Lesson 3 of 9
When growth adds value
Growth adds value only when new capital earns more than it costs. Below that hurdle, faster growth is a smaller company, not a larger one.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Growth adds value only when the return on the capital it consumes exceeds the cost of that capital.
- Below the cost of capital, growth destroys value: the company gets bigger while the shares get worth less.
- The same growth rate on the same earnings is worth 50 percent more, or about 62 percent less, than no growth at all, depending on one number: the return on new capital.
Growth is not automatically good. It is good only when a dollar reinvested earns more than a dollar costs, and it destroys value when it does not, however fast the company is growing.
Value of the same growth rate at three returns on new capital
- Return on new capital: 6% · below the 9% cost of capital416.7
- Return on new capital: 9% · equal to the cost of capital1,111.1
- Return on new capital: 15% · above the 9% cost of capital1,666.7
Value with no growth at all: 1,111.1
The rule in one line
Value equals Operating profit after tax x (1 − growth ÷ return on new capital) divided by Cost of capital − growth.
Example100 x (1 − 0.05 ÷ 0.15) ÷ (0.09 − 0.05) = 1,666.7
Mauboussin and Callahan reach the same principle with a full cash flow model in "The Math of Value and Growth": growth only adds value when the company earns a return on its investment above its cost of capital, and it is of no economic significance when the return equals the cost of capital exactly.
Same growth rate, three different returns
At 6 percent, growth is destroying value: the company is worth less than it would be at zero growth, because every dollar it reinvests is worth less than a dollar once it is invested. At 9 percent, growth changes nothing: the no-growth value and the growing value are the same number, 1,111.1, because a dollar earning exactly its cost of capital is a dollar either way. At 15 percent, the same growth rate is worth 555.6 more than no growth at all.
Why the same number destroys value here and creates it there
The formula's middle term, growth divided by the return on new capital, is the fraction of earnings a company must reinvest to sustain that growth rate. A company earning a low return needs to reinvest a larger fraction of each dollar to grow at all, which is why low returns and growth are the expensive combination: more capital committed at less than its cost.
Buffett made the same point in the 1992 letter: growth and value are not opposing approaches, because growth is always a component in the calculation of value, and its effect can be negative as well as positive. He also described, in the same letter, a real transaction where a bank overpaid to acquire growth and destroyed value in the act. A company that grows by committing capital below its cost of capital is doing the same thing on a smaller scale, in every reporting period.
The other order: asset value first, growth last
Greenwald's ordering in Value Investing: From Graham to Buffett and Beyond puts growth in the least reliable of three tiers, after asset value and earnings power value. The reason: growth's contribution to value depends on a return you have to forecast, while the first two tiers can be read from what a company has already filed. Growth is worth paying for only after that comparison is made, never before it.
Check yourself
A company earns exactly its cost of capital on every dollar it reinvests. What does growth do to its value?
- Increases it, because earnings are larger
- Nothing, the value is the same as at zero growth
- Decreases it, because reinvestment reduces the dividend
Show the answer
Answer: B.
When the return on new capital equals the cost of capital, growth is worth exactly what it costs. The growing and no-growth values are identical.A company grows by reinvesting at a return below its cost of capital. What is happening to its value?
- It rises, because the company is larger each year
- It falls, because each dollar reinvested is worth less than a dollar
- It is unaffected, because growth and value are separate questions
Show the answer
Answer: B.
Below the cost of capital, each dollar of new investment returns less than it cost to raise. Growing faster means doing this more, which destroys value faster.In Greenwald's three-tier ordering, why does the value of growth come last?
- Because growth is the least important thing to a business
- Because it depends on a forecast return, while the earlier tiers can be read from filed figures
- Because growth always destroys more value than it creates
Show the answer
Answer: B.
Asset value and earnings power value can be built from what a company has already reported. The value of growth needs an estimate of a return that has not happened yet, which makes it the least reliable of the three.Sources
- Mauboussin and Callahan, "The Math of Value and Growth", 2020, on growth adding value only above the cost of capital.
- Berkshire Hathaway shareholder letter, 1992, on growth and value being joined at the hip, and on a value-destroying acquisition made to buy growth.
- Greenwald, Kahn, Sonkin and van Biema, Value Investing: From Graham to Buffett and Beyond, 2001, on asset value, earnings power value and the value of growth, in that order of reliability.
What this leaves out
- The worked example uses round invented inputs so the arithmetic can be checked by hand.
- The return on new capital is rarely a filed figure. It is estimated from how much a company has had to invest to produce its recent growth, and that estimate is the part most likely to be wrong.
- The formula assumes the growth and the return last forever, and it gives the value of the whole business before debt.
- A single blended return hides that a company can earn well above its cost of capital in one part of the business and below it in another.
- Nothing here is advice about any security.