Modeling The Turnover Tax's Financial Drag on Earnings (EPS)
A simple model for understanding what an organization's turnover tax is and how it silently impacts financial performance, operating income, and earnings per share.
Before we begin this latest edition, you may have noticed that the newsletter has been rebranded. No Work Left Behind is now No Talent, No Alpha! This new name reflects what I’ve always believed—without top talent, there’s no market outperformance. Get ready for even sharper insights into how human capital drives financial success!
As we all know by now, I spend much of my time thinking about human capital and how organizations thrive (or don’t) based on the strength of their workforces. And while we often hear about the importance of culture, leadership, and employee engagement, there's one factor that's too often overlooked: turnover.
High employee churn isn’t just a headache for HR, it's actually a silent killer of financial performance and stock returns. The reason turnover is so frequently ignored by investors is simple: its effects are indirect, diffuse, and often hidden in the weeds of financial reports.
The reality is that traditional metrics like revenue growth, profit margins, and earnings per share (EPS) don’t capture the full scope of turnover's impact. The costs associated with recruiting, training, lost productivity, and the ripple effect on team morale aren't always immediately visible in the numbers. But the truth is, turnover chips away at earnings in ways that often go unnoticed until it’s too late.
Understanding the Turnover Tax
The Turnover Tax represents the direct and indirect costs associated with employee churn. These costs include:
Recruitment and onboarding expenses
Lost productivity during vacancy and ramp-up periods
Impact on team morale and efficiency
Let’s take a closer look at how the Turnover Tax can significantly erode profitability. If turnover-related costs amount to 2.5% of a company’s total revenue, this may seem like a manageable figure at first glance. But when you break it down, the impact becomes glaring.
For instance, if a company generates $100 million in revenue, a 2.5% turnover-related cost amounts to $2.5 million in lost value. But where does this 2.5% figure come from, and why is it so meaningful?
The 2.5% turnover cost is not arbitrary. It’s an average estimate based on a number of key turnover-related expenses that are often overlooked by investors. Here’s how I arrived at this figure:
Recruiting and Hiring Costs: The cost to replace an employee is often more substantial than most realize. Research shows that replacing an employee typically costs 20% to 50% of their annual salary, depending on the role and industry. For example, in a company where the average salary is $75,000, replacing an employee could cost anywhere from $15,000 to $37,500 per person. In a business with 100 employees, assuming 15% annual turnover, this can quickly scale up to hundreds of thousands in expenses related to recruiting and hiring alone.
Training and Onboarding Costs: Once hired, new employees need to be onboarded and trained. Depending on the role’s complexity, this can cost 10% to 15% of an employee's salary. In a company where employees earn $75,000 annually, onboarding and training could easily add another $7,500 to $11,250 per employee. Multiply this by 15% turnover, and you're looking at a significant ongoing investment.
Lost Productivity: When employees leave, productivity takes a hit. The time spent transitioning new hires—covering roles while a replacement is found, training new employees, and bringing them up to speed—can cost up to 1.5 times the employee's annual salary in lost productivity. For a company with $75,000 average salaries, this amounts to an additional $112,500 in indirect costs per employee, adding even more strain on the bottom line.
Employee Morale and Engagement: High turnover can lead to disengaged employees, creating a ripple effect that drives up turnover even further. While harder to quantify, some studies suggest that disengagement costs can add up to 10% of revenue in high-turnover organizations. As teams become demoralized, performance and engagement suffer, potentially leading to further turnover and compounding the costs.
After factoring in the recruiting, training, lost productivity, and morale issues, the total turnover-related cost typically ends up being about 2.5% of a company’s total revenue. This isn’t a one-time expense; it’s a recurring drag on earnings that compounds over time. In a company generating $100 million in revenue, that translates to $2.5 million every year—$2.5 million that could otherwise be reinvested into growth, innovation, or shareholder returns.
Now that we have a rough idea of how much Turnover Tax is, here’s how to think about how the tax affects key financial metrics. Pay attention here, this is crucial:
1. Impact on Operating Income:
Turnover reduces the operating margin from 20% to 17.5%.
2. Impact on Net Income:
Assuming a tax rate of 25%, net income would then decline by a further $1.875 million, or 12.5%.
3. Impact on EPS:
If the company has 10 million outstanding shares, this turnover tax reduces EPS by 12.7%.
4. Impact on Stock Price:
Lastly, if you assume an approximate Price-to-Earnings (P/E) ratio of 20x, then the Turnover Tax leads to a $3.80 per share decline!
That’s not a trivial amount at all!
So, while the Turnover Tax for organizations may be hidden, its impact is undeniable. For investors, understanding the link between workforce stability and financial performance is key. It is my experience in consulting and in theory that companies which actively manage turnover and invest in employee retention aren’t just creating better workplaces, they’re truly securing superior returns for shareholders.
What a weird and wonderful world,
