Thursday, October 27, 2011

Growth (Part 3): The Value of Growth

Consider a firm that has $ 100 million invested in capital that generated $ 10 million in after-tax income in the most recent year. For this firm to generate more income next year, it has to do one of two things:
  1. Manage its existing capital (assets) more efficiently: Thus, if the firm can cut its operating expenses and increase its income to $12 million next period, it will have a growth rate of 20% for the next period. Let's call this efficiency growth.
  2. Add to its capital base: If the firm can add another $ 10 million to its capital base and maintain its current return on capital (10%), its income next period will be $ 11 million, with a growth rate of 10% over the prior year. Let's call this "new investment" growth.
While both components feed into observed growth, they are not equal in their effect on value on two dimensions:

  • Time: A firm can cut costs and make itself more efficient over time but only to the extent that these inefficiencies exist. Thus, a firm that is badly managed may be able to generate efficiency growth for 3, 4 or maybe even 5 years, but not forever. New investment growth is called sustainable growth because it can be continued for as long as the firm can maintain its policy on reinvestment and the return it generates on its investment. 
  • Value: Efficiency growth always creates value, since no investments are needed and earnings and cash flows will go up.  Whether new investment growth creates value revolves around whether the higher earnings created are justified by the additional investment that is required to generate them. Since it costs companies to raise capital (the cost of equity for equity and the cost of debt for borrowed money), the return generated on that capital has to exceed the cost of capital for growth to add value. In the example above, introducing a cost of capital of 10% into the analysis will make the new investment growth "worthless", since what is added in value through the higher growth  will be exactly offset by the higher reinvestment (and lower cash flows) needed to generate that growth. As an exercise, you can try entering different combinations of growth, return on capital and reinvestment and measure the value effect in this spreadsheet.

Looking at any company's past, you can draw conclusions about whether the growth registered in the past was valuable, neutral or value destroying, by comparing the return on capital generated on the growth investments to the cost of capital. The return on capital itself is computed based on operating income and the book value of capital invested:
Return on capital = Operating income (1- tax rate)/ (Book value of equity + Book value of debt - Cash)
This calculation is also in the spreadsheet referenced in the last paragraph. It is the only place in valuation/corporate finance, where we use book value and we do so because we are looking at the profits generated on what was originally invested in existing assets (rather than their updated market values). There are a host of dangers associated with trusting accounting numbers and I have written about them and what to do to compensate in a paper on measuring returns.

So, how well do publicly traded companies do in terms of delivering returns? Which sectors do the best? To answer the first question, I computed the return on capital and cost of capital for all publicly traded companies listed globally in 2007 and 2008 and found the following:

While the crisis in 2008 took at toll on returns, even in 2007, a good year for most companies globally, about a third of all companies in the US and a higher proportion elsewhere generated returns on capital that were less than the cost of capital. While you may quibble with the year and have issues with how I computed cost of capital and return on capital, I think you will agree that value destruction is far more common at companies than we would like to believe and that quality growth (that increases value) is rare. To answer the second question, I compute returns on capital and cost of capital, by sector, for US companies and report them on my website at the start of every year. You can get the most recent update (from the start of 2011) by clicking here.

For those of you who do not want to go through the process of computing return on capital and cost of capital, I have a simpler proxy for measuring the quality of growth. Start by computing the capital invested thus:
Capital invested = Book value of equity + Book value of debt - Cash
Divide the change in operating income over the period by the change in capital invested over the period; the ratio is a measure of the the quality of the growth, with higher ratios representing higher quality. In the table below, I have computed the number for Google going back to 2003:

In the last column, I computed the marginal return on capital in that year by dividing the change in operating income that year by the change in capital. Based on this measure, in 2009 and 2010, Google saw a drop off in its quality of growth, a drop off I would attribute to acquisitions made by the company to keep its growth rate high. Its pre-tax marginal return has dropped to about 20%; in after-tax terms that would be closer to 13 or 14%, a good return on capital, but not a great one.  Investors have had wake up calls in Amazon and Netflix as well in recent days, as the costs of delivering growth have come to the surface. In most growth companies that disappoint, the clues are available in the years before.

Blog post series on growth


CJF said...

It looks like a flaw in your analysis is that you aren't accounting for any economic or cyclical factors in 2009. It wasn't exactly a period of run-of-the-mill slowdown. The global financial crisis of course impact corporate incremental returns.

A metric that would be value is how Google fared with regard to incremental operating profits relative to those of the market.


Aswath Damodaran said...

Any time you use one year numbers, you will be exposed to this issue. It is possible that the drop off you have seen in the last 2 years is more a function of the economy but let's see.... If you see Google announce more acquisitions, I think you will have your answer sooner than you think.

JK said...
This comment has been removed by the author.
JK said...

Under efficiency growth, you missed the point of "pricing power". Volume may remain same, unit selling price increasing... hence the growth.
And if its a niche product, the growth can stay much longer than 4-5 years.

Aswath Damodaran said...

Unless its increasing pricing power, it should already be embedded in the growth rate. If you have increased pricing power, I think of it still as efficiency growth, because you are deriving it on existing assets.

Paula said...

Google's numbers are going down in the near future. There's no question of that. It's gonna be same for Microsoft and Nokia. And probably for Apple too. The reason is smartphones. These companies are fighting hard for market shares and survival right now. Apple has published some numbers and they are investing insane amount of dollars in this game. One billion is not that much in this big boys game. Google also needs more patents and they are not gonna be cheap either.

Anonymous said...

Dr. Damodaran,

In your spreadsheet titled "growth breakdown" can you explain the calculation behind cell B24 (valued added by future growth).

Can you explain the underlying logic in more detail. This cell has more involved calculations than your explanation in the article.

I really appreciate your work.

Thank you.

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Hemanth Manda said...

Can't agree more .. great post as usual. I was curious as to how Google has been doing since 2010 and did some number crunching ( you can view my analysis here : As expected the trend of declining returns ( marginal as well as overall ROC) continued through 2013. What I am not 100% sure though is the impact of timing on returns. Sometimes it takes a while for an investment (e.g. Youtube) to start contributing to the bottomline. But looking at the numbers, it is clear that Google has been making some inefficient capital allocation off late.