- September 6, 2020
- Posted by: Ramkumar
- Category: Strategy
Link Between The Right Growth Strategy and Value Creation
The chase for continuous growth clasps the business world. The prevailing view is that a company must grow to endure and succeed. Growth generates value, mainly when a company’s new customers, projects, or acquisitions generate returns on invested capital (ROIC) more significant than its capital cost. For more prominent companies in the mature industries, discovering useful, high-value-creating projects becomes more tricky. Thus, striking the right balance between growth and return on invested capital is critically important to value creation. This post, i shall present my insights on the link between the right growth strategy and value creation.
Drivers of Revenue Growth
In my view, the following are three drivers of revenue growth:
- Portfolio momentum – This is the organic revenue growth a company experiences because of overall expansion in the market segments outlined in its portfolio.
- Market share performance – This is the organic revenue growth (or reduction) a company gets by gaining or losing share in any distinct market.
- Mergers and acquisitions (M&A) – This describes the inorganic growth a company realizes when it acquires or sells revenues through acquisitions or divestments.
If we analyze the above three drivers, we find that being in fast-growing markets was the largest growth driver. The least relevant was market share growth. However, larger companies in matured markets concentrate most of their offerings on expanding share in their existing product markets. While it’s essential to control and sometimes grow market share, shifting a company’s exposure to shrinking to growing market segments should be the right focus.
Link Between The Right Growth Strategy and Value Creation
While companies typically aim for high growth, the highest growth will not certainly generate the most value. The reason is that the three drivers of growth (portfolio momentum, acquisitions, and market share gains) do not all generate value in similar measure.
- Growth from improvements in market share, especially in slow- and -moderate-growth markets, seldom generate much value for long, because entrenched competitors typically retaliate to protect their market shares. Lasting value creation could only happen in situations where smaller competitors are pushed out of the market entirely or where the company offers differentiated products or services that are difficult for competitors to imitate.
- Growth driven by price increases happens at the expense of customers, prone to respond by decreasing consumption and trying substitute products. The distinct value created by price hikes may not remain long.
- Growth induced by overall market expansion comes at the expense of companies in other industries, which may not even recognize who they are losing market share. This category of the offering cannot retaliate, making product market growth the driver likely to generate the most value.
- Growth from acquisitions is more challenging to distinguish because it depends so much on the acquisition price.
Link Between The Right Growth Strategy and Value Creation – A Hierarchy of Growth Scenarios
The scenarios with the tremendous potential to generate value are all varieties on entering fast-growing product markets that exercise revenues from foreign companies, rather than from direct competitors or customers via price rises.
- Growing new products or services that are innovative to design entirely new product categories has the highest value-creating potential. The greater the competitive advantage a business can build in the new product category, the higher will be its ROIC and the value generated. For instance, traditional music retailers have lost their market share to online music sales giants such as iTunes and Amazon. More recently, digital entertainment has cropped up as consumers have taken up online streaming services for Spotify, Amazon Music, Apple Music, and others.
- The next highest value-creating growth tactic comes to convincing current customers to buy more products or similar products. For instance, post-COVID, if Procter & Gamble persuades customers to clean their hands more regularly, hand soap will grow quicker. Direct competitors will not react because they profit as well. The ROIC linked with the added revenue is likely high because the firms’firms’ manufacturing and distribution systems can typically provide new products at a little added cost. The profit will not be as large if the company has to raise costs considerably to achieve those sales. For instance, offering bank customers insurance products entails the cost of an entirely new sales force. The products are too complicated to append to the list of products the bankers are already selling.
- Gaining share from incremental innovation—for instance, through incremental technology developments that neither radically transform a product nor constitute a wholly new category and possible to imitate—won’t generate much value or secure the advantage. From a customer’s perspective, hybrid and electric vehicles aren’t distinct from gas or diesel vehicles, so they cannot charge much of a price premium to compensate for their higher costs. The total amount of vehicles sold will not rise. If one organization gains market share for a while, competitors will attempt to get it back, as competitors can mimic each other’s innovations before the innovator has been able to secure much value. All in all, auto companies, whether new or incumbent, may not generate much value from hybrid or electric vehicles; competition will likely shift most advantages to customers.
- Increasing share through product pricing and promotion in a mature market seldom generates much value, if any. Huggies and Pampers control the disposable-diaper market and are financially sound, and each can efficiently react if the other tries to win share. Consequently, any growth resulting from, say, an intensive campaign to decrease prices that hit right at the other competitor will evoke a response. And as Amazon extended developing into the U.S. consumer electronics retail market in 2009, Walmart slashed prices on primary goods such as game consoles, even though Amazon’s $20 billion in sales in 2008 were a fraction of Walmart’s $406 billion sales in the same year.
- Price extensions can generate value as long as any resulting slump in sales volume is meager. Nevertheless, they tend not to be repeatable: if a firm or numerous competitors get away with a price hike one year, they are unlikely to continue the next. Moreover, the first increase could get decayed relatively soon. Otherwise, companies would be raising their profit margins year after year, while in actuality, long-term increases in profit margins are exceptional.
- There are two principal strategies for expanding through acquisitions. Growth through bolt-on acquisitions can generate value if the premium paid for the target is not too expensive. Bolt-on acquisitions deliver incremental additions to a business model—for instance, by building or stretching a company’s product offering. In opposition, generating growth through large acquisitions—say, one-third the size or more of the acquiring company—tends to produce less value. Large acquisitions typically happen when a market has begun to mature, and the industry has excess volume. While the acquiring company registers revenue growth, the combined revenues usually do not grow, and sometimes they decline because customers prefer to have multiple suppliers. Any new value comes principally from cost-cutting, not from growth. Moreover, integrating the two companies needs significant investments and includes far more complexity and risk than integrating small, bolt-on acquisitions.
Picking a Growth Strategy
The thesis demonstrating why growth from product market expansion effects more significant and more sustainable value than growth from taking share is compelling. Nonetheless, the dividing line between the two types of growth can be blurred. For example, some innovations limit existing competitors from countering, even though the innovator’s products and services may not seem new. Walmart’s innovative retailing strategy in the 1960s and 1970s gave a completely new shopping experience to its customers, who thronged to the company’s stores. One could assert that Walmart was taking share away from small local stores. But the fact that its competitors could not counter implies that Walmart’s approach constituted a genuinely innovative product. In general, underlying product-market growth tends to generate the most significant value. Firms should strive to be in the fastest-growing product markets to realize growth that consistently generates value. If a business is in the wrong markets and can’t immediately get into the correct ones, it may do better by sustaining growth at the same level as its competitors while discovering methods to develop and sustain its ROIC.
Why Sustaining Growth Is Difficult
Maintaining high growth is much more complicated than sustaining ROIC, particularly for larger companies. The math is easy. Assume your core product markets are rising at the rate of the gross domestic product (GDP)—say, 5% nominal growth—and you currently have $10 billion in revenues. Ten years from now, hoping you grow at 5% annually, your revenues will be $16.3 billion. Assume you aspire to grow organically at 8% a year. In ten years, your revenues will need to be $21.6 billion. Hence, you will require to discover new revenue sources that can rise to more than $5.3 billion per year by the tenth year. Adjusting for 1 to 2% inflation, you need an additional $4.3 billion to $4.8 billion per year in today’s dollars. Another way to conceptualize it is that to gain such revenues, you would want to reinvent a business roughly half your current size and close to a Fortune 500 company. If your product markets increase at only 5%, how can you probably achieve that growth degree?
Sustaining growth is challenging because most product markets have natural life cycles. The market for a product—which suggests the market for a narrow product category sold to a distinct customer segment in particular geography—typically follows an S-curve over its life cycle until maturity. First, a product has to establish itself with early adopters. Growth then accelerates as more people desire to buy the product until it approaches its maximum penetration point. After this maturity period, and depending on the product’s characteristics, sales growth falls back to the same growth rate as the economy, or sales may begin to contract.
Sustaining high growth proffers significant challenges to businesses. Given the typical life cycle of products, the single method to deliver consistently high growth is to consistently discover new product markets and penetrate them successfully in time to experience their more successful high-growth phase.
To maximize value for their stockholders, firms should know what drives growth and how it generates value. For large organizations, the growth of the markets in which they serve mainly drives long-term revenue growth. Although gains in market share add to revenues in the short term, these gains are far less critical for long-term growth.
Sustaining high growth is more challenging than starting it. Because most products have natural life cycles, the exclusive means to realize ongoing high growth is to continue launching new products at an accelerating rate—which is almost unattainable.