When it comes to evaluating a company in which we want to invest, the future growth of the company can be a factor of great weight in the final result. However, growth is not always profitable and does not generate shareholder value. Next I am going to leave you my translation of an article by Aswath Damodaran, professor at the Stern Business School of New York University, entitled “The value of growth”, Which addresses the issue of the value of growth in a company, which is undoubtedly of great importance to investors.
The value of growth in a company
Consider a company that has an invested capital of $ 100 million and that generated an after-tax profit of $ 10 million last year. In order for this company to generate higher profits next year, you will have to do one of 2 things:
- Manage your existing capital (assets) more efficiently. In this way, if the company is able to reduce its operating expenses and increase its profit to 12 million euros next year, it will have a growth of 20%. Let's call this growth for efficiency.
- Expand your base capital. If the company can add another 10 million to its base capital and maintain its return on current capital (10%), its profit next year will be 11 million dollars, with a growth of 10% over the previous year. Let's call this growth due to new investments.
While both components fuel the observed growth, they do not have the same effect on value in two dimensions:
- Time: A company can reduce costs and become more efficient over time, but only as long as those inefficiencies exist. Thus, a poorly managed company may be able to generate efficiency growth for 3, 4, or perhaps 5 years, but not forever. Growth from new investments is called sustainable growth because it can continue as long as the company can maintain its reinvestment policy and the profitability it generates on its investments.
- Value: Efficiency growth always creates value, as no investment is required and profits and cash flows increase. Growth from new investments will generate value only if the higher returns justify the additional investment required to generate them. As the raising of capital by companies has a cost, the profitability generated on that capital must be higher than the cost of capital used for growth to generate value. In the example above, with a cost of capital of 10%, the growth would be worthless, as the value added by the higher growth would be offset by the higher reinvestment (and lower cash flows) that were needed to generate that growth. You can test different combinations of growth, return on equity and reinvestment and measure their effect on the value in this spreadsheet.
By looking at the pace of any company, you can draw conclusions about whether its past growth was valuable, neutral, or value destroyed by comparing the return on equity generated by growth investments to the cost of equity. Return on equity is calculated based on operating profit and book value of invested capital:
Return on equity = Operating profit (1-Tax rate) / (Book value of equity + Book value of debt - Cash)
This calculation is also included in the spreadsheet. It is the only place in corporate finance and valuation that we use book value and we do so because we are looking for returns based on what was originally invested (rather than based on its current market value). There are a lot of dangers associated with believing in book values. I have written about it and what to do to make up for it in a article on profitability measurement.
So how are listed companies doing when it comes to their returns? What sectors do it best? To answer the first question, I calculated the return on equity and cost of equity for all listed companies in the world in 2.007 and 2.008 and found the following:
Return on capital and cost of capital of companies listed in 2.007 and 2.008
While the 2.008 crisis hurt returns, even in 2.007, a good year for most companies in the world, over a third of US companies and a larger proportion in the rest of the world generated returns on equity below the cost of capital. capital. Although the year and the way the return on equity and cost of equity were calculated can be discussed, I think we will agree that value destruction is much more common than we would like and that growth quality (the one that increases the value) is unusual. To answer the second question, I calculated the returns on equity and cost of capital by sector for US companies and present them on my website at the beginning of each year. Can see the last calculation in this link.
For those of you who don't want to calculate return on equity and cost of equity, I have a simpler approximate method for calculating the quality of growth. You start by calculating the invested capital in this way:
Invested capital = Book value of equity + Book value of debt - Cash
We divide the change in operating profit during the period by the change in capital invested during the period, obtaining as a result a ratio that serves to measure the quality of growth, with higher ratios representing higher quality. In the table below I have calculated the result for Google between 2.003 and 2.010.
In the last column, I calculated the return on marginal equity by dividing the change in operating profit for that year by the change in equity. Based on this measure, in 2.009 and 2.010 Google saw a drop in its quality of growth, a drop that it attributed to acquisitions of the company to maintain its high growth. Its marginal profitability before taxes fell as much as 20,15%. After taxes it will be close to 13 or 14%, a good return on equity, but not a great one. Investors have woken up at Amazon and Netflix in recent days as well, as the cost of growth has come to light. In many disappointing growth companies, clues are available years in advance.