When growth creates value (and when it doesn’t)

In this article you’ll find
• why growth does not always create value
• how ROIC and WACC help evaluate expansion decisions
• when a larger retail network becomes economically weaker

When discussing value, it is important to remember that it does not come in a single form. In retail, as in many other economic systems, value can emerge in different ways.

It can be created for customers, employees, suppliers, local communities, society as a whole and, naturally, for shareholders. All of these dimensions matter and contribute, in different ways, to a company’s ability to create value over time.

If, however, we isolate shareholder value for a moment, the topic of growth takes on a particular perspective. In retail, growth is often perceived as positive almost by definition: more stores, more revenue, more visibility, greater market share, higher EBIT.

All of this appears perfectly reasonable and desirable. Yet from a shareholder’s perspective, growth and value creation are not necessarily the same thing.

A retail network can continue growing while simultaneously beginning to destroy value. Understanding this distinction is often useful when evaluating an expansion project.

Every new opening is a capital allocation decision

For a shareholder, opening a new store does not simply mean generating additional revenue. It means investing capital, increasing operational complexity, absorbing managerial attention, expanding working capital requirements and coordinating additional people, processes and activities.

Every opening requires initial investments, working capital, execution capability, managerial support and organizational capacity. In other words, it requires resources that could have been deployed elsewhere and that, precisely for this reason, must generate an adequate return.

This is why every new opening is first and foremost a capital allocation decision. The real question should therefore not be:

Will the new store generate a profit?

The real question should be:

Will the new store generate returns above the cost of the capital required to open it and keep it operating?

Not all growth has the same quality

Not all growth produces the same outcomes. Some initiatives strengthen returns, improve capital productivity and make future cash flows more resilient.

Others, despite generating additional revenue, achieve the opposite result: they absorb capital, compress returns and reduce the economic quality of the system.

Yet in both cases, we continue to call it growth. Revenue may increase. EBIT may improve. Even net income may rise. And yet the economic value generated by the capital invested in the business may progressively decline.

This distinction is less intuitive than it may appear, yet it is probably one of the most important: beyond a certain point, it is possible to continue growing while destroying value.

Measuring the quality of growth

In retail, measuring the quality of growth is one of the most important and often one of the most debated topics. When can we genuinely say that growth has also created value? The deeper we explore the issue, the more we realize that the answer is neither simple nor obvious.

There are many ways to measure growth. For example, a company that increases revenue and grows net income is clearly growing. And that is true. But measuring the quality of that growth is an entirely different matter.

Imagine that the same company increases sales by 15% and net income by 15%. It has undoubtedly grown. But if achieving those results required doubling capital expenditures, perhaps through investments in new production equipment, the picture begins to look very different.

When evaluating growth, focusing exclusively on revenue and profit is rarely sufficient. Revenue and earnings growth seldom occur without additional investment. And those investments do not always appear only in the income statement. In many cases, they also appear on the balance sheet.

For this reason, measuring the quality of growth requires more than measuring revenue growth or profit growth. It requires asking a different question:

Has the additional capital employed generated an adequate return?

Only then can we begin to evaluate the quality of growth.

When measuring growth quality, it is difficult to avoid ROIC (Return on Invested Capital). It measures the operating return a business is able to generate relative to the capital invested in the business.

A simple concept, but an extremely useful one. For shareholders, ROIC is one of the most important metrics for evaluating growth quality.

Because the issue is not simply whether a business is growing. The issue is understanding how much return is being generated relative to the capital required to sustain that growth.

The higher the ROIC, the more productive the capital employed. The lower the ROIC, the less return is generated for every euro invested in the system.

The threshold between value creation and value destruction

Now imagine that the same retail company that delivered a 15% increase in net income decides to accelerate the expansion of its network through a large number of new openings.

At first glance, everything appears to improve. Revenue increases again. EBIT increases again. The network becomes even larger.

But from the perspective of invested capital, has growth also improved the economic quality of the system? Not necessarily.

If invested capital grows faster than operating returns, or if operating profitability deteriorates (and, incidentally, both conditions can occur simultaneously), the return generated on invested capital, namely ROIC, may begin to decline.

And when this happens, growth may begin destroying value. This is precisely the moment when a different question becomes relevant:

Was the expansion worth it?

If the return generated on invested capital falls below its cost, growth may create more economic costs than benefits. The logic is straightforward. Growth almost always requires additional capital, whether in the form of equity, financial debt or retained earnings.

Even when growth is financed through retained earnings, the logic does not change. Those resources could have been distributed to shareholders instead of being reinvested in the business. From a shareholder’s perspective, reinvesting those funds is economically equivalent to asking shareholders to contribute additional capital.

For this reason, that capital has a cost and must generate returns that exceed the cost of financing it. If the return generated on invested capital is not higher than the average cost of the capital employed, growth has not created value. It has destroyed it.

This is why the threshold between value creation and value destruction is inevitably represented by WACC. It represents the minimum return invested capital should generate in order to adequately compensate the capital employed by the business.

This is where the most important distinction emerges. When:

ROIC > WACC → the business creates value.

When:

ROIC < WACC → the business progressively begins destroying value.

Even if revenue continues to grow. Even if EBIT continues to improve. Even if the retail network continues to expand.

A Practical Example

Imagine a retail network generating:

• €200 million in revenue
• an EBIT margin of 12%
• a tax rate of 30%

This results in:

• EBIT of €24 million
• NOPAT = EBIT × (1 − Tax Rate) = €16.8 million

Now imagine that the capital structure is composed of:

• €80 million of equity
• €40 million of financial debt

For simplicity, assume that excess cash is zero.

Total invested capital therefore amounts to €120 million.

Now assume that the return required by shareholders (Ke) is 12% and that the average cost of financial debt (Kd) is approximately 4%.

Since ROIC > WACC, the business is creating value.

Now imagine that the network accelerates its expansion through numerous new openings. As discussed earlier, everything initially appears to improve. Revenue increases. EBIT increases. The network becomes larger.

However, after this expansion phase, imagine that ROIC falls to 8% because invested capital has increased far more rapidly than the returns generated on that capital.

In this scenario, revenue could continue to grow. EBIT could continue to improve. The number of stores could continue to increase. And yet the business would be progressively destroying value.

The return generated on invested capital would no longer be sufficient to compensate for the cost of the capital required to sustain that growth.

In this case, the more the system grows, the more value it destroys. The size of the network increases, but the economic quality of the invested capital deteriorates.

Scale does not correct weak economics

There is one final misconception that is surprisingly common in retail: the belief that scale automatically improves the economics of a business. In reality, scale tends to amplify what already exists.

In a business where ROIC exceeds WACC, growth can strengthen efficiency, profitability and competitive advantages. In a business where ROIC falls below WACC, the opposite may occur.

Growth can amplify inefficiencies, complexity and capital intensity. Scale does not necessarily correct weak economics. Sometimes it simply makes them larger.

What really matters

The objective should not be growth for its own sake. The objective should be allocating capital to activities capable of generating returns above their cost.

And ideally maintaining those returns over time, or even improving them, although in practice this is often far more difficult than it sounds.

We will return to this topic in a future article when discussing the concept of a moat. In retail, scale increases visibility.

Capital productivity creates value.
Over long periods of time, the distance between the two can become enormous.

Sometimes even unsustainable.