Overview
The simplest way to think about this idea is how quickly will you get paid back for any outlay of capital. Inherently, good business leaders already do this, whether you might call it something else or not.
Think about the following analogy. Let’s say you live in a town with two bakeries for sale at $1 million each. Both offer similar products with almost exactly the same type of customer and asset structure — one earns $100,000, the other $150,000. Which one do you buy? The one that makes more money! That one has the highest yield, which in this case is the second bakery. In fact, if these numbers held up, bakery number two would pay you back in less than 7 years, a full 3 years ahead of the first one. All things being equal, this is an easy calculation. All things are rarely so cut and dry.
To know whether an asset is worth buying, you have to know the profit it generates compared to the price you’re paying, otherwise you’re simply speculating on whether or not you can sell it at a later date for a higher price. Not all art or Jordan sneakers fetch higher prices.
For example, if you buy a house for $500,000 and lease it for $2,500 a month, the annual yield before expenses is 6%. For private businesses it’s the profit for the price you paid. In the public markets, companies listed on big exchanges like the NYSE or NASDAQ tend to remain in business a lot longer and are thus valued at higher multiples of earnings. This means looking for growth potential at a fair or discounted market price.
Very rarely will investors acquire shares in an excellent growth company at prices where payback periods are apparent. These companies must grow into the high yield prices. An example from the world’s most valuable company, as of 2023.
2008
Apple (AAPL)
Value: $76 billion
Profit: $6.1 billion
Yield: 8.0%
2018
Apple (AAPL)
Value: $1.01 trillion
Profit: $56 billion
Yield: 73.9% on 2008
Payback Period
The payback period is the length of time it takes for an investment to recoup its initial cost and start generating a profit. It is typically measured in months or years and is calculated by dividing the initial cost of the investment by the expected cash flows. The payback period is used to evaluate an investment and compare it to other potential investments or strategies based on their projected returns. It is calculated by discounting future cash flows to their net present value and comparing them to the initial cost of the investment. The shorter the payback period, the quicker the investment is expected to start generating a return.
The payback period is a financial measure used to evaluate the feasibility of an investment. It is the length of time it takes for an investment to recoup its initial cost and start generating a profit.
To calculate the payback period, the initial cost of the investment is divided by the expected cash flows. For example, if an investment has an initial cost of $100,000 and is expected to generate annual cash flows of $20,000, the payback period would be five years ($100,000 / $20,000 = 5).
The payback period is often used to compare different investments or strategies based on their projected returns. A shorter payback period is generally considered more favorable, as it indicates that the investment is expected to start generating a return more quickly.
However, it is important to note that the payback period does not take into account the time value of money, which means that it does not consider the fact that money has a different value over time. For this reason, the payback period is often used in conjunction with other financial measures, such as the internal rate of return (IRR) or the net present value (NPV), which do consider the time value of money.
In conclusion, the payback period is a useful tool for evaluating the potential of an investment by considering the length of time it takes for the investment to start generating a profit. It is important to consider the payback period in conjunction with other financial measures to get a complete picture of an investment’s potential returns.
More Examples
- An investor buys a rental property for $200,000, and the property generates $1,000 in monthly rental income. The payback period for this investment would be 200,000 / 1,000 = 200 months, or approximately 16.7 years.
- A company invests $500,000 in a new manufacturing plant, and the plant generates an additional $100,000 in annual profits. The payback period for this investment would be 500,000 / 100,000 = 5 years.
- An individual invests $10,000 in a new business venture, and the business generates $1,500 in monthly profits. The payback period for this investment would be 10,000 / 1,500 = 6.7 months.
Risk Reward Ratio
Crucial to the payback theory is the risk-reward ratio is a measure that compares the potential for losses to the potential for gains for a particular action. Risk management aims to optimize this ratio, taking into account an organization’s risk tolerance, rather than necessarily eliminating all risk. The goal is often to minimize the risk relative to the potential reward. The following are a few examples of a risk/reward ratio.
Investing
Based on a proprietary estimation, an investor guesses that the S&P 500 has equal chance of going up 20% or going down 5% in the next year. The investor sees the risk/reward of 1:4 as attractive and buys into the index.
Product Development
An electronics company is considering launching a line of 3D printers. The development costs are significant and the company estimates there is an equal change of net income of $3 billion or a net loss of $2 billion from the product within the first 5 years. The company views the risk reward of 2:3 as unattractive and decides not to develop 3d printers.
Marketing
A luxury hotel is considering changing their pricing strategy to add a resort fee of $33 a day. They know that such fees are unpopular and the hotel has recently experienced declining ratings on popular travel review sites. They calculate that the price change will generate revenues of $1 million dollars but that there is a 50% chance of a customer backlash that will cost $12 million dollars in lost revenue due to a lower occupancy rate. The resulting risk/reward ratio is 6:1 meaning that the price increase is a risky proposition that’s unlikely to payback.
Types of Risk/Reward Ratio
The risk-reward ratio is a simple mathematical equation: risk / reward that can be used to evaluate strategies, tactical actions and processes for their potential payback. For simplicity, the ratio is often expressed as gains and losses that are estimated to have equal probability. More accurate methods model risk as a risk matrix or probability distribution.