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Mar 07, 2017

Focusing on What Counts: The Ultimate Measurement of Business Succes

Featuring Gary Karlitz

Many business owners like to brag. It’s a “soft reward” for their toil and worries, so why not? Professional service firms are eager to point out their revenue per consultant, and other productivity measures, while restaurateurs are fond of citing favorable food costs, labor costs, table turns, etc. Retailers rave about things like, their vast customer base, returning customers, and sales growth. On the other hand, wholesalers like to highlight their inventory turns, gross margins, and lack of vendor or customer concentration. 
 
But, is reliance on these industry-specific quotients really enough? Are these assessments truly the ultimate measure of business success, or are these numbers, although valuable, merely a smoke screen enabling business owners to avoid focusing on what really counts? And, at the end of the day, how does one measure what really counts?

Watching one’s net worth grow is a fair, and reliable, measure of success. But, what is most often the largest component of someone’s net worth? You guessed it, the value of their business. 
 
The ratios discussed above are an important part of evaluating a business, and hats off to those entrepreneurs who monitor those statistics, but they are not stand-alone proxies for what really counts - business value!
 
There are many moving parts in valuing a business. Generally, business valuation results are influenced by the following three factors: (1) cash flows; (2) the growth of those cash flows; and, (3) the risks associated with those cash flows including its growth. The aforementioned ratios, and industry quotients, are a part of this three-pronged measurement, but do not comprise valuation on their own. 

So, how do industry metrics fold into the valuation?
 
  • Cash flows – When valuing a restaurant, for example, lower food costs, as a percentage of sales, result in higher gross margins, and thus larger cash flows. With all else being equal, larger cash flows equate to a higher value. 
  • Growth – When valuing a retailer with a fast-growing customer base, all else being equal, a growing company translates to a higher value when compared to a company with a shrinking customer base. 
  • Lower risk – Extreme customer concentration presents a significant increase in risk.  When valuing a wholesaler, for example, if concentration is so extreme that one customer accounts for 90% of the revenues, there is a clear risk.  Again, all else being equal, the greater the risk, the lower the business value. 
Notice how I isolated the impact of each determinant in my examples by holding “all else being equal.”  The trouble with this myopic view is that all else is not typically equal. And, herein lies the problem with measuring success by reference to stand-alone industry metrics.

It is common to have contra-indications when viewing various ratios. It has been well established that dropping one’s per-unit price increases its demand, and ultimately should lead to increased sales. But, if everything was simple, why wouldn’t everyone do that?
 
Here’s why. Imagine a fast-growing company with deteriorating margins. Those increased revenues might compensate for the increased cost, but they also might not. Without specific strategies in mind, mere revenue growth is virtually never as important as the growth of net cash flow.  Which ratio, or attribute, controls or trumps the other? There is no easy answer when valuing a company – it depends.

Revenue Ruling 59-60 was published by the Internal Revenue Service (“IRS”) 58 years ago, and incredibly it is, to this day, widely accepted as the seminal treatise in valuing a closely-held business. Here is what Revenue Ruling 59-60 tells us about valuing a business:
 
  • Valuation of a closely-held business is not an exact science; and
  • Because valuations cannot be made on the basis of a prescribed formula, there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. For this reason, no useful purpose is served by taking an average of several factors (for example, book value, capitalized earnings, and capitalized dividends), and basing the valuation on the result. Such a process excludes active consideration of other pertinent factors, and the end result cannot be supported by a realistic application of the significant facts in the case, except by mere chance.
I would submit that the ultimate measure of success is tracking the value of your business on an annual, or bi-annual basis, by either obtaining a true valuation opinion or a Calculation of Value.  Either way, the most valuable businesses are those that are ready to be sold at any moment. Tracking the value of your largest holding is focusing on what really counts!

ABOUT THE AUTHOR
Gary M. Karlitz, CPA, ABV, CBA, ASA, brings more than 40 years of experience to his role as the practice leader of the firm’s Valuation and Forensic Services Group. He provides a wide range of forensic and valuation services in the areas of shareholder disputes, mergers and acquisitions, matrimonial disputes, economic damage analysis, corporate recoveries, and intellectual property disputes. He can be reached at 212.697.1000 or at gkarlitz@citrincooperman.com.

Citrin Cooperman is a full-service accounting and consulting firm with 10 locations throughout the Northeast United States. Visit us at www.citrincooperman.com.