My July 2010 column, titled “Where, Oh, Where Are My Profits,” took a look at a couple of key ratios extracted from the recent NAQP Financial Benchmarking Study. More specifically, the extractions compared the financial performance of 15 companies near the top in terms of profitability to an equal number located near the bottom.
Note that I used the word “near” because I really didn’t want to use averages for the very top quartile (76-100th percentile) versus those in the bottom quartile (0-25th percentile). Instead, my idea was to back off just a bit from the extremes and see if the gaps between the best and worst were really as bad as they often look. The short answer is “Yes!”
Even after eliminating the “outliers” from the original raw data, and after checking out every single data entry for statistical aberrations, I can’t help but observe that even the worst of financial recessions would not and could not account for what still remains—a huge gap in profitability between the best and the worst.
There are indeed many explanations as to why some companies consistently achieve profit leader status while others wear the profit laggard banner. However, the state of the national economy is rarely a major cause; certainly not when compared to other factors and practices impacting profitability.
Last month I briefly referred to Profits per Employee (PPE) and shared with readers the following data:
High Profit Companies:
Average Sales: $1,040,278
Owner’s Compensation: $175,648
Owner’s Compensation Percent: 16.9%
Profits per Employee: $15,260
Low Profit Companies:
Average Sales: $ 988,785
Owner’s Compensation: $45,921
Owner’s Compensation Percent: 4.6%
Profits per Employee: ($2,284)
A Simple Calculation
If you feel comfortable calculating owner’s compensation (OC), then arriving at profits per employee (PPE) should be quick and painless. The main difference between the two ratios is that PPE excludes what is termed a fair market salary for the owner.
What do we use to calculate a fair market salary for the owner? My approach uses what is now considered an industry standard. The formula: $14,000 plus 4% of annual sales, the total of which is then multiplied by 1.18, which basically adds 18% to cover additional payroll costs and perks. Thus my fair market salary adjustment for the top firms, based upon sales of $1,040,278 would be:
+41,611 (4% of $1,040,278)
$55,611 x 1.18 = $65,625
We then subtract $65,625 (our base, fair market salary) from the reported owner’s compensation of $175,648, and we end up with $110,027. Finally, we divide this number by the total number of employees—which, in this case, is 7.21—and we end up with a PPE of $15,260.
Negative Profits per Employee
Now the guys at the other end of the spectrum end up with a negative $2,284. How does that happen? It’s pretty easy for some, it seems. Basically, there are companies in this industry that don’t produce enough in owner’s compensation to even pay themselves what we consider to be a basic minimum salary, let alone exceed that threshold and produce “excess earnings.”
Excess earnings, by the way, is at the heart of most company valuation methods. If a company fails to produce excess earnings, it will have little if any value other than what is represented by the old iron.
As a perfect example, once we take the owner’s compensation of $45,921, reported for the Low Profit companies, and make our adjustment for a fair market salary for a single working owner, we end up with a negative $17,269. Divide that by total employees of 7.56 (excludes owner), and we end up with a PPE of ($2,284).
Even though our low profit performers reported $51,000 less in sales, they spent $64,229 more in payroll costs. That is shocking—absolutely amazing! And no, don’t start trying to rationalize that maybe it’s the population density, or competition, or market pressures that account for these differences. That isn’t true. Some companies simply do a much better job in controlling payroll costs and maximizing productivity, while others simply don’t.
Just look at the huge differences in payroll costs, with low profit companies spending $357,301 (36.1% of sales) on total payroll costs as compared to $293,072 (28.2% of sales) ) spent by the profit leaders. Remember, these numbers exclude any payments and benefits paid to the owners.
To be honest, I would willingly give away an hour of my consulting time absolutely free just to assist owners who find themselves struggling with high payroll costs. Remember, “Pride goeth before a fall,” and some owners will ultimately end up closing their doors when, looking back, they had some real options and alternatives.
By the way, the “profit” in “Profits per Employee” is another way of stating excess earnings which, in turn, is a term we refer to often when valuing businesses; i.e.: how much money is available, after allowing for a fair market salary for a working owner, to buy back or pay the seller for his or her business.
No Faith in Appraisal Reports
Thanks to many friends in this industry, I have had the opportunity to examine many formal valuation documents prepared by outside, independent appraisal firms. Almost without exception, they all seem to share a couple of things in common.
First, 70-90% of the content of these appraisals is generic in nature. They contain boilerplate copy that makes absolutely no effort to distinguish one industry from another.
Second, although these reports often run an impressive 45-75 pages in length, they are rarely worth the paper they are printed on, let alone the $1,800 to $3,500 typically charged to prepare them.
Many of these appraisals, although careful to cite various IRS rulings and guidelines for their authority, typically violate one of the basic guidelines for appraisals offered up by the IRS in Revenue Ruling 59-60, to whit: “Individuals preparing business valuations should maintain a reasonable attitude in recognition of the fact that valuation is not an exact science. A sound valuation will be based upon all of the relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.”
-IRS Ruling 59-60
(Underlining is mine for purposes of emphasis.)
Most formal appraisals I have seen fail miserably in regard to these guidelines. Most of the authors of these appraisals lack any familiarity with the printing industry. Worse, when they seek to quote industry statistics, their industry knowledge is so weak that they often use the wrong reports and studies.
Another common characteristic of these appraisals is that they consistently offer up extremely high valuations relative to both sales and profits. But then again, that should come not come as a surprise since every single one of these reports has been prepared on behalf of a potential seller, not a buyer. This is one of those cases where not only should the buyer beware, but so also the sellers. Sellers are getting bad information and they don’t know it until they try to sell their businesses for what the appraiser said it was worth.
The Fix Is In…
There is no doubt in my mind that the fix is in regarding the reliability of many business appraisals. Most of these reports sacrifice a great deal of candor and honesty in favor of high valuations. In fact, I have yet to read an appraisal (granted, my sampling is relatively small) that offers up anything close to a candid assessment regarding the business at hand, especially so when the facts and figures demand nothing less.
All of the reports I have read are far too rosy, far too optimistic, and far too one-sided to be of any value to either a seller or a buyer. Surely there are thorns to be found in even the best run firms, but you would hardly know that from reading the appraisal reports.
In fact, I’ve got a special favor to ask of readers. I need to obtain some additional samples of valuations and appraisals, whether prepared by formal appraisal companies or their lesser brethren, business brokers. I cross my heart and hope to die and promise to keep all information confidential. Nonetheless, I would really appreciate your assistance in this area. If you have such and appraisal or know of someone else who has one, please consider sending me a copy for my further research.
An Amusing Anecdote
I am currently involved in a third party valuation of a printing company. I have been hired by a company that is hoping to bring together a potential buyer with a potential seller. In early 2007 the seller arranged to have a formal appraisal of his firm.
My contact told me the seller had paid $2,000 to have the appraisal conducted. The appraisal was prepared in early 2007 and based upon 2006 figures. In very rough numbers, the formal valuation of the business was $650,000. Interestingly enough, that was very close to what the business was doing at the time. The resulting ratio, by itself, is nothing short of a rarity, especially these days, but even more so when dealing with a business that had recorded pre-tax losses in the $15,000-$20,000 range every year for the past five years.
Even more shocking was discovering the blatant mistakes contained within the report, including failing to account for the fact that the seller reported that the owner’s compensation of $85,000 actually represented the efforts of two individuals, not one.
Whether that mistake was intentional or just misinformed is not known. What is known, however, is that any appraiser or broker who fails to discover such an obvious error is at best incompetent, and at worst committing a fraud. The end result of this oversight was the ability to inflate or distort the value of the business by $120,000 to $160,000.
Combined Payroll vs. Owner’s Comp
As I’ve noted many times in the past, there is a world of difference between what a husband and wife may collectively withdraw from a business and what they must report when calculating owner’s compensation. These are two different numbers; two different calculations.
Under no circumstances do you count the combined salaries of both owners or partners and report that number for your owner’s comp.
Oh wait, there is one exception to this rule, and that is if one of the partners is actually sold (just like another asset) to the new buyer, and remains on with the business, performing his or her functions as they have in the past. Maybe they get a bunk and mattress in the back of the shop. Not withstanding that generous offer, it isn’t very likely one of the two partners is going to agree to stay on with the new owner while the other partner kicks back on some beach in the Caribbean.
Senior contributing columnist John Stewart is president of Q.P. Consulting. He is co-author of the industry best seller “Print Shop For Sale” (www.printshopsforsale.net). Follow John’s blog on his website at www.quickconsultant.com. Contact him at 2110 S. Dairy Road, West Melbourne, FL 32904, call 321/727-2444, or email email@example.com.