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Is Your Business A Good Investment?

Most entrepreneurs over-estimate their actual returns and under-estimate their required returns.

Is Your Business A Good Investment?

Many entrepreneurs assume that if they look after their business, then their business will automatically look after them. Sadly, that's rarely the case. Most business owners don't achieve the financial freedom and generational wealth that they dream about, because they conflate business metrics with investment metrics.

If you ask an entrepreneur how well their business is performing, they'll likely point to their turnover or net profit. However, a business can make a lot of money or be highly profitable without being a good investment.

For any investment to be considered "good", it has to generate actual returns that equal or exceed an investor's required returns. Unfortunately, many business owners don't understand either, so they're blissfully unaware of how they're being short-changed.

Actual returns are your ownership earnings divided by the capital that you've personally invested.

Note that your ownership earnings don't include your employee earnings, so they're basically your total compensation less a fair market-related salary. And your invested capital isn't just the money that you've put into your business, it's also the money that you've kept in your business (i.e. retained earnings).

Required returns are determined by an investment's risk profile.

For example, we don't expect double digit interest rates from a savings account because depositing money with a bank is a very low risk investment. Listed companies and immovable property are riskier investments, so we require proportionally higher rates of return.

A small business, by comparison, is one of the riskiest assets that you can trust with your hard-earned cash. Many fail, often within the first few years. Therefore, the required rate of return for a SME is usually at least 30%, and often 40% or higher.

The net consequence is that many business owners are subject to a double whammy:

1. They over-estimate their actual returns (often because they don't factor retained earnings into their invested capital, or mix employee and ownership earnings).

2. They under-estimate their required returns (often because they're emotionally invested and have an inflated sense of control over their future).