Don’t Fall Into the Trap of the Quarterly Economy - by Jeff Sisco
With a little more than half of the fiscal year in the rear view mirror, many clients use July as an opportunity to assess their financial performance relative to the strategic planning they did at year end. One pitfall associated with these semi-annual reviews is the overweighting of quarterly profit and loss performance at the expense of long term value creation. I call this the trap of the quarterly economy. The senior executive and his or her strategy team must balance the desire to maximize short term earnings against the necessary—and often expensive—investments needed to create long-term value. Many, if not all, senior executives and business owners would nod their heads in agreement with the previous statement. We invest now when business is strong and realize gains, in the form of increased enterprise value, at a later date. This is not innovative stuff. Or is it?
If we assume widespread acceptance that it makes business sense to invest now so that we realize increased value at a later date, why do businesses of all shapes and sizes do the exact opposite? America’s public corporations ignore this idea en masse. Public companies are under tremendous pressure to deliver quarterly earnings that exceed analyst’s expectations, often to the detriment of their own long-term growth. We will set them aside for the purpose of this discussion. Why then do many small to middle market companies, under no such similar pressure, fall into the same trap? What do executives and their advisors find so compelling about the short term? I will examine a few themes that we see in many of clients.
First, many small to middle market businesses operate under the misconception that the profit and loss statement is the most important measure of their company’s performance and its value. We often see this in our valuation practice. Executives are quick to point to their net income, EBIT or EBITDA as proof that their company is “doing great.” While it is obvious that the P&L is an important look into a company’s historic performance, it is not the window in the company’s soul that most executives believe. Sacrificing capital investment in order to generate short term profit is something that we see on a daily basis.
Second, many small to middle market businesses struggle to understand what financial metrics, or Key Performance Indicators (KPIs) drive long-term value creation. Most executives understand and are comfortable with profitability and liquidity metrics—gross margin, net margin, current and quick ratios. However, much like the information gleaned from the P&L statement, those ratios tell us very little about how we create future value.
Last, many privately held business owners fear the risk associated with the future. Often times, it just seems “right” to them to take short-term profits over long term value creation. Creating forward looking cost benefit analyses, financial forecasts and present value calculations seems daunting and overly complex to many owners. Many companies point to a history of demonstrable success and a “this is the way we’ve always done it” mindset. This is understandable as most small to middle market companies do not have the internal manpower and expertise to reliably perform these analyses.
Business owners have a diverse set of business goals. In our valuation and strategy practice, we see owners who want to transition a family business to the next generation. We see owners who would like to get to an exit event in order to create a new business or retire. We meet with owners who want to recapitalize their business in order to take some “money off the table” and diversify their portfolio of investments. Regardless of your current set of goals, it is critically important to avoid making decisions that bloster the short-term performance of the business—specifically net income—to the long-term detriment of value creation.
Our valuation and strategy practice has created a unique service offering that bridges the information gap between value and strategy. Knowing that a privately held company cannot look to the market place to understand its value, we created a product that is vital to your strategic planning process. Our Value Intelligence service gives senior executives the insight into firm value that is critical to the formulation of strategy. In addition to providing you with a Calculation of Value, we identify several financial drivers that impact long-term value creation in your business. Lastly, we also identify the top 3-5 risks to your company’s ability to create value in the next 1-3 years.
If you have any questions or would like to discuss a valuation or strategy engagement, please contact Jeff Sisco at [email protected] or at 973.994.9494, or visit our website at https://www.sobel-cpa.com/services/valuation-strategy