Growth-Centrism Is Flawed

by: Brian Grosso


On average, growth is meaningless and thus, growth-centric analysis and strategy is flawed.

Focus should be instead on ROIC and WACC, which informs of implications on corporate value of growth and gives quite a bit of other qualitative information about the business.

There is still a place for growth in corporate strategy and investment research, but definitely after ROIC and WACC.

This article is theoretical, yet largely unsupported by statistics, and will not be introducing any new knowledge to financial academia. Read at your own risk.

It seems to me that financial markets overall far overestimate the value of growth. Growth only creates value where ROIC > WACC and that is not the case as often as people using metrics like PEG alone assume. This random slide from a Polaris Industries (NYSE:PII) investor presentation shows S&P 500 average ROIC for 2013 to be just 8%:

Source: Polaris May 2014 Investor Presentation

If you want to be theoretical and take a short run "risk-free" interest rate and add a 4-6% equity risk premium, WACC is probably closer to 5-6% in this low-rate environment for most companies, but if you think about the cost of equity practically as the minimum return you would be content with from your investments (10% for me), than WACC for most companies is probably about 8% - at least for those I've encountered.

So we have established 8% ROIC and 8% WACC. What that means is that, on average, growth is meaningless. A company borrowing money at 8% to invest it and then earn 8% on the investment has done nothing but waste time and human capital. The company would be better off returning capital via dividend or, where appropriate, share repurchases.

Again, since growth, on average, neither creates nor destroys value, it also seems a waste of investment research time to look at it. That is why analysis and valuations supported solely by revenue and earnings growth rates kills me. I must admit that even I've been guilty of this in the past.

What should investors do with all their newfound time now that they aren't looking at growth (at least initially)? A good start would be to first figure out the implications of growth by calculating ROIC and WACC. Finding these numbers not only tells you what happens to the value of the company when it grows (or returns excess capital); I would argue that it also tells you much of the qualitative information you need to know about a business as a responsible investor. High ROIC businesses tend to have strong competitive advantages in consolidated, high margin industries. Low ROIC businesses with little hope for substantial ROIC improvement, for lack of a better word, suck. Companies with WACCs much lower than the cost of equity starting point (again, 10% for me), tend to be creditworthy companies that the credit markets (which tend to take a longer and more stringent view) deem worthwhile investing in at lower rates because of their excellent long term prospects. To make my point more clear: when I see that a company has been able to sell bonds maturing in 10 years at a, say 4.5% rate, I see that as a very good sign. When I see a company with a very good credit rating, say A1 from Moody's, I see that as a good sign. When I see a company with even just a low investment grade credit rating like Baa2 from Moody's despite considerable financial leverage (debt/assets > 50% or so), I see that as a good sign. It is important to differentiate between companies with substantial debt that are trying to optimize WACC and those that are just desperate for cash.

I realize that ROIC and WACC can be very intimidating (they were and still are for me) because they can be calculated in a variety of ways and probably should be calculated differently depending on the situation. For ROIC, I typically use:

((EBITDA - Capex - Change in Working Capital)*(1 - Tax Rate)) / (Total Assets - Current Liabilities)

For WACC, I usually assume cost of equity to be 10% and divide after-tax interest expense by average debt to get cost of debt. I then take a weighted average of the cost of debt and cost of equity.

Examples of high ROIC businesses are AutoZone (NYSE:AZO), Polaris Industries, Tim Hortons (THI), Panera Bread (NASDAQ:PNRA), Apple (NASDAQ:AAPL), etc. Examples of low WACC businesses are Express Scripts (NASDAQ:ESRX), AutoZone, Tim Hortons after recent financial leverage increase, banks in general, and GNC (NYSE:GNC).

I'd like to close by saying that there is a place for growth in corporate strategy and investment research, but its place is definitely after ROIC and WACC, where its implications are already known. A high ROIC, low WACC, high growth business can do some pretty amazing things. A low ROIC, high WACC, high growth business is nothing special and should probably be focused on returning capital to shareholders or pursuing a strategy that promises meaningful improvements to ROIC rather than blindly growing.

Thanks, readers, for letting me sort this out for myself through writing and I hope you find it helpful.

Disclosure: The author is long ESRX. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.