A finance view of company growth

24 06 2014

The dominant finance view of growth is very much focused on shareholder value and for private companies it could be translated to value to the owners. Brealey et al (Brealey et al., 2001) state that, for large companies, where separation of management and ownership is a necessity, management’s objective is to maximise the value of the firm to its stakeholders and that management teams that deviate too far from this rule are likely to be replaced.

The management of a firm should take advantage of the growth opportunities of all positive net present value (NPV) projects in the company in order to maximise the earnings’ growth rate. The latter is expected to be, at worst, equal to the industry’s growth rate. During the financial planning process, corporate staff might require from divisions the development of a best case, or aggressive growth plan, where aggressive capital investment and rapid growth of existing markets takes place; a normal growth plan in which the division grows with its market; and a retrenchment plan; where the firm’s markets contract. Financial planning in this context allows for exploration projects in markets where the company seeks to apply some of its existing strengths although there is no immediate positive NPV, but rather promising future investment opportunities (Brealey et al., 2001).

Should the company seek external, and especially equity financing for its projects, it should be in position to offer an attractive return to its shareholders. This is captured by the required rate of return, the discount rate compensating the share owners for the time value of money and risk (Fabozzi & Peterson, 2003) and is captured by metrics such as earnings per share (EPS). This shareholder view implies the expectation of continuous growth, year-on-year or even quarter-to-quarter, to make it a worthy investment. This kind of growth can be relevant for the sole or few owners of an SME. Considering these as investors, they too have an opportunity cost of investing in their own company or another in the same or another industry as part of an exit strategy.

However, EPS growth is criticised as a yardstick for company decisions as there is no empirical evidence linking an increased EPS with the value created by a transaction. This fallacy, as pointed out, is nevertheless equivocally accepted by stakeholders (bankers, executives, shareholders) as the de facto metric the markets use. As a result of focus on short-term EPS major companies often bypass value creating opportunities. In a survey of 400 CFOs, 80% would reduce discretionary spending on value creating activities such as marketing and R&D in order to meet short-term EPS targets. This emphasises the failure of assumptions such as that firms are infinitely rational and invest only in profit maximising projects (Coad, 2010).

Some of the publicly traded companies and especially large capitalisation technology companies in the US, manage to follow a slightly different route. Many investment pundits criticise the low valuation multiples in the technology sector where many companies trade at lower multiples relative to firms with similar characteristics in other sectors (Zenner et al., 2011). They argue that tech companies hold too much cash and have been slow to adopt financial policies that are consistent with their current, and lower, growth profile. This can be an effect of the tech bubble, which has led such companies to accumulate cash in order to mitigate risks. Another issue is that much of this cash is offshore and cannot be repatriated without incurring high taxation. This in part reflects the fact that business risk is materially higher than comparable consumer and industrial firms.

Nevertheless, technology companies present a different model of growth and earnings than consumer and industrial firms (Figure 1). The high P/E ratio of 44.1x, compared to S&P500 and shortly after the tech bubble, has dropped by 66% to 14.9%, a contraction which can be explained by the maturing of the sector. The risks, shortcoming in P/E and high net cash positions are also reflected on the dependence of valuation on long-term EPS growth. Looking at the 40 largest tech and 40 largest industrial/consumer firms, there is a pronounced correlation between valuation and growth for tech companies compared to industrial/consumer (Figure 2). It is also interesting that for tech industries there is a big difference between the valuations for 12%+ growth and 10-11.99% growth companies, which is not observed for industrial/consumer.

Figure 1: Earnings multiples over the past decade

Figure 2: Impact of growth on valuation

What this shows is that, despite all the criticism, investors put more money on companies that are likely to have higher long term growth in technology markets. Strangely, they put the same money on consumer and industrial firms, regardless of their expected growth.

So it seems that although technology companies do not favour shareholders’ value but put more wight on long term value, investors do not shy off (let alone market maturity). Does this approach make sense? Are technology firms correct in stashing cash piles for future development? Should technology SMEs focus on value for the owners or not?

2 Works Cited

[1] Richard A. Brealey, Stewart C. Myers, and Alan J. Marcus, Fundamentals of Corporate Finance, 3rd ed.: The McGraw-Hill Companies, Inc., 2001.
[2] Frank J. Fabozzi and Pamela P. Peterson, Financial Management & Analysis, 3rd ed. Hoboken: John Wiley & Sons, Inc., 2003.
[3] Alex Coad, “Neoclassical vs revolutionary theories of financialconstraints: Critique and prospectus,” Structural ChangeandEconomicDynamics, vol. 21, pp. 206-218, 2010.
[4] Marc Zenner, James Rothschild, Tomer Berkovitz, and Alton Lo, “Beyond Growth: Valuation and Financial Policy in the Maturing Tech Sector,” J.P.Morgan, 2011.
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