1% growth or 1% profitability – what would you choose?

A review of the value drivers of a company – does extra profits or extra growth leads to more value? Is it really a Hobson’s choice as it is made out to be? An interesting …

A review of the value drivers of a company – does extra profits or extra growth leads to more value? Is it really a Hobson’s choice as it is made out to be? An interesting study done by HBR back in the day!

Growth or Profitability?
The greatest danger in business and life lies not in outright failure but in achieving success without understanding why you were successful in the first place. – Robert Burgelman

Question: What do you believe is more valuable for your company – an extra percent of growth or an extra percent of profitability?

Our initial reaction might be to go for an extra percentage of profitability. Increasing profitability is difficult – it takes at least 7 to 8% of growth to result in an extra percent increase in margins.  Large corporations undertake huge cost-cutting exercise and implement streamlined operations just to show an extra basis point difference in the bottomline.

On the other hand, a percentage of extra growth signals hope. ‘Growth is life’, as Reliance’s motto says. Small growth rates compounding over time can build up to a flywheel of network effects which is difficult to stop and challenging to replicate. Growth provides an intrinsic motivation for an entrepreneur to achieve more.

Why this question is important?

In today’s world, growth and profitability have almost become the two ends of the spectrum where it is normal to sacrifice one for another. If a firm is going for growth, it is expected that it may not achieve profitability, in some cases, probably never.

On the other hand, some firms focusing on profitability lose out on market share in the name of ‘quality profits’ while activist shareholders clamour for growth.

We believe a direct relationship between growth and profits in business parlance – as much as it exists in the financial statements – would allow for better and informed decision-making in allocating resources. More importantly, we would see the companies who have followed the middle way of profitable growth have provided greater and faster value to the markets.

How can we measure which approach is better?

In 2005, Nathaniel J. Moss from HBR introduced a concept called Relative Value of Growth (RVG). RVG measured the impact of additional percent of growth or profit on the overall value of the company. Moss analysed leading corporations across different industries (e.g. P&G, Exxon Mobil, Kelloggs) by building discounted cash flow model and seeing the impact of an extra 1% on growth and profitability on the Enterprise value. Moss  wanted to isolate growth and profitability and see the solitary impact of each of them on the company value.

Overall findings:

  1. Moss found that an extra percentage of growth is 5 to 7 times more valuable than an extra percentage of profitability
  2. RVG ratio is different across industries which reflects the difference in underlying business fundamentals
  3. This framework can act as a tool to explain to the market a reason to expect extra growth or profitability

Moss found out that P&G had an RVG of 7.2 while Exxon Mobil had 2.1. This meant that an extra percentage of growth would enhance the value of P&G 7x more than an extra percentage of profitability. For Exxon Mobil, the extra growth would increase the value by 2.1x than profitability. The difference in growth can be attributed to different business fundamentals in both these industries.

Value drivers for Relative Value of Growth (RVG)

The variation of RVG across companies / industries depend on four different factors.

  1. Margin
  2. Capital Intensity
  3. Growth rate vs cost of capital
  4. Combined impact of all of the above

Let us look at this one by one.

  1. Margin – A growth cannot create value if it does not result in profitability. A good growth is sustainable – i.e. it gives back more than it uses to grow. P&G’s profitability margin was 18% while Exxon’s was 12%. Clearly, the more P&G grew, it created more profitability and hence more value for the shareholder.
  2. Capital Intensity – P&G requires low working capital than Exxon Mobil.  This is because it costs less to make Herbal Essences (yes, that’s a P&G brand!) than it would cost Exxon to discover oil in say, Guyana. Hence, for P&G, it costs less to generate a $ of value than it does for Exxon.
  3. Growth rate vs cost of capital – Coming from the terminal value formula of the DCF, this means a higher growth rate would reduce the impact of a higher cost of capital. If the difference between cost of capital and growth rate is high, it means that the cash flows are discounted at a higher rate and hence, the value would be lower. The growth rate again depends on company and industry & market cyclicality.
  4. Combined impact of above four – while the impact of above value drivers are high, Moss mentions the case where all the above boxes are ticked because the combined impact of the above value drivers are higher than the sum-of-its-parts. If P&G has a higher operating margin than Exxon, requires less capital and has a higher growth rate, for one extra percentage of growth, market would reward with a higher increase in value than it would for a 1% growth of Exxon Mobil.

What does it mean for young companies or startups?

The results of the experiment clearly show that Growth is far more valuable than profitability. However, the focus should be on good growth i.e. growth which gives back more than it takes.

A corollary to the above is that going after increased margins especially through cost-cutting is detrimental to a company’s value.

Though as Moss states, the biggest challenge to profitable growth is a subconscious belief that growth and profits cannot be pursued in-tandem. It is not a Hobson’s choice. Profitable growth is pursued as a strategic choice. The rule of 40 illustrates that growth and profitability are not mutually exclusive and should be looked at jointly. Amazon had its eyes on profits all along. Unaffected by market pressure to show profitability, it went long on growth  which ultimately led to a trillion+ dollar company now with soaring profits.

If at all, Amazon and Jeff Bezos has proved that the largest profits come with fastest growth.

I’m convinced, how should i find out the impact on value of my company?

The Relative Value of Growth as a strategic tool should be in the arsenal of an entrepreneur to decide the best strategy ahead. A company can build a discounted cash flow model to discover, identify and estimate the impact of an extra growth or profit percentage. Also, one can look at the inter-relationship between the four value drivers mentioned above to identify which levers to pull to increase the value of your company.

At Samkhya, we build discounted cash flow models that brings out the implicit assumptions within the financial projections so that you can refine, build and share your assumptions. A sound understanding of your company’s metrics and value drivers would lead to better choices, attract more investors and negotiate better terms.

Photo by Wayne Robinson on Unsplash

Leave a Comment