Value Of Growth

Value Of Growth

Today, growth has become a mantra for organizations. Thus, when companies do M&A, they pursue growth. First, buyers need to validate whether the price they are paying for development equals the value they derive.

In my view, growth adds value only when:

1)First, it improves operating income/earnings.
2)Second, how sustainable are these growth rates?
3)ROIC from the growth should exceed WACC

Let me substantiate my view with an example of a firm A with the following.

a)NOPAT (After Tax Operating Income) – $10 million
b)#WACC – 10%

Thus, Value of Assets in place – 10/0.1 = $100 million

Now, firm A looks at #mergersandacquisitions to grow at 3% by financing the acquisition through internal accruals at 20% reinvestment. Thus, #ROIC for this transaction is 3%/20% = 15%

Value of Firm A after acquisition = 10*(1-20%)/(10%-3%) = $114.28 million

Thus, the M&A transaction has added $14.28 million ($114.28 – $100) for Firm A. However, if firm A funds this acquisition at a 30% reinvestment rate, the value of Firm A is $100 million. In this case, ROIC is 3%/30% = 10%

Value of Firm A at 30% reinvestment = 10*(1-30%)/(10%-3%) = $100 million

Thus, 3% growth only adds value to firm A when ROIC>WACC. When ROIC = WACC at 10%, this growth of 3% does not add any value to Firm A.

However, i have seen companies pursuing M&A for growth at ROIC<WACC. In such a scenario, M&A destroys #shareholdervalue.