What makes a good business? Part 3 of the IRR trilogy

This post was inspired by reading a Quora response where the child of a top 1% family says that one of the advantages of his upbringing is that his parents taught him about how business works. “Business” is a somewhat broad term that some schools say takes two years and $120k in tuition to “master”. However, as we typically do in this blog, we can educate ourselves on some of the central concepts of business on our own through spreadsheets!

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Our hope is that anyone with internet access can find this page and play around with the spreadsheets to begin to think about what makes a good business. Now if only this site could also provide the exotic travel experiences, connections, and the ability to take risks with a safety net that growing up in the 1% also provides…

So what makes a good business? Is a good business one that offers great perks like free food and snacks? Or pays their employees the most? Or perhaps one that offers generous parental benefits and integrates children into working parents’ lives? While these are plusses (especially the last one!), we’d argue that one starting point for thinking about what makes a good business is the rate of return generated by the business on the money invested to get the business running. From a big picture perspective, before starting a business, you have the choice of either putting your money into existing public businesses via the stock market (earning maybe 5-7%),  or investing in your new business and potentially earn more.

As a reminder, the internal rate of return (IRR) is an important concept in finance that gives the user a sense of how good an investment is based on the amount and timing of cash flows received from the investment in the future. We explored the idea in our recent posts evaluating whether medical school is worth it and whether it is better to buy or rent a house.

We want to point our readers to a great YouTube video by Bill Ackman, which explores business concepts in detail in video format. We’ll demonstrate calculating the rate of return from a business by following the video’s example of a lemonade stand.

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Profits

At the core of every business is the value proposition and the profits generated by that value proposition. Every business provides something that its customers demand at a price that both: 1) makes the customer better off by purchasing and 2) covers the business’ costs and provides some profits.

In the case of the lemonade stand, the refreshing glass of lemonade is sold for one dollar, costs the lemonade stand less than one dollar to provide, and is valued higher than one dollar by its customers. As another example, the value proposition of a grocery store is that it provides a convenient place for customers to buy food for a price slightly higher than it takes the store to purchase the food as well as labor and other expenses.

For Ackman’s lemonade example, one lemonade stand sells 800 cups of lemonade per year at $1 per cup, spends $200 of COGS (cost of goods sold: i.e. the raw materials like lemons, sugar, cups and water), $60 in depreciation of the lemonade stand and other equipment, and spends $530 on labor, for an operating profit before interest and taxes of $10.

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We can turn this into a spreadsheet, with simple formulas for certain entries:

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Startup costs

So if our lemonade business generates $10 in profit after expenses, is it a good business? That depends on how much money we had to put into the business to get it off the ground. To sell lemonade, we need to invest money up front in inventory (lemons, sugar, water, cups) and fixed assets (the stand itself). In our example, it takes $500 to get the equipment necessary to start the lemonade stand:

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Now we can add it to our spreadsheet:

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Business Financial Ratio Analysis

We can analyze our business by looking at certain common financial ratios:

Gross Margin: This is the percentage profit of each unit sold after subtracting the direct costs of the items sold (lemons, water, cups and sugar for lemonade).

EBIT Margin (Operating Margin): This is another profitability measure relative to sales after taking out other operating costs (administrative, rent, depreciation).

Inventory turnover: This tells you how efficiently the inventory is being managed and sold.

Return on Invested Capital: This tells you what percentage return you are currently earning on the overall money invested in the business

Here are the ratios added to the spreadsheet:

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Beyond year 1:  Our return on invested capital is only 2% for our lemonade stand, which would clearly not be a good business. However, we realize that this is only year 1, and things could get better as the business grows and margins potentially increase from the scale of the business. Rather than walk step by step through our model, please download it below and walk through it yourself. We will assume that we grow by one lemonade stand per year until year 10, gross margins stay the same, operating margins gradually increase to 10% from reduced labor expense, inventory turnover increases to 7x (each store carries roughly 50 days of lemons/sugar/cups), inflation is 2%, and we run our business through 50 years.

Here’s what our business model looks like now:

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See the spreadsheet here: What Makes a Good Business?

For our IRR calculation, we sum together our yearly cash flows into and out of the business on  lines 37 and 38. The negative cash flow is the money invested into the business: every time we expand to a new lemonade stand we have to invest new money to build the stand and buy additional inventory. The positive annual cash flow received from our business is the EBIT. Yes, we are somewhat simplifying here by ignoring taxes, financing, and assuming depreciation and capital expenses are the same.

We get an IRR on our invested capital of 23%, which is not too bad, although it might still be too low to compensate someone for a very risky startup lemonade business.

Here’s a further exercise: Try tracking key profit margin, inventory, and return numbers for other businesses to give a sense of what the numbers look like for real businesses. This will allow you to see how they differ in the ways they make money and give you a sense for what is “normal” for a given industry. For example, you might see a company like Tiffany & Co has very high profit margins but doesn’t sell as many items, while Walmart has incredibly low margins but sells a very high volume of goods.  Or you might see that successful software companies have very high ROIC:

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Yahoo Finance has average financial metrics by industry as well

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