The Net Present Value of Culture

“People are our biggest asset.” It’s a common phrase thrown out in media interviews, corporate addresses, and in everyday conversation. It’s used so frequently, one would assume that companies across the globe have employees that are thriving, bringing unprecedented value to their respective companies. We all know, however, that despite the habitual referencing of the executive locution, most companies don’t practice what they preach. This is clear when you simply look at the trending employee data. Employee engagement is at its lowest level in the past fifteen years, with two thirds of workers disengaged, leading to turnover rates that are at their highest levels in ten years. This isn’t groundbreaking news, considering employee data has been trending this way for over a decade, and companies have more access to big data now than ever before. Considering costs such as talent acquisition, talent loss, operational losses, supply chain disruption, value of intellectual property, and pace of disruptive change from companies like Amazon and Uber; why aren’t most companies looking to invest in the sector that drives every one of these metrics? Their people.

The answer to this question, unfortunately, is much more conceptual and complex than it seems. We are in a time of unprecedented change, with corporate lifecycles on the S&P 500 decreasing from 67 years in the 1920’s to just 15 years today, according to Yale University. This is a telling sign that times have changed, but businesses haven’t. The most commonly used metrics to measure a company’s performance are linked to the way businesses were judged over the past century, of which, the largest and most profitable were in the Manufacturing Industry. Not surprisingly, there areas of investment were aligned with the largest and most impactful returns, which were almost always tangible assets. The problem with this model is bluntly defined in an AON Hewitt report that shows $19 trillion dollars, or nearly 85% of the S&P 500, is linked to intangible assets (intellectual property), which is exactly the reverse of what it was in the 1920’s (15% intangible assets). 

In my opinion, the disconnect between where and why companies invest can be linked back to a single metric, Return On Invested Capital, or ROIC. The problem with ROIC relates back to its application from the Industrial Age up until the present. Investing in factories, machinery, and other tangible assets drove corporate profits in a manner that was easily reported to shareholders. It’s unequivocally the opposite today, and there aren’t proper financial reporting systems in place for investors to monetarily understand what creates true wealth in modern business; knowledge, creativity, inventions, ideas, reputations, employee engagement, and other elements that generate immensely profitable intangible assets. All of which are entirely related to people. It’s only when these intangibles are transformed into reportable assets such as patents, software, hardware, commodities, and customer bases (market share) that they make their way to a line item inside GAAP reporting. Some of the major investments needed to create intangibles, and usually the most profitable ones, can take years to materialize in an era that’s increasingly (and foolishly) managing more and more by the quarter. 

In lieu of all the empirical data, and the most profitable companies on the planet placing vast stockpiles of money behind their people, the majority of businesses still default to traditional ways of finance and operations. Why? When you look at GAAP reporting, costs to develop intangible assets are recorded as an expense when incurred. Simplistically, allocating money towards the development of your people is reported as a cost and not and investment. It’s no secret that hoards of companies chase the dragon by cutting costs to drive short-term profits. In turn, it’s incredibly commonplace to home in on targeting cuts that directly drive the creation of intangible assets. This leaves an obvious gap, which is the long-term growth and financial stability of the organization. This is precisely why a corporate strategy driven by ROIC has dramatic flaws to a prophetic financial outlook, and why you’re seeing legacy industry pillars like Sears and Blockbuster being eradicated at record speeds. 

The continually increasing demand pushing the C-Suite to manage to the quarter, the thirst for enormous shareholder ROIC, and the GAAP reporting drawbacks of investing in the creation of intangible assets has naturally moved companies towards a more centralized budgetary governance. The problem with this approach is self-evident, because the more centralized and regulated a company becomes, the more it loses its ability to enable the front line and midlevel employees’ entrepreneurial agility. It’s simply obtuse thinking that the C-Suite and Senior Leadership know how to drive progressive changes two or three levels beneath them, which is precisely what leads to the collapse of enterprises, they don’t invest in flanking the “Amazon or Uber” that will render them irrelevant. No longer do enterprises have the margin of error to intensely analyze and debate every allocation or capital, because by the time they decide they’ve fallen dramatically behind. 

Looking at capital allocation from an operational development stance, or moreover a Net Income Per Employee (NIPE), will help them properly create more fluid systems to deploy it. This shift in financial strategy requires progressive CEO’s and CFO’s to embrace the radical change, which is imminently clear, that their talent is what creates their value. Executing this shift would reach across the entire enterprise with powerful implications. It would allow the C-Suite to properly invest in initiatives that are directly correlated to the creation of intangible assets and be judged upon the growth of NIPE.

Like every other time of transition and adversity in American capitalism, there are tremendous opportunities for the C-Suite to exploit the problems they (and their competitors) face. By no surprise, those opportunities once again exist among employees. However, without revisiting the challenges posed earlier, there are areas of focus where investing in people can provide a rapid impact to overall revenue growth and ROIC. These opportunities can be identified by measuring a combination of the payback method and Net Present Value, or NPV. Payback method is simply the time an investment will return the capital that was invested, and NPV demonstrates the fact that money in the present is worth more than the same amount of money in the future. A positive NPV indicates that an investment, in present dollars, exceeds the projected costs at completion, also in present dollars. Implementing payback and NPV assessments when evaluating investments in Human Capital can help the C-Suite increase ROIC and NIPE, if they can find a rapid payback with positive NPV. Although payback and NPV don’t directly correlate to ROIC and NIPE, since ROIC and NIPE are “rates” or return and payback/NPV are valuations of “time”, it can identify opportunities that will pay themselves back faster than others, and at a rate that beats inflation. They also will also be able to properly articulate to shareholders that “expenses” towards the creation of intangible assets, recorded under GAAP reporting, are in fact intentionally selected “investments” to drive NIPE.

On the surface, opportunities that have a short payback period combined with a positive NPV may seem like unicorn investments. However, when we leverage science and little bit of personal experience, the answers are hiding in plain sight. Most of a company’s expenses on its balance sheet are tied entirely to their employees. Not in the form of investing in the creation of intangible assets as described above, but as outright expenses. Payroll, healthcare, absenteeism, turnover, workers compensation, safety, talent acquisition, etc. These expenses are so basic and so consistent, that they routinely get ignored as simply the cost of doing business. The irony is insurmountable since they’re not only some of the largest expenses affecting ROIC, but they can be the easiest and fastest to eliminate. Decrease actual expenses you can control, and you’ll organically increase ROIC.

How is it financially possible to rapidly decrease costs tied to employees? Business may have changed over the past century, but people haven’t. Not biologically, anyway. Employee turnover rates are a record levels because they’re being ignored, it’s very simple. People, from a fundamental perspective, want to help the companies that employ them. They want to feel valued, and they want their jobs to have purpose. By simply addressing these two fundamental elements a company will be able to break the 20th Century stigma of an “employer/employee contract”. 

The employer/employee contract is a term coined to define how an employee determines how much work they’ll give an employer. Basically, “If you pay me X, I’m going to give you Y in return.” The companies that place a heavy cultural focus on valuing and recognizing their employees not only have dramatically lower turnover rates, but they will also extract more NIPE. Sir Richard Branson explained it perfectly when he said, “Clients do not come first. Employees come first. If you take care of your employees, they’ll take care of your clients.” In layman terms, your employees will work dramatically harder for you at the same salary levels if you invest in their growth. This brings us back to the problems with ROIC and GAAP reporting showing intangible investments as an expense, investing in people can’t be directly tied back to ROIC. However, decreasing costs tied to turnover, absenteeism, healthcare premiums, workers comp premiums, and safety absolutely can increase ROIC.

The reasoning is simple, and its engrained in our DNA. When humans are recognized and feel valued, the brain releases the chemical serotonin which gives us the feeling of acceptance. The release of serotonin is the biological element behind the added value we bring to our employers, and it has an immediate impact. This is why companies that throw more salary at disengaged employees are usually unsuccessful in decreasing turnover costs, because money most likely isn’t the reasoning behind their disengagement. 

Disengagement can also be linked back to our biology, specifically with the release of cortisol. Classified as the “fight or flight” chemical, cortisol is released when humans are in stressful scenarios, especially where they feel threatened. In a business environment with little or not trust, employees are not only extremely likely to quit but also to hold back valuable information. There are varying levels of monetary examples linked to disengaged employees, which most people can think of when they reminisce about their careers. The spectrum is broad, ranging from smaller incidents like withholding an idea for a process improvement, all the way up to the collapse of Enron and Arthur Anderson due to the egregious absence in reporting rampant fraud. 

It’s understandable that this type of operational and cultural management is viewed with skepticism, since 20th Century valuation practices haven’t caught up to where the value lies in 21st Century businesses, but the proof is in the pudding. McKinsey reported that over a ten-year span, companies that increased growth also increased their ROIC by 8 percentage points, along with a higher Total Return to Shareholders (TRS). Since driving growth is viewed as increasing expenses, it’s seldom implemented when a C-Suite views their ROIC as the encompassing metric behind their valuation. Ultimately, it comes down to the strength of the C-Suite to properly convey their strategy to shareholders and/or their Board. Those that focus entirely on 20th Century financial strategies are going to be left behind, and those that adopt to the reality that talent creates value, will see profits soar. Investing in people and culture is no longer a “nice to have” initiative, it’s a “need to have” necessity. The revenue creation and cost savings associated with it are directly correlated to driving financial metrics across the enterprise, which should convince every senior leader that the NPV of investing in their culture will always be positive.