Growth: value creation or value cremation?

Author:Rizzi, Joe

Many firms are experiencing a difficult 2016, with continued weak earnings and stock prices. Especially concerning is sluggish revenue growth at many businesses. Explanations for these results include a low-growth economy and political uncertainty, both of which are likely to continue. Some analysts are even pushing for high-risk transformational change to restart growth. Consequently, managers are under increased pressure, real or imagined, to grow either organically or through acquisitions. Uncritically succumbing to the pressure to grow, however, can destroy shareholder value.

Firms need to first evaluate the financial viability of their growth strategy to ensure they are not overpaying for growth. Growth is not free; it requires capital, which carries a cost. The evaluation involves comparing the costs of the required capital investments with their expected returns under multiple scenarios. This is the same capital budgeting process used to evaluate projects like plant expansion; this time applied at the corporate level. Next, the credibility of projections must be assessed.

Many companies have failed to earn their cost of equity since the Great Recession. Their persistent low return on equity (ROE) reflects aging business models and unattractive industry dynamics. Growing under these conditions is unlikely to fix the return problem underlying depressed stock prices. Moreover, it violates the first law of hole digging--stop when you are in one. Understandably, the market response to most growth strategies, particularly acquisitions, is lukewarm at best.

Firms should only grow if there is a reasonable likelihood of ROE exceeding their cost of equity based on believable projections preferably supported by historical evidence. Such evidence reflects a sustainable competitive advantage or moat. Growth without a moat is likely to be fleeting once competitors respond. Many firms will be hard pressed to satisfy this test, and should not grow. Instead managers should reallocate capital to shareholders through increased dividends.

Understandably, most management teams prefer to run larger growing firms for both prestige and compensation reasons. Others believe higher dividends signal lower expected...

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