X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Growth could be dangerous for these companies - Views on News from Equitymaster
 
 
  • PRINT
  • E-MAIL
  • FEEDBACK
  • A  A  A
  • 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.

     

     

    Equitymaster requests your view! Post a comment on "Growth could be dangerous for these companies". Click here!

      
     

    More Views on News

    How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

    Jun 10, 2017

    Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

    Will They Haul Off Trump's Statue, Too? (Vivek Kaul's Diary)

    Aug 16, 2017

    All across the country, the old gods become devils. New, gluten-free gods take their places...

    This Company Beat the Business World's 'Three Killer Cs' (The 5 Minute Wrapup)

    Aug 16, 2017

    And what it has in common with beating the stock market too.

    5 Steps To Become Financially Independent (Outside View)

    Aug 16, 2017

    Ensure your financial Independence, and pledge to start the journey towards financial freedom today!

    Let's Hope This Correction Continues (The 5 Minute Wrapup)

    Aug 14, 2017

    Last week's correction is making a number of Super Investor stocks look a lot more attractive...

    More Views on News

    Most Popular

    Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

    Aug 7, 2017

    The data tells us quite a different story from the one the government is trying to project.

    Proxy Plays: A Smart Way to Bet on 'Off Limits' Companies(The 5 Minute Wrapup)

    Aug 4, 2017

    The small-cap space is full of small players that are clear proxies to great growth stories and Indian megatrends.

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

    Aug 7, 2017

    Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

    More
    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407
     

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms

    S&P BSE SENSEX


    Aug 17, 2017 12:25 PM

    MARKET STATS