Generic Appraisals Offer Little Value

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

Payroll: 28.2%

Owner’s Compensation: $175,648

Owner’s Compensation Percent: 16.9%

Profits per Employee: $15,260

Low Profit Companies:

Average Sales: $ 988,785

Payroll: 36.1%

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:

$14,000

+41,611 (4% of $1,040,278)

$55,611

$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.