The business buyers and owners we work with in the SME market tend to target a return on investment in a range from 10 to 40%.
This range is influenced by factors such as:
- industry prospects
- competitive dynamics
- points of difference
- use of technology
- delivery capability
...and a myriad of factors relating to the business model and specific enterprise.
Private business versus shares – a very different investment
In determining what is a fair return for an investment in a private business, it’s important to recognise that investing in a private business is not like investing in a blue-chip share on the stock exchange. Unlike shares, a private business is a relatively illiquid investment – it cannot be easily sold.
As we know, investments provide two forms of return, income return and capital return:
- Income return – each year a business generates earnings, net of tax, which can be distributed as dividends to owners;
- Capital return – the change in the market value of an asset.
It’s relatively easy to get a capital return from a listed investment, because you have a liquid market – you can sell all or a portion of your shares when they appreciate in value. With a SME, that capital return is harder to achieve because, as we often say, selling a business is not a simple exercise!
Therefore, most private business owners expect their business’ income return to be higher than that of a listed stock, to make up for the risks associated with the capital return.
In our experience, business owners generally expect returns from 10 to 40% on investments in the SME market, to take into account factors such as:
- lack of liquidity in the market
- risk of achieving predicted cash flows
- potential higher cost of finance relative to a larger corporate.
Why such a big range in expected ROI?
Ten to 40% is a significant range in terms of expected return on investment, and a number of factors influence where a business falls in that range. (Of course, there are also SMEs that are returning below 10% – as with any investment, not all opportunities are necessarily in the positive range, or positive all of the time. In fact, the relative volatility of investment returns in the SME market can also be a factor to consider when making investment decisions.)
Capital intensive versus operational spending
One factor influencing returns relates to the business model and capital structure.
For example, businesses with a higher level of heavy, tangible, fixed assets e.g. plant and equipment, will often command a lower return relative to a company that has less tangible and more intangible assets, such as projects, services, customers and contracts.
This is simply a function of what $1 of capital invested generates in terms of free cash flow.
Some capital-intensive businesses might generate $0.10 for every $1.00 of capital invested and they might have ongoing needs for capital reinvestment to maintain this earnings level (e.g. an earth-moving business).
Other businesses might have a greater reliance on operational expenditures (e.g. labour, business systems and processes) and less need for ‘hard’ capital – in a business like this, for every $1.00 of capital invested it might generate $0.25 in free cash flows (e.g. a business services firm).
However, every business is different and there can be the inverse of the examples identified above. Why? Usually because of business-specific issues such as:
- competitive advantages
- unique IP and points of difference
- operating and business model efficiencies
- supplier and customer contracts etc.
It’s a truism that not all businesses are the same and not all returns are the same. I’m afraid there are no helpful ‘rules of thumb’ in this area!
What to look for as an investor or owner
Business owners and those looking to acquire a business – either as a bolt-on or a new venture – should be careful to identify the following factors:
1. The quality of the earnings that drive the returns;
2. The degree to which the business requires additional expenditure (i.e. capital and operational expenditure) to sustain current and future returns.
These are separate considerations, but they can also be connected as earnings may be dependant on additional capital investments.
Ultimately, an understanding of these factors is critical to evaluating:
- where one should invest
- what the likely return might be
- the related risks.
'Quality earnings' the key
At JPAbusiness we often provide clients with business valuations and related due diligence advice on business acquisitions – the factors mentioned above are key in helping our clients make decisions on such investments.
They can also be very important for clients who are business owners, as understanding the returns on capital invested in their business makes for a more informed decision-making process about the performance of the business and helps identify the value drivers for future performance.
If you would like support or advice regarding whether the business you own or are looking to acquire has quality earnings, what its value may be in the market, and the issues to consider to protect and grow your investment, contact the JPAbusiness team on 02 6360 0360 (Orange) or 02 9893 1803 (Parramatta) for a confidential, obligation-free discussion.
James Price has over 30 years' experience in providing strategic, commercial and financial advice to Australian and international business clients. James' blogs provide business advice for aspiring and current small to mid-sized business owners, operators and managers.