This transcript was generated from the episode audio and may contain minor errors.
Hey friends, and welcome back to Side Hustle School, winding down the year here, episode 2913, 2013. Today, a question about understanding ROI. That, of course, is return on investment. How do you understand ROI when buying a local business? This listener is, in fact, considering buying a business, and this is a big decision.
Of course, it involves some costs, significant costs perhaps, so let's look at how do you estimate a payoff period, any factors that impact profitability, any tools to make this decision or at least the analysis easier. The listener's name is Daniel. Can I bring you his question and my answer right after this quick shout-out to our sponsor? Hey Chris, this is Daniel from Atlanta. I'm thinking about buying a local business and trying to wrap my head around the concept of ROI.
I know that understanding the return on investment is crucial, but I'm not sure how to calculate it or what a reasonable time frame for the payoff should be. What should I consider when estimating how long it will take to see a profit, and how can I make sure I'm making a smart financial decision before taking the plunge? Alright Daniel, I love the specificity of this question. Let's talk about ROI, return on investment. As a simple model, it is just a measurement of how long it takes for the money you've invested in something to come back to you as profit.
Here's a really basic way to think about it. To get a rough idea of ROI, you take the profit you expect to make in a year and divide it by the total investment you're making in the business, and you multiply by a hundred to get a percentage. For example, if you're investing $50,000 and your reasonable expectation, try to be conservative with these numbers, expect to make $10,000 in profit on this business, then your ROI is 20%. You've spent $50,000 or you've invested $50,000, you're going to make $10,000 this year, let's say 20% ROI. And then if that estimate continues to hold up, you've got five years to reach payoff time.
ROI and payoff time, a couple terms to pay attention to here. In terms of what is a reasonable payoff time, most people aim to recover their investment in a business within three to five years. This is for a small business, this is not for a bigger business, but if you're expecting to make $10,000 per year from a $50,000 investment, then you've got those five years to fully recover your costs and start making a profit beyond that. I would say for some internet businesses, then the payoff time is often even shorter. You want to not go beyond, let's say two to three years, because who knows what the internet's going to be like in this particular industry or business.
And of course, it varies a great deal depending on what kind of business and such, but a lot of business models change very frequently. New competition, new models themselves come into the picture. So much is being done by AI these days, we didn't know that five years ago. And then for some bigger businesses that are very established, then that might have a longer payoff time. But I want to encourage people to be conservative with their projections, just so you don't get in over your head.
You're not investing your life savings and then not seeing a return for a long time. You want to find opportunities to accelerate the ROI. So in fact, this is another thing to think about, how could you increase revenue to speed up the ROI? If you're like, "Okay, I've got this model of $50,000 invested. I think I'll make $10,000 in profit." That's what the owner did last year, perhaps like the person I'm buying it from.
But I think I can do better because they're not doing X, Y, and Z. There's lots of strategies that they've been sleeping on because they've been busy with other stuff, perhaps, or they just don't know how, or it's not a priority. But I'm going to make this a priority, and I'm going to make $25,000 in profit, therefore I have a two-year payoff time. Anything you can do to increase that or decrease the payoff time, increase the ROI is going to be helpful. Lots of ways to make it more complicated, but that is a simple way to think about it, and we're all about simplicity here.
Thank you again for the specific question. Listeners, thank you for being out there. I'm excited to come to the end of this year, 2,900 plus episodes, and we've got listeners out there doing all kinds of interesting things. I can't wait to hear what you're up to in the months to come. All right, that's it for now.
My name is Chris Guillebeau, and you're listening to Side Hustle School. From the Onward Project. From the Onward Project.
