are the average annual total (income and capital appreciation) arithmetic mean for 1926 to 2000 in the United States.
2 Micro-Cap Stocks is defined as the portfolio of stocks comprised of the 9th and 10th deciles of the New York Stock Exchange. According to the Center for Research in Security Prices, University of Chicago, the average capitalization of micro cap companies from 1926 to 2000 was $68 million.
3 Returns are return to total capitalization (debt and equity).

Each investment listed in the table above was publicly traded, thus marketable. The lowest rate of return was U.S. Treasury bills at 3.9 percent annually and the highest was Micro-Cap stock at 18.4 percent annually. Similarly, the investment with the lowest amount of risk was the U.S. Treasury bill, and the investment with the highest amount of risk was the Micro-Cap stocks. Although not shown here, this was determined by using the standard deviation of the returns.

If we try to relate the returns on this table to small, privately held businesses, we can assume the required returns for such would be higher than the riskiest investment in the table – Micro-Cap stocks. The primary reasons are as follows:

1) The average private company will be less marketable than the average publicly traded Micro-Cap size company, therefore involving more risk.
2) The average private company will be smaller than the average publicly traded Micro-Cap size company and have poorer access to equity and debt capital involving higher costs and risk.

Remember that the required rate of return on an investment reflects the degree of risk of the investment. Risk is the degree of uncertainty that a given investment will actually yield the returns (income) that are anticipated. As risk rises, so must the rate of return to compensate the investor for the risk he or she bears.

This article was written by David L. Perkins, Jr. He is a VERCOR partner, M&A Consultant, business appraiser and editor and publisher of the national newsletter titled The Business Owner.