Does Growth Creates Value?

Investors reward growing companies, managers are compensated for growing sales and executives target growing market for future expansion. “Growth” has been and will be “investing Mantra” for investors in India and Huge Wealth is waiting to be created by the investors in India…. but wait we all know that story doesn’t ends here , we are all focusing on only one side of the coin because other side says that “all growth are not good

In this section we be discussing around our central theme “all growth are not good” through some examples and what triggers are necessary for the company for creating wealth for the shareholders and at last section we will providing some insights on “how to actually find them”.

Investor’s Delusion

Investors believe that all that grows are good be it sales growth, profit growth, earnings growth etc. Huge wealth is not been created in the market just by identifying the companies that grows ‘net profit’ or ‘earnings’ at rapid phase but rather by identifying the companies which has got ‘ profitable growth’ and understanding the economic value added by the
company.

So, what does ‘profitable growth’ or ‘positive EVA’( Economic Value Added ) mean?

Profitable Growth:

First let us consider, how does a company grows ?

Companies growth is determined by two major factor:

  1. Return on Invested Capital ( ROIC)
  2. Reinvestment Rate

Return On Invested Capital

A core test of success for a business is whether one rupee invested in the company generates the value of more than one rupee in the marketplace.

For Example: Say a company invests Rs 1000 crores in its business and the starting of the year and earns 300 crores at the end of the year, then the ROIC is 30% ( 300/1000), which is nothing but net profit after tax divided by total capital invested by the company.

Now we know that the company earns 30% ROIC in its business but knowing only ROIC doesn’t help the investor in taking any investing decision.

So, now is the time to understand what is ‘ cost of capital ’ through another simple example. (we don’t want to get into academic definition but rather show how to use practically).

Let us consider that, You start a business and you need Rs 100 cores for its growth.

You now consider to take a loan from the bank at 8% interest rate at the beginning of the year.

Let us view in two scenario for better understanding :

  1. In the first scenario, at the end of the year, company grows and produces say 10 crores that is 10% after tax earnings. Now you go to the bank pay 8 crores as interest (8%) and you are left with 2 crores and you reinvest that money into your business for the future growth.
  2. In the second scenario, company grows and produces say 6 crores that is 6% after tax earnings. Now you go to the bank pay 8 crores as interest but you have only 6 crores. There is a deficit of 2 crores in your business.

The insight we get is even though, the company is making profit in both the cases, in case 1 company grow above the hurdle rate (8%, in our example) , this hurdle rate is called as ‘cost of capital ’ in accounting language.

Until the company grows its profit above its cost of capital, the company is said to be growing in profitable manner( case 1) and if the company is not generating enough return above ‘cost of capital’ the companies further growth is useless.

One of the main thing to be noted is, in both the cases the company is not making any losses  they are generating net profit but in case 1, company would generate higher shareholder value from its growth and in case 2, if the company decides to grow by borrowing money again, it would lead to ‘value destructing’.( all growth are not good).

Coming back to the discussion of ROIC, as we said ROIC alone can’t provide any meaningful insight but by comparing the ROIC with ‘cost of capital’ and comparing with its peers would give some useful insight on how effectively and efficiently the company grows.

The mathematics is simple, if the company earns returns more than cost of capital over the period of time , the company is in the ‘profitable mode’ else it is in ‘ value destructive mode’ of the shareholder’s money.

How to filter companies using this simple concept

  1. First find the total ‘ capital invested ’ by the company i.e.,( share capital + reserves + total borrowing – cash – investments) from the ‘balance sheet’. Now we can obtain  ‘net operating profit after tax’ for the corresponding year from the ‘profit and loss’ statement.
  2. Now divide ‘net operating profit’ by cost of capital’ for that fiscal year.
  3. Now if the resulting answer is greater than capital invested than the company is
    creating value else it is not.

For example, let us consider a company ‘Pidilite Industries Ltd’, the required data are

Total capital invested (March,2018) = 2290 crores
Cost of capital = 15%
Net operating profit = 962 crores
So, net market value for the investments is = 2290/0.15 = 6413 crores.

Since market value of the investments is greater than invested capital,(6413 > 2290) the company is growing profitable or creating positive economic value added and one can get more insights can be acquired not by calculating profitable growth for single year but by calculating on rolling 3-5 year basis or else the result would get skewed. Calculating on rolling basis also gives us trend of the profitable growth of the company.

Caution:

One should not take investment decision solely on ROIC or ‘profitable growth’ metric but rather consider as ‘good staring point’.

Later:

In the next upcoming post we will be discussing more on many valuable metric which provides us with useful insights about the profitable growth of the company and take good investments decision.