If you are seeking funding for your business by way of investment, it is likely that you will need to include an estimate of the return on investment an investor can expect to make from their investment in your business plan. Investors use the return on investment calculation to compare several different investments in deciding whether to invest or not.
How to Calculate Return on Investment
Different investors will use different methods to calculate return on investment, various techniques exist, the main ones of which are described below.
When presenting your plan and financial projections for funding, you should decide which method suits the particular application and include the calculated amount in your documents.
Return on Investment – ROI
The return on the investment measures the overall profit on an investment expressed as a percentage of the amount invested. It takes no account of the time value of money, and represents the return over the lifetime of the investment.
The return on investment formula is
As an example, if an investor invests 100,000 in your business and after 5 years receives 400,000, then the ROI is given by.
ROI = Profit / Investment ROI = (400,000-100,000) / 100,000 = 300%
Annual Return on Investment – AROI
The AROI seeks to give an average annual return based on the total return on investment.
Using the figures form the previous example, the AROI calculation is then given as follows:
AROI = ROI / Term AROI = 300% / 5 = 60%
Implicit in the calculation of this AROI is the assumption that the business goes on forever with annual returns of 60,000.
The multiple, tells and investor how many times their original investment has been returned. The multiple is given by the formula:
In the example above, the amount returned was 400,000 and the amount invested was 100,000, the multiple is calculated as follows:
Multiple = Total amount returned by the investment / Investment Multiple = 400,000 / 100,000 = 4
Again, the multiple takes no account of the time value of money.
Compound Annual Growth Rate – CAGR
The compound annual growth rate seeks to take account of the time value of money. The calculation uses discounted cash flow techniques, and seeks to find the steady annual growth rate which the investment cash flows are equivalent to.
Mathematically, the compound annual growth rate is the same as the internal rate of return (IRR) of the cash flows from the investment.
In the above example, the investment was 100,000 and the investor received 400,000 after 5 years. In this simple example the internal rate of return or compound annual growth rate is given as follows:
Compound annual growth rate = (Amount returned / Amount invested)(1 / Term) - 1 Compound annual growth rate = (400,000 / 100,000)(1 / 5) - 1 = 31.95%
This can be seen in the table below
So when an investor receives 400,000 after 5 years from an initial investment of 100,000, it is equivalent to them receiving a compound annual growth rate of 31.95%.
Our compound annual growth rate calculator can be used to work out the discounted cash flow calculation for you.
Typical Rates of Return on Investment
Depending on the stage your business is at, the return required by investors will vary. Generally the earlier stage the business, the more risky it will be perceived and the greater the return required.
Typically investors will look for the best return on investment with a minimum of 30 – 40% compound annual growth rate. The table below sets out example compound annual growth rates with corresponding ROI, AROI and multiples for a 5 year term.
Whichever method is chosen, the return the investor is expected to make by investing in your business, should be clearly identified in you business plan summary or financial projections.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.