Jun 21, 2010|
Growth could be dangerous for these companies
A short quiz. Assume that there are two economies, A and B. Economy A has grown at an average of 6% in nominal terms for quite a few years. While economy B has grown at a rate of 10% during the same time period. Now, which one of these is a better economy? You will make a big mistake if you blindly answer economy B. Just because it is growing at a faster rate does not mean that economy B is a better economy.
It should be noted that the growth rates that we have talked about are nominal growth rates. Thus, we would need the trendline inflation numbers in these economies to arrive at the right answer. Now, what if we say that the long term inflation in economy A is 2% whereas that in economy B is 8%? That does it, we believe. On using these numbers, we come to the conclusion that economy A is indeed the better economy as it enjoys a greater GDP growth of 4% in real terms. In comparison, economy B is growing at a real rate of just 2%.
The above illustration quite clearly highlights the pitfalls of considering growth numbers in isolation. An economy can indeed grow quite fast. But if it is also eroding purchasing power at an equally fast pace, then there could be very little real growth in it. And real growth of some magnitude is a must if there has to be prosperity and better standard of living.
A lot of investors fail to grasp this simple point. Their ignorance though is not limited to just macroeconomic matters. They commit equally big blunders while investing in companies as well. Infact, it is amazing how even the most seasoned investors fail to grasp this most fundamental point about investing in stocks.
Just as not all high growth rates are good for an economy, they are not good for a firm either. While investing, it is normally believed that investors should buy into companies that are growing their profits the fastest. Thus, investors always tend to prefer companies growing at 25% over the one growing at say 15%. However, nothing could be further from the truth.
In addition to the growth in profits, there are two other things that are extremely important. These are the return on invested capital and the cost of capital. The return on invested capital is nothing but the kind of profits that the company makes from the capital invested in the company. If it earns Rs 15 for every Rs 100 invested in the company, its return on invested capital becomes 15%. The cost of capital on the other hand is the total payout for the debt and equity financing that it has undertaken.
Now, for a growth to create value, it is important that the company's return on capital exceeds its cost of capital for a preferably long period of time. A 25% growth rate would be value destructive for a company if its cost of capital is 15% and return on invested capital is 12%. At the same time, even a 15% growth in profits is value creative over the long term if the return on capital is 15% and the cost of capital is 12%.
To conclude, do not just look at the growth rate of profits in a company. Check out what has been the long term history of the company with respect to the difference between return on invested capital and cost of capital. Growth will create value only when the former exceeds the latter.
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