When growth creates value

In this article you'll find
• why not all growth creates economic value
• how competitive advantages and barriers to entry influence the quality of growth
• why the sustainability of returns matters more than growth itself

In the previous article, we saw that growth does not necessarily coincide with value creation. We also introduced two fundamental concepts:

  • ROIC
  • WACC.

When the return generated by invested capital exceeds the cost of the capital required to finance it, a company creates value. When returns fall below the cost of capital, growth progressively begins to destroy value.

This principle is relatively simple.
What is far more complex is understanding which investments are truly capable of maintaining returns above the cost of capital over time. This is where growth quality comes into play.

What kind of growth are we talking about?

Imagine a retail company identifying an apparently highly profitable opportunity:

  • the investment requires 100
  • the company estimates a return of 15%
  • the cost of capital is 10%.

At first glance, this appears to be a value-creating investment. But there is a more important question.

How long can that 15% return be maintained?

If other operators can easily replicate the initiative, enter the same market and offer a similar proposition, returns will progressively begin to decline.

Competition will increase. Industry capacity will expand. Margins will begin to compress. Returns will continue to fall until they converge toward the cost of capital.

At that point, the initial economic advantage will have largely disappeared. Growth will have occurred. Value creation, much less so.

The duration of returns

The ability to generate high returns is important, but the ability to sustain them is even more important. Two investments may produce the same initial return. However, if the first maintains that return for ten years while the second loses it after only a few months, the value created will be profoundly different. For this reason, the central question is not simply:

How much does this investment earn?

The central question is:

How defensible are these returns over time?

Competitive advantages and barriers to entry

Above-average returns tend to attract capital. New competitors enter the market. Existing operators increase investment. Capacity grows. Competition intensifies.

In the absence of barriers to entry, this process progressively reduces returns for all participants. For this reason, growth creates value primarily when a company possesses competitive advantages capable of limiting the erosion of returns. These advantages can take different forms:

  • brand strength
  • economies of scale
  • network effects
  • strategic assets
  • distribution advantages
  • high switching costs.

The stronger and more difficult these advantages are to replicate, the greater the probability that returns will remain above the cost of capital for extended periods.

When growth destroys value

There is a fairly common mistake. Confusing a good opportunity with a good competitive opportunity.

Many markets appear attractive precisely because they generate high returns, but those returns are often only temporary. In the absence of sustainable competitive advantages, new entrants will be attracted by the same profits.

The outcome is predictable. More capital enters the industry. Competition increases. Returns decline. In some cases, enthusiasm can even generate excess capacity severe enough to push returns below the cost of capital.

Under these conditions, growth does not create value. It destroys it.

What really matters

Growth should not be evaluated solely in terms of:

  • revenue
  • margins
  • market share
  • number of stores.

It should also be evaluated based on a company’s ability to protect the returns generated by invested capital. Because the real distinction is not simply between those who grow and those who do not.

The real distinction is between those who grow while maintaining returns above the cost of capital and those who grow without being able to defend them.

Over the long term, it is this distinction that determines whether growth creates value or destroys it.

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