All businesses experience growth. If a business does not grow at all to aspire towards becoming a market leader, it is just a matter of time when a competition catches up and takes over the competitive advantage of an existing business. Some companies grow for the better creating more wealth and shareholder value while other companies destroy wealth and shareholder value as they grow. Thus, there is nothing great about growth if growth does not create more wealth and value.
How do we distinguish good growth from bad growth? To understand the distinction, we look first at a company with balanced growth. A company with balanced growth will increase it's revenue and other items in the financial statements such as net income, equity, liabilities and total assets at the same percentage every year. This means that the ratio of such important items in the financial statements to revenue remains the same every year. Other metrics like net profit margin and return on equity remains constant.
For a balanced growth company, the steady increase in revenue and net income makes the company more valuable through the years. However, the trade off is that the company has to maintain this growth with new capital every year that grow at the same rate as the growth in revenue and net income.
A typical balanced growth company has the characteristics on it's financial statements as follows. To make things simple, this company is assumed to be without debts and has only equity as the sole consideration for it's capital invested.
For this example of a balanced growth company, revenue, net income, equity and the amount distributable to shareholders (amount distributable to shareholders is calculated from net income minus additional required capital investment in the form of equity) all grow at similar rate of 10% per annum. Net profit margin and return on equity are relatively constant at 10% and 20% respectively.
To calculate the present value (PV) of the distributable cash flow to shareholders, one can use the formula as follows.
PV = C X [(ROC - G) / (R - G)] ,
C is the amount of capital at the start
ROC is the return on capital
R is the cost of acquiring capital
G is the rate of growth
For this balanced growth company, it's return on capital (ROC) is 20% (same as it's return on equity) since it is assumed to have only capital in the form of equity and no debts. It's capital at the start (C) is the equity it has which is $100 million. It's rate of growth (G) is 10% since it grows it's revenue and net income at 10%.
Where growth does not add value nor destroy value
For the case when the return on capital (ROC) is equal to cost of acquiring capital (R) (e.g. both ROC and R are 20%),
PV = $100 million X [(0.20 - 0.10) / (0.20 - 0.10)]
= $100 million
Thus, the present value (PV) of the distributable cash flow to shareholders ($100 million) is the same as the amount of capital invested by shareholders at the start ($100 million). The shareholders do not get more in present value of distributable cash flow as compared to their capital invested at start. This means that the company does not add value nor destroy value for it's shareholders even with a 10% growth rate of it's revenue and net income.
Where growth adds value
For the case when the return on capital (ROC) is more than the cost of acquiring capital (R) (e.g. ROC at 20% and R is 12%),
PV = $100 million X [(0.20 - 0.10) / (0.12 - 0.10)]
= $500 million
Thus, the present value of distributable cash flow to shareholders ($500 million) is higher than their capital invested at start ($100 million). This means the company adds value to it's shareholders even with a 10% growth rate of it's revenue and net income.
Where growth destroys value
For the case when the return on capital (ROC) is less than the cost of acquiring capital (R) (e.g. ROC at 20% and R at 22%)
PV = $100 million X [(0.20 - 0.10) / (0.22 - 0.10)]
= $83.3 million
Thus, the present value of distributable cash flow to shareholders ($83.3 million) is lower than their capital invested at start ($100 million). This means that the company destroys value to it's shareholders even though there is a growth rate of 10% in revenue and net income.
Conclusion
It is time to debunk the belief that all growth creates value for shareholders. Growth of a company usually requires some amount of additional investment of capital (be it in the form of equity or debts). Financiers of equity or debts will require their interests or returns on their capital provided to the company. This is the cost of acquiring capital the company has to bear in order to allow growth to be possible. When a company requires a higher cost of acquiring capital compared to the returns on acquired capital in order for growth, then growth may not be that good afterall since it destroys value for shareholders. Thus, the next time a company speaks of magnificent growth plans, it is time for a potential investor to look deeper into whether growth does creates value or not.
Termite infestation, a case where rapid growth destroys value.
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