Making Better Investment Choices as a Business Owner

How do you know if investments make sense? When is the return worth the risk? What’s the opportunity cost of your financial decisions?

Many business owners go off gut feelings or simple back-of-the-envelope calculations. However, the best investors understand two important concepts that help inform their investment decisions: discount rates and margin of safety.

Understanding your discount rate helps you determine whether an investment’s future returns are actually worth the time, risk, and capital required. Applying a margin of safety ensures you don’t overpay, overestimate future performance, or lock up cash in deals that look good on paper but fail to deliver in reality.

The Discount Rate

The discount rate, also called the “required rate of return,” the “hurdle rate,” the “risk-free rate,” or simply seen as the opportunity cost of your capital is the benchmark for all your investments. For instance, if your discount rate is 4.5%, it means any investment must at least beat 4.5% annually to be worth your time and risk. You can choose your own discount rate. For instance, Warren Buffett uses long-term Treasury bond yields. However, your discount rate should reflect what you safely earn on your capital without taking risk.

Before we move on, keep this in the back of your mind: If you have a high discount rate (higher benchmark), you have more selectivity when risking your capital. If you have a low discount rate (lower benchmark), risky alternatives look much better. This is one reason stocks are trading at all-time high valuations. The Federal Reserve and banking system have effectively taken most people’s “discount rate” (the rate they earn on savings in bank accounts) to zero. Therefore, stocks with little growth that are trading at rich valuations appear more attractive… for now. Far too often, people fall victim to TINA (there is no alternative), forcing them to take on risk to keep up with inflation.

This also explains the dire situation many pensions are in. Historically, achieving an 8% return on bonds was attainable, but with the Fed cutting rates over the past 40 years, pensions struggled to keep up with their retirement obligations — defined benefits. Their “discount rate” was lowered, and because there were no viable alternatives that offered a similar return, they were forced to either accept lower returns and beg governments for bailouts or allocate capital to riskier opportunities, hoping to achieve a higher return.

Applying Your Discount Rate

Every business owner should have some familiarity with ROI, IRR, and NPV. Here’s a brief overview.

ROI: Return on Investment

• For every dollar you spend, this shows you how many you get back in profit

• ROI% = [(Money Gained — Money Spent) ÷ Money Spent] x 100

• Example:

  • You pay a marketing firm $1,000 to run ads

  • This generates 500% ROAS (return on ad spending) = $5,000 in new sales

  • Your 25% net margins leave you with $1,250 in profits

  • ROI = [($1,250 — $1,000) ÷ $1,000] x 100 = 25%

• Summary: You earned 25% on your $1,000 investment. On the surface, this sounds pretty good. However, while ROI might be helpful for short-term investment decisions, this does NOT factor in time. Is 25% a great annual return? Sure. Does 25% spread out over five years justify the risk of this not panning out? Or, does it justify the opportunity cost of locking up your capital in lieu of better opportunities? Maybe not.

  
  

IRR: Internal Rate of Return

• IRR also shows your return on investment, but it factors in time

• IRR% = More complicated calculation, but there are several calculators online

• Example:

  • You pay a marketing firm $1,000 to run ads

  • You bring in $1,000 in new sales each year for five years

  • Your 25% margins leave you with $250 in annual profits

  • IRR = 7.93%

• Summary: If we assume the $250 in profits are spread out over five years, our annualized internal rate of return is 7.93%. This illustrates our return according to when we get the money back. The 7.93% doesn’t sound awful, but there are two big factors missing = our opportunity cost (discount rate) and risk.

  
  

NPV: Net Present Value

• This is the net present value of all future cash flows for an investment “discounted” back to the present since dollars today are worth more than dollars tomorrow (time value of money)

• Here’s the calculation assuming a 4.5% discount rate; there are also calculators for this

• NPV = [CF₁ ÷ (1 + r)¹] + [CF₂ ÷ (1 + r)²] + [CF₃ ÷ (1 + r)³] + [CF₄ ÷ (1 + r)⁴] + [CF₅ ÷ (1 + r)⁵] — CF₀

• CF₀ = Initial investment = $1,000

• CF₁, CF₂, CF₃, etc… = Cash inflows each year = $250

• r = Discount rate (i.e., 4.5%)

• Present value of future cash flows = $1,097.69

• NPV = $97.49

• Summary: The net present value factors in time (like IRR) when calculating cash flows, but it also applies your discount rate. An NPV > 0 effectively means your investment beats your discount rate. An NPV < 0 effectively means your investment doesn’t keep up with your discount rate. Therefore, in this scenario, our $1,000 investment leaves us with $1,097.49 in present value future cash flows. That’s a $97.49 profit discounted back to the present. With all else being equal, and assuming your assumptions can’t be wrong, this investment makes sense.

Margin of Safety

While NPV does a great job of telling us whether stated cash flows make sense for longer term investments, it leaves out a critical factor: risk. You likely know the cost of your initial investment, but how certain are you of the annual cash flows? Could they be wrong? This is as much of an art as it is a science, and this is precisely why Ben Graham (Warren Buffett’s mentor) came up with the term Margin of Safety.

Heads, I win. Tails, I don’t lose much. — Mohnish Pabrai

A margin of safety is applied to our investments to incorporate the fact that we don’t know everything. There are really two solid ways to calculate this.

1. Make conservative top-line adjustments to estimated revenue/net income

2. Apply a margin of safety to the present value of future cash flows

Let’s start with the top-line adjustments. Let’s say you think the marketing company you hired to run ads might be a little overconfident (been there, done that) with their ROAS estimates. Let’s say that instead of the 500% they promised, you’re worried it might only be 400%. This still gives you $4,000 in revenue and $1,000 in total profit, leaving you with a 20% ROI. So far, not bad.

But now, your IRR is 0%. Your annualized five-year return is nothing. OK, you still didn’t lose money. But, when we factor in your discount rate of 4.5% (what you could have safely earned), the net present value drops to -$122.00. The investment no longer makes sense. You’ve achieved less profit than what could have been earned without taking risk.

Another way to calculate this is by taking your present value of future cash flows and applying a margin of safety. If we apply a 25% margin of safety to our present value of future cash flows, we end up with: $1,097.49 x (1-.25) = $787.10. This is much lower than our $1,000 initial investment, indicating that our investment may be way too aggressive when factoring in downside risks.

Your margin of safety will likely differ on all of your investments. Some investments are shorter-term with easily attainable results, which may not require a large margin of safety. Others are likely longer-term with many moving parts, which may require you to use a much larger margin of safety.

Choosing Your Discount Rate

Do you know your discount rate? Are you willing to lock up capital for 10 to 30 years in Treasury bonds like Buffett, who manages an insurance float with predictable premium inflows and claims? Your discount rate shouldn’t reflect some hypothetical possibility, but what you actually earn on your cash when you aren’t investing in your business.

Where’s your cash right now? Is it earning a taxable 0.5% in your bank account? If you’re in a high-yield savings account or a 12-month CD, do you know what your discount rate will be in two or three years from now? Do you have a sustainable and predictable discount rate for longer-term projects? What if the Fed keeps cutting rates?

Let’s say you use 0.5% as your discount rate because that’s what your cash is actually earning for you. Your NPV increases from $97.49 to $231.47. Suddenly, even with your margin of safety, this investment may make sense. However, your returns didn’t change. Your benchmark changed. You settled for LESS because of TINA (there is no alternative). This keeps you reinvesting back into lower value investments.

However, what if your discount rate was 6%? Suddenly, your NPV drops to $53.09. The investment, especially after incorporating a margin of safety, is less attractive. Again, your cash flows didn’t change. Only your benchmark did. Now, you wait for a better opportunity.

This is all about opportunity costs. Before you make any investment decision, you should first factor in your discount rate. The higher the discount rate, the more selective you can be with your capital. Why tie up money in low-yielding investments that come with risk if you can get similar guaranteed growth on your capital while you’re waiting for the grand slam opportunities?

We also need to compare investment decisions to one another if multiple opportunities exist. NPV, when applying an appropriate margin of safety, allows us to determine which investment adds more value.

Whole Life Insurance

A unique, but time-tested product provides the best discount rate for business owners — it’s the cash value growth within a dividend-paying whole life insurance policy. Forget the insurance part for now. The growth is tax-free (if structured properly), shielded from market downside, and accessible via policy loans, giving business owners a reliable internal rate of return baseline.

When evaluating investments, the policy’s growth rate can be thought of as a risk-free IRR floor: any investment under consideration should generate a higher IRR than the policy’s growth to justify taking on additional risk. By anchoring your analysis to the policy’s growth, you not only ensure that your NPV calculations are grounded in a realistic opportunity cost but also raise the bar for what counts as an acceptable IRR, because the policy is earning a steady, compounding return on your money already.

Instead of feeling like you have to reinvest every last dollar into lower-yielding investments that rarely pay off, you get paid to wait. Suddenly, TINA is nowhere to be found.

It’s critical that you have someone design these properly, but when you do, the growth is tax-free. Let’s assume your tax rate is 25%. Now, that 4.5% “discount rate” becomes an after-tax equivalent of 6% because your business income is taxable. If your alternative is a taxable 0.5% in bank accounts, virtually every investment opportunity seems to make sense. But if your hurdle rate is 6%, you become far more selective.

Lastly, there’s one other huge factor. Your 0.5% interest in a bank account doesn’t compound. When you choose to invest that money, your cash is gone forever. With whole life insurance, we borrow AGAINST our capital base, keeping our money compounding permanently. This process is called Infinite Banking.

By finding a reliable and strong benchmark and applying a margin of safety to your investment decisions, you can stay focused on achieving higher growth rates while limiting downside risks. Book a call here to upgrade your discount rate.