There are several ways to track how productive a company has been at managing its resources. In this article, I will explain why we pay special attention to one of them, internal rate of return, and how we calculate it.
Revenue/Assets Growth
Some companies obsess over revenue and revenue growth rate. Revenue is always the biggest number in the profit and loss statement (“top line”), and therefore, the most impressive one. However, what really matters is how much of that revenue ends up being profit. Revenue can be very high while the company is making almost no money, or even losing money. I become very suspicious when some business owner just talks about revenue. What matters is not how much money enters your cash register, but how much stays after paying all expenses.
Earnings/Assets Growth
Earnings are a more accurate measure of how things are going (operating cash flow can be better depending on the business). Earnings (the “bottom line” in the profit and loss statement) tell us how much of that revenue has remained after paying all expenses. Earnings should not just be compared to revenue, to come out with the profit margin, but also with assets. It is not the same to make $1 a year with $20 in assets than with $5 in assets, the second company is four times as productive.
A good way of tracking how good a company has been at managing assets consists in dividing how much are the company’s current earnings by the initial investment, the value of the initial net assets. This, then, should be annualized. For example, a company that started with $10 in assets and 3 years later is making $5 a year would have an earnings to initial assets ratio of 50%. If we annualize this, it would be 14.47% a year.
Internal Rate of Return: Earnings
If this company has been distributing past earnings as dividends, they should be included in the calculation. This way we can calculate the internal rate of return. For example, if this same company distributed $0.5 one year after inception and $1 two years after inception, if the assets are still valued at $10 nowadays, then this company would have generated $0.5 after one year, $1 after two and $15 ($5 profit and $10 assets value) after three years. The internal rate of return would then be 19.1%.
Internal Rate of Return: Book Value
This is not how we calculate the internal rate of return in Alpha Rock Capital. This is because there is a problem with earnings. Earnings do not fully show the picture of what is going on. Alpha Rock Capital does not just generate earnings, but our book value keeps increasing. We calculate book value as the result of multiplying the last 12 months monthly average Seller’s Discretionary Earnings by 28 (this would be the “goodwill”) and then add our net assets. The book value is what we would get if we liquidated our business.
We keep increasing the goodwill of our FBAs by improving them and by further investing money in them (profits and raised capital). This increase in the goodwill value is not seen if we just look at the earnings. It only becomes part of the earnings if we sold those businesses and therefore we realize a profit, the difference between the amount we are getting for the goodwill minus the amount that was originally paid for it.
I will use an example to try to show why we pay attention to goodwill instead of just earnings:
We buy a business that made (in SDE terms) an average of $10,000 a month in the previous 12 months, for 28 times that amount, $280,000. Inventory is nine times SDE, which would be $90,000 for a total of $370,000.
After buying it we start improving it, as the previous owner was not running it optimally. We keep reinvesting all the money the business produces. In the first month, it makes $11,500 SDE. Then $12,000. 12 months later, it is already making $15,000 a month, and the average of the last 12 months has risen to $13,000.
Out of those $13,000, we spend 35% in operating expenses, so we have $8,450 left. After amortization and corporate taxes, around $6,800 stay. Therefore, earnings would be $81,600 in the first year. Out of a $370,000 investment, this is a return of 22.05%.
As that business has made an average of $13,000 SDE in the last 12 months, assuming inventory has increased in the same proportion (from $90,000 to $117,000), if we wanted to sell it, using the same multiple, its price would be:
\[Selling\;Price= {($13,000 * 28) + $117,000} = $481,000\]
Now we are talking about a 30% return ($111,000 out of $370,000). This is not seen if you just pay attention to earnings.
Therefore, when calculating the internal rate of return in Alpha Rock Capital we pay attention to our book value, instead of just looking at earnings.
This metric allows us to know how productive we have been with the money that has historically entered the company. We take into account when and how much was initially invested in Alpha Rock Capital when it was established and when and how much has been raised in each of our capital increases. Also, we calculate our current book value, so that the internal rate of return tells us what would have been the annualized return since inception if the company was sold for that book value.
For example, if we start the company with $10 in assets, three months later $5 more is invested through a capital increase, six months later $10 are invested and one year later the book value is $35, our internal rate of return would be 39.49%.
Every month investors receive from us a financial report in which, among many other things, they are informed of what is our current book value, book value per share and internal rate of return since inception.
The multiple we are currently using to calculate our book value is just 28 times monthly average SDE. We think that if we sold our portfolio it would be possible to do so at a higher multiple than 28. This is because it is already big enough to attract bigger buyers and it also is quite stable and robust as we sell many different items.
Why do we use 28 then? Because that is what we have historically been paying for businesses, so this allows us to see how good we have been at managing capital, without considering any “roll-up strategy” effect.