The global financial crisis prompted many companies to pull in their horns, hoard cash, trim costs, and take a wary view of large investments. Yet the same crisis ushered in a new age of capital superabundance. Bain & Company’s Macro Trends Group carefully analyzed the global balance sheet and found that the world is awash in money. Global capital balances more than doubled between 1990 and 2010 — from $220 trillion (about 6.5 times global GDP) to more than $600 trillion (9.5 times global GDP). And capital continues to expand. Our models suggest that by 2025 global financial capital could easily surpass a quadrillion dollars, more than 10 times global GDP.
Capital superabundance, combined with tepid economic growth, has produced historically low capital costs for most large companies. For much of the 1980s and 1990s, for instance, the average cost of equity capital for large U.S. corporations hovered between 10% and 15%. Today, the average cost of equity capital sits at close to half that: just 8% for the roughly 1600 companies comprising the Value Line Index. And the after-tax cost of debt for many large companies is close to the rate of inflation. So, in real terms, debt financing is essentially free.
The ready access to low-cost capital should change the way business leaders think about strategy, and in particular the relative value of improving profit margins versus accelerating growth. When capital costs are high, strategies that expand margins are almost always better than strategies that accelerate growth. When money is expensive, a dollar today is worth a lot more than a dollar tomorrow — or even the promise of many dollars tomorrow. But when capital costs are low, the time value of money is low. So the promise of more dollars tomorrow (through growth) exceeds the value of a few extra dollars next quarter. In these circumstances, strategies that generate faster growth create more value for most companies than those that improve profit margins.
The Refresher: Net Present Value
To elaborate, a company’s intrinsic equity value reflects the long-term cash flows that shareholders expect to receive over time, discounted at the appropriate risk-adjusted cost of equity capital. Equity cash flows, in turn, are a function of a company’s long-term return on equity (ROE), growth, and the value of shareholders’ equity on its books. This relationship gives rise to three important heuristics:
- If a company’s long-term ROE is anticipated to be 400 basis points (bps) or more above its cost of equity capital, then the value created by accelerating growth will exceed the value created by improving pre-tax margins
- If a company’s long-term ROE is anticipated to be between 300 and 400 bps above its cost of equity capital, then the value created by accelerating growth will be roughly the same as the value created by improving pre-tax margins
- If a company’s long-term ROE is anticipated to be less than 300 bps above its cost of equity capital, then the value created by improving pre-tax margins will exceed the value created by accelerating growth. In fact, in cases where a company’s long-term ROE is anticipated to be below its cost of equity capital, accelerating growth will destroy value
Historically, when debt and equity costs were high, for most companies the trade-off between profitability and growth favored profitability. Accordingly, business leaders sought to improve efficiency by employing Six Sigma, process reengineering, spans and layers, and other tools.
But the scales have now tipped in favor of accelerating growth. For the average company, defined as the equity-weighted average of the roughly 1600 companies comprising the Value Line Index, the cost of equity capital is just 8%. And the average long-term ROE is more than 25%, reflecting improved efficiency combined with greater reliance on financial leverage at most companies. On average, then, the value created by accelerating growth by 1% far exceeds the value created by increasing pre-tax margins by 1% on a sustained basis. In fact, the multiple of value created by growth versus margins is more than four to one.
But a lot can get lost in the averages. Every company faces a different trade-off between growth and profitability. For example, in some industries — say, construction — long-term ROEs are very close to the cost of equity capital. For these companies, taking steps to improve margins will generate higher returns for investors than those designed to boost growth. But in most other sectors, ROEs are much greater than the cost of equity capital. In these settings, investors should value strategies that accelerate growth over those that improve margins (see the chart below).
So if companies should value growth more than margins these days, why don’t they? In our experience, companies still focus more on cutting costs than on developing and executing new growth strategies. Reuters found that total new capital expenditures and spending on R&D was less than the amount many companies devoted to share repurchases last year. Finally, in earnings call after earnings call, we hear CEOs describing one or two bets — at most — on growth, and devoting most of the time to showcasing the results of restructuring, offshoring and other cost-focused initiatives.
Why is growth shortchanged at so many companies?
In our work with clients, we see three common reasons why companies continue to pursue margins over growth — but we also see how smart companies avoid those traps:
A dearth of good ideas. Creativity and ingenuity have always been precious. A single great idea can put a company on top. Think the iPhone at Apple, horizontal drilling at Continental Resources, or the reinvention of home goods at Ikea. And having a number of small good ideas can keep a company ahead of its rivals for years.
But many companies struggle to come up with enough promising growth options. Some focus their best people on finding ways to squeeze out more profitability from existing operations, rather than creating new businesses. Others reward easy-to-measure improvements in existing processes over less-easily-quantified innovations. And then there’s culture: Many organizations implicitly or explicitly discourage risk taking, limiting their employees’ desire to put new growth ideas on the table. Others fail to build in time for experimentation or penalize unsuccessful experiments — even though few breakthroughs spring forth without some initial failure. The result: a shortage of good growth ideas.
Companies that encourage innovation take steps to overcome these organizational obstacles. They create flux time for employees to devote to new projects. (3M, for example, has long allowed engineers to devote 15% of their time to skunkworks projects, without supervisor approval.) They reward risk taking, by encouraging executives to capture learnings from efforts that come up short and then build these lessons into the next round of experiments. And nearly all of them provide their employees with autonomy and authority to bring new ideas to life. It’s hard to create an organization capable of generating a pipeline of good growth ideas, but it is imperative in today’s world of superabundant capital.
Practices (and beliefs) that foreclose too many growth options. Sadly, some companies do start with a healthy pipeline of promising growth ideas, but then screen out too many of them by employing outmoded approaches to strategic investment planning. A flood of great ideas goes into the top of the funnel, but only a trickle emerges from the bottom.
A central premise of traditional strategic investment (e.g., Pareto analysis) is to limit the field of potential options, focusing the company’s precious capital on a few “sure bets.” In an era of low-cost capital, these traditional practices end up closing too many doors. More worrisome, these screens encourage executives to stick for too long with the few investments that do make it through, rather than cashing out and starting over. Finally, the continuous winnowing of growth options based on investment attractiveness (and other tests) can lead organizations to adopt a “growth is risky” mindset that bleeds into other aspects of the business, discouraging subordinates from developing and considering new growth options.
Companies that are successful in fueling growth lower hurdle rates and relax other constraints that reflect a bygone era of scarce capital. Like Alphabet, Google’s parent, they invest in a number of experiments — say, Google Fiber or autonomous vehicles. They are quick to spot the losers and shut them down, and double down on the experiments that show promise. These companies don’t seek to screen out ideas at the start, but instead look to open as many doors as possible before deciding which ones to walk through.
A lack of talent and capabilities to translate promising growth options into profitable new business. The assets that are truly scarce at most companies are the skills and capabilities required to turn great growth ideas into successful new products, services, and businesses. Even when an organization has a robust pipeline of growth ideas and manages to keep many of them alive, it may lack the human capital needed to accelerate growth.
Bain recently completed research on workforce productivity. This research highlights that companies that treat the time, talent, and energy of their workforce with the same discipline as they do financial capital perform far better than the rest. The most productive companies have the talent they need to generate good growth options. And they put these “difference makers” in roles where they can make the biggest difference in the company’s profitability and growth. Workers at these companies have the time they need to devote to creative work, free from excessive process and bureaucracy. And, perhaps most important, employees at these organizations are engaged and inspired by their work, bringing far more discretionary energy to their jobs every day.
The best companies in our research are 40% more productive than the rest. These companies get as much done by 10:30 AM on Thursday morning as their rivals do all week. And they keep working, serving customers, innovating, and generating many more new ideas. Not surprisingly, the best generate profit margins 30%–50% higher than industry peers and grow faster.
Today’s era of superabundant capital rewards faster growth. To thrive in this new world, leaders must overcome the obstacles to growth in their organizations. They must reward the creativity and ingenuity required to devise new growth options. They must avoid screening out too many growth ideas, and opt instead to invest in a portfolio of growth experiments (or options). And, finally, they must build the skills and capabilities required to capitalize on their most promising experiments. This requires treating the time, talent, and energy of a company’s workforce as the truly scarce resources that they are and managing them with the same care and rigor that has been brought to financial capital in years past.
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