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Measuring Success

By AICC Staff

March 25, 2019

Return on investment (ROI) = (profit on investment ÷ cost of investment). If you purchase a stock for $1,000 and sell it for $1,500, then your ROI is 50 percent ((1,500 – 1,000) ÷ 1,000)). Pretty good, right? But what if you held the security for 10 years, and what if the effective tax rate on the gain is 30 percent? Then I guess you would say that the ROI is 2.33 percent ((1,500 – (0.3 × 5,000) – 1,000) ÷ 1,000 ÷ 10)). Not so good, right?

But what if you are considering an investment in a piece of equipment, purchasing a line of business, retooling a plant, selling off a division, entering into a licensing agreement, or hiring new salespeople? The costs of the proposed transactions are often not clear-cut, the cash flows generated or given up by the proposed transactions are often difficult to predict, and the measurement period is usually arbitrary. The more variables you add to each revenue or expense stream, the more complicated the calculation becomes. In addition, this method does not take into account the time value of money (net present value, or NPV), in that a dollar received in the future is not as valuable as a dollar received today.

Another way to look at this is by measuring the “payback period.” The payback period is the length of time required to recover the cost of an investment. The formula for calculating payback period is the cost of the investment divided by the annual cash flow. So, an investment in something that costs $500,000 and is expected to generate $100,000 in annual cash flow would have a payback period of five years. Obviously, the longer the payback period, the less attractive the investment is. This method is subject to the same difficulties in calculating both the investment and the resulting cash flows, and whether the number of years is good or bad is also somewhat subjective. This method also does not factor in the NPV of the cash flows.

The only thing that really matters is the increase in enterprise value (EV), and everything should ultimately be measured against EV.

In order to take into account the time value of money, economists came up with the concept of internal rate of return (IRR), which is also known as the discounted cash flow rate of return. This method used a discount factor to the annual cash flows in an attempt to make them equivalent to current dollars in the rate-of-return calculation. Use of the term “internal” refers to the fact that the internal rate excludes external factors, such as inflation, the cost of capital, or various financial risks. While this method may be superior to the others because of the NPV calculations added to the formula, the selection of the discount rate to use is also somewhat arbitrary.

Those of you who have read some of my previous articles know that, in my opinion, the most important factor in making an investment is the ability to generate enough cash flow annually to pay for the investment. Since there are very few investments that create enough efficiencies on their own to pay for themselves, the enterprise must generate additional sales to break even. This calculation of break-even sales is rather simple (negative cash flow ÷ expected contribution margin of new sales = sales required to break even); it basically quantifies the amount of new revenue the enterprise must generate each year to cover the costs of the investment. For example, let’s say you buy a new piece of equipment that costs $1 million, will cost the company $220,000 per year in note payments, and will require a crew of three people costing $150,000 per year, plus other operating costs (maintenance, insurance, utilities, etc.) of $50,000 per year. The annual cash flow to break even would then be $420,000 per year. If a conservative contribution margin on new business for this piece of equipment is 30 percent, then the sales required to break even would be $1.4 million ($420,000 ÷ 30 percent). One could certainly argue that this cash flow should be reduced by any tax savings that the operating expenses, interest expense, and depreciation expense would generate, but of course this is valid only if the company is profitable. Under the current tax laws, the entire $1 million would be deductible in year one, so the cash flow required to break even in year one could be close to zero, depending on the tax rate.

All of these methods—and others—have a place in evaluating a specific investment. They are all limited by various assumptions and fraught with inaccuracies and complexities, but in a world filled with investors, creditors, and bankers, the prudent businessperson must make some calculations to justify the investment. In addition to these stand-alone methods, a pro forma balance sheet should also be prepared to evaluate the investment from the point of view of leverage and working capital.

But is crunching all of the numbers and preparing the pro forma statements on each investment enough? What do measurements of profitability, cash flow, liquidity, and leverage really tell you? Are they, in and of themselves, measurements of success or failure? There are various measurements that can be made at the company level to ascertain what the overall returns to the company are on such things as sales, assets, and equity. Certainly a high percentage of net income, EBIT (earnings before interest and taxes) or EBITDA (adding back depreciation and amortization as well) computed against sales, assets, or equity would be an indication of success. They all have their places in the world of finance, but do they really tell the story?

In order to evaluate them, you need to understand the rules that generally accepted accounting principles use in the calculation of net assets and net equity, and in how capital costs are charged to income. Balance sheets, which show the asset and equity values, are based upon historical costs, not current values. So that building Grandpa bought in 1950 for $1 million that sits on 50 acres of prime real estate is now on your books for $250,000 (original land cost) plus the depreciated cost of whatever improvements were made to the property over the last 70 years or so. The fact that it is worth $100 million today is not reflected anywhere in these calculations. So, if the company made $1 million last year, the calculated return on assets or equity might look pretty darn good, but if you added the $100 million to the equation, the returns would be less than 1 percent. Similarly, recently purchased equipment that is worth less than the current depreciated cost on the books creates problems with these calculations. In addition, balance sheets are often puffed up with intangible assets created by capitalizing the costs of obtaining debt or equity financing, which leaves the assets and the equity overvalued.

I apologize for getting a little technical with you here, but I felt the need to highlight a serious problem that we all have with how to measure success. As you all know by now, I am a great believer in the KISS school of finance, which is why I like the calculation of break-even sales in the arena of equipment justification. It is a fairly simple calculation that yields a powerful result—what additional sales revenue do I need to generate to pay for this thing? My opinion of the overall measurement of success for business enterprises is that the only thing that really matters is the increase in enterprise value (EV), and everything should ultimately be measured against EV.

At the end of every year, the key questions should be:

  • Did we increase EV?
    • Which investments contributed to or reduced EV and why?
    • What future investments can we make to help us increase EV?
    • What were the internal and external factors that contributed to the change in EV?
  • What was our overall return on EV?
    • Are there better alternatives for us to invest in if we monetize some or all of our EV?

Public companies know what their EV is at all times, so this kind of analysis is much easier for them. Private companies can find out for sure what they are worth only if they put some or all of their assets out to market, which in and of itself can be constructive or destructive to their value. If customers or competitors know they are for sale, their operating environment will most definitely change. Therefore, one of the keys for all private companies is to find a methodology by which to compute EV and apply it on a consistent basis to help them measure their current success, to plot their future success, and to evaluate their current and future ROI.

So, loyal BoxScore readers, you now have a homework assignment. Give some thought to what your company is worth and why, and see if you can come up with a rational methodology with which to make this calculation at every measurement date. Then calculate the change from the last measurement period and your returns against this value. You will end up with a truer measure of your success (or lack thereof). Since everyone seems to enjoy a good cliffhanger, I will give this some further thought as well, and do a future article on various methodologies that can be used to calculate economic value. See you all in Miami—safe travels to all.


width=150Mitch Klingher is a partner at Klingher Nadler LLP. He can be reached at 201-731-3025 or mitch@klinghernadler.com.