Corporate Growth Lifecycle and the Shareholder Value- Valutrics
Corporate growth and success – often measured in terms of turnover or profit – are what’s seen as important, and the business develops a momentum of its own. A company’s business and financial strategies must operate in tandem to deliver the value demanded by its shareholders.
Once the new product has been successfully launched into its marketplace, the sales volumes should start to grow rapidly. Not only does this represent a reduction in the overall business risk associated with the product, but it also indicates the need for a modification in the strategic thrust of the company. The key emphasis of the competitive strategy should now be placed on marketing activities in order to ensure both that the total growth of product sales are satisfactory and that the company increases its market share of this expanding sales volume.
These critical issues show that the business risk, although reduced from the start-up stage, is still high during the period of rapid sales growth. Thus the appropriate source of funding must be designed to keep the financial risk profile low, which indicates continued use of equity funding.
However, an important aspect of managing the transition from start-up to growth is that the initial venture capitalist investors will be keen to realize their capital gains in order to enable them to reinvest in other new start-up businesses.
This means that new equity investors need to be identified to replace the original venture capital and to provide for any continued funding needs during this period of high growth. The most attractive source of such funding is often from a public flotation of the company.
The higher sales volumes which should now be achieved at quite reasonable profit margins will generate much stronger cash flows than during the start-up stage. However, the company should be investing heavily in both overall market development and market share development activities, as well as requiring investments to keep pace with the increasing levels of operational activity.
Consequently, the cash generated by the business is required for reinvestment in the business with the result that the dividend payout ratio will remain very low. This should not be a problem for the new equity investors in the company because they will have been attracted primarily by the prospects of high future growth.
These growth prospects would have been reflected in a high price/earnings multiple applied to the low existing earnings per share of the company when calculating the current share price. As the dividend yield is very small, the bulk of the investors’ expected return has to be generated as capital gains, by increases in the share price. This means that the company has to produce substantial growth in earnings per share during this stage of development; this should be achieved by winning a dominant market share in the rapidly growing market.
It is important to realize that it is during these first two stages of the product life cycle that the company has its main opportunities to develop the sustainable competitive advantage which it will utilize during the later, cash positive, maturity stage.
GROWTH HIGH BUSINESS RISK
This need to develop the sustainable competitive advantage is a good indicator of the level of business risk which is carried over from the start-up stage into this growth phase of the life cycle. For most companies, the major entry barriers to the industry are constructed during the rapid growth period so as to prevent competitors following the company’s competitive initiatives once the product’s potential has been identified. These barriers can take many forms, such as the development of strong branding (which differentiates the product in the minds of customers), and the early achievement of significant economies of scale or learning curve cost reductions (which establishes a potentially sustainable position as the low cost producer in the industry).
There are obviously significant risks associated with the implementation of each of these competitive strategies and they all require considerable up-front investment by the company, which is financially justified on the expectation of the future long-term growth in the sales of the product. Thus for these companies the level of business risk remains high because these risks must be considered alongside the risks that the anticipated growth in demand will not fully materialize. However, some companies can enter this stage in a more confident position, as their competitive advantage has already been well established during the start-up phase.
A classic example would be in the pharmaceutical industry where a completely new drug would normally have been patented as early as possible.
If the subsequent development process, including the essential clinical trials, and the actual product launch are successful, the patent guarantees its owner a finite period of sustainable competitive advantage during which the returns are predominantly governed by the total growth of demand for the product.
The substantial contribution of a single product, Zantac, to the Glaxo pharmaceutical group’s tremendous financial success during the 1980s and early 1990s clearly highlights this point. The converse to this is, of course, that the development costs of such a new product are immense and the associated risks of failure very high; it simply means that the major risk-taking period is earlier in the life cycle for some industries than others.
Another reason for the business risk of the growth phase to be considered as still being high is that the transition from start-up to growth requires a number of changes to be implemented by the company. Change always implies risk as, if the change is not managed properly, it can lead to a downturn in the future performance of the business. Where the required changes are significant and wide-reaching, the level of increased risk that results is also greater. An obvious area of change is in the strategic thrust of the company. During their start-up periods, most businesses would have concentrated on research and development, either in order to exploit an identified market opportunity or in the hopes of creating one through a technological breakthrough. Even in its latter stages where the product was being prepared for launch, the main emphasis would have been on problem-solving as quickly as possible. Delays in getting the product into the marketplace can prove extremely expensive if, as a consequence, a competitor is able to establish its product first, or if the window of opportunity has simply been closed during the period of delay.
Once the product has been successfully launched, the company should concentrate its efforts on building both the total market and its share of this expanding market. This requires a marketing focus on the part of senior managers rather than the R & D or technology focus which may have been more appropriate during its earlier years. A fundamental change in management focus is not easy to achieve (without changing the managers) and so the scale of the required change is important in terms of the risk associated with this transition. If the company’s original product development strategy was very market oriented, the change may not be that great. However, for many very high technology businesses the requirement to focus on the needs of customers rather than solving stimulating intellectual problems has proved very difficult to manage.
There also needs to be a fundamental change in the investor profile during the transition from start-up to rapid growth style of company. The venture capitalist is the ideal shareholder for the newly formed very high risk company, but, it is not appropriate for the company to retain this investor base throughout its movement through the growth stage. However, the continuing high business risk associated with most rapidly growing companies means that low risk financing is still appropriate. This requires finding new equity investors who are prepared not only to buy out the original venture capital shareholders but also to provide any funding needed during this period of rapid growth.
These new investors are taking on a lower risk investment than did the venture capitalists, because the product is normally now proven and at least some customers will have accepted the specific product offering of the company. Also the company is now much more substantive than the business plan and product concept which it may have comprised when initial financing was being raised.
Hence it is possible to look to raise this new equity funding from a broader potential base of investors, possibly including the ‘general public’.
In most countries there are much tighter rules applying to the control of companies which wish to raise funds from the general public; even though, unfortunately, several recent abuses of financial management in major public companies have highlighted that these controls do not always work. The objective of the increased controls is to try to safeguard the less-sophisticated investor and to maintain the confidence of investors in general in the way financial markets are administered. Clearly, if the confidence of investors were undermined they would either cease to invest altogether or would demand significantly increased returns to compensate for their higher risk perceptions.
The implications for companies needing to raise equity funding would be very severe in either case. An immediate practical implication of these tighter controls, designed to maintain a high level of investor confidence, is to increase the costs to the companies concerned. These higher costs relate to registration fees (including the costs of being listed on a stock exchange and of having share price information included in major newspapers and other information services): legal and professional costs of raising funding and of maintaining a stock exchange listing; shareholder communication costs (to both existing and prospective shareholders and to all shareholders whether large or small); and the costs of compliance with the rules of the various bodies of which the company becomes a member.
Many of these costs can be minimized if this second phase of equity funding is raised by private placement (without inviting the public to invest in the company) and if the company does not seek a stock exchange listing for its shares. Many private equity institutions have portfolios including pre-IPO companies, which have raised private funding as a second stage of their development prior to flotation. However, these new investors must be prepared, with part of their funds at least, to buy out existing venture capital shareholders: this portion of their investment does not go to the company itself, but into the hands of existing shareholders. The remainder of the investment goes into the company and is used to finance the rapid growth of the business.
Thus the major financial return to these new investors will take the form of capital gains on their shares, as in the case of the venture capitalists. Unless these investors are going to stay in the company until it eventually does become mature, cash positive and dividend paying, they too will require other new investors to buy their shares in due course. This is a key problem caused by continuing to use private (i.e. non-public) sources of equity finance; it provides initial funding to the company but it does not create an easy exit route for these investors who wish to sell some shares and realize part of their capital gain.
The best way of achieving this exit is for the company to be quoted on a stock exchange so that prices for its shares are known. Equally importantly, financial traders (market makers) stand ready to buy and sell the shares at all times, thus providing a ready exit route for current shareholders.
REINVESTMENT PROJECTS
Growth companies tend to be developed with full retention of their post-tax profits (i.e. a nil dividend payout ratio on their ordinary shares) and tend to continue to reinvest a high proportion to finance their high growth objectives. Such growth can come from taking on projects with a very similar risk profile to the existing business, or taking on projects with a different risk profile.
If growth is through new projects with a similar risk profile to the existing business, the return on reinvestment must be at least equal to the investors’ demanded return on equity if shareholder wealth is to be enhanced not destroyed.
However, many businesses expand in different directions, such that it is not true that all their projects face the same level of risks. A fundamental reinvestment question is therefore whether all reinvestment projects should be expected to make a return greater than the company’s cost of capital. It should be immediately clear that this would be illogical; if a project has a lower risk than the average risk of the company, it should be expected to make a lower return.
As long as the expected return from the project is greater than its risk-adjusted cost of capital, the project is financially acceptable. If all projects are required to earn more than the company’s average cost of capital, the business runs the risk of rejecting many financially attractive, low risk projects while accepting some unattractive higher risk projects.
Unfortunately, this concept is not applied by many leading companies. In many cases the company’s cost of capital (which should be related to its overall risk level) is taken as a minimum required rate of return for reinvestment projects, with extra return requirements being added for above average risk projects. This leads to the position where low risk investment opportunities are rejected because their return is below the company’s cost of capital.
CREATING SHAREHOLDER VALUE
In a perfectly competitive market, market forces would dictate that all investments would receive only their risk-adjusted required rates of return. Consequently no shareholder value would be created. Accordingly it stands to reason that shareholder value is only increased by exploiting imperfections in the marketplace.
The greatest imperfections arise in product markets, i.e. the actual marketplaces in which specific products are sold to customers. Therefore, companies can increase shareholder value by creating a sustainable competitive advantage through selecting and implementing an appropriate competitive strategy.
For example, barriers to entry into an industry may be created to keep out competitors and thus prevent the rules of perfect competition from applying in that industry. As a result, new companies cannot economically afford to enter the industry even though the financial returns available are above normal levels. This restriction on potential new competition enables the existing players in the industry to enjoy an apparently excessive financial return on their investments.
However, in reality, the creation of an effective barrier to entry normally requires substantial additional financial investment; either in very strong branding through heavy marketing expenditure, or in achieving material cost advantages through the development of significant economies of scale, etc. Consequently this apparently excessive financial return can initially be regarded as providing the normal required return on this additional investment. Any remaining excess financial return represents the true ‘value added’ for shareholders.
The three main metrics of measuring shareholder value are:
• Shareholder value analysis
• Economic profit
• Total shareholder return.
SHAREHOLDER VALUE ADDED (SVA)
The Shareholder Value Added (SVA) approach devised by Alfred Rappaport uses discounted cash flow techniques to estimate the value of an investment, discounting forecast cash flows by the cost of capital. Rappaport stated that the value of a company is dependent on seven drivers of value:
1. sales growth
2. operating profit margin
3. cash tax rate
4. incremental investment in capital expenditure
5. investment in working capital
6. time period of competitive advantage
7. cost of capital
Management can use their knowledge of current sales levels and forecasts of the first five drivers in order to prepare cash flow forecasts for a suitable period.
Such a period would be defined based on the likely period of the company’s competitive advantage – driver six. Discounting these at the cost of capital (driver seven) leads to an enterprise value for operations; this can easily be translated into a value for equity. This technique is most effectively applied to individual business units within a company, whose separate values can be cumulated to arrive at the value of a business, or to create alternate scenarios.
Unlike the two metrics discussed below, SVA can be difficult to use as a one- period tool. Positive free cash flow in a period is not necessarily good; negative free cash flow may not be bad. The metric is mainly used for valuation and planning rather than as a periodic measure of performance.
ECONOMIC PROFIT (EP)
Economic profit (sometimes known as ‘residual income’) is a generic name that covers many of the different variants of profit-based measures of shareholder value. This is the surplus earned by a business in a period after deducting all expenses including the cost of capital.
Economic profit is primarily used for performance measurement. It has the advantage that it teaches managers a great respect for capital – it is no longer seen as ‘free’ – and encourages them to run their businesses so as to minimize capital employed. In many instances this behavioral change is beneficial to the business, although some would argue that EP is a single-period measure, and taking it to extremes can lead to capital-starved businesses, limiting growth.
There is of course a relationship between SVA and economic profit. It can be shown that the discounted value of the projected economic profits of a business for the appropriate time period will equate to the SVA. Perhaps more intuitively, whereas SVA shows the value of a business over its lifetime, economic profit shows whether the company is creating value in any single period.
TOTAL SHAREHOLDER RETURN (TSR)
Both SVA and economic profit are ‘internal’ measures of shareholder value: in terms of the two-decision model they show how well the company is using its competitive strategy to create value from the product- market mix it selects. Total shareholder return (TSR) is an ‘external’ measure – it looks at the value created for shareholders. TSR represents the total return to the shareholders in a period: the increase in share price, plus any dividends paid during the period. This performance measure is very commonly used in directors’ long term incentive plans, often calculated over a three year period.
From the point of view of the shareholders, TSR is probably the most accurate measure of value – it shows exactly what they have received from the company in the period. However, as a measure of managers’ performance the metric has limitations. Share prices reflect the market’s expectations, rather than corporate performance. Adequate performance from a company expected to do poorly might increase share price far more than superb performance from one that was already a market favorite.
A company could be doing well, but be in an out-of-favor sector and thus see its share price fall. Alternately, a poor company could see its price rise for reasons unconnected with underlying performance. When used as a measure of directors’ performance, TSR is generally benchmarked relative to similar companies, which helps eliminate some – but by no means all – of these difficulties.
Warren Buffett, the legendary investor who runs Berkshire Hathaway, effectively states this in his ‘Owners’ Manual’ for shareholders. He sets out 14 principles, the 14th of which is that his aim is for shareholders to record a gain/loss in the market value of their investment which is proportionate to the gain or loss in the intrinsic value of the share. Or, to put it another way, that the share price should accurately reflect, as far as possible, the fundamental value of the company.
The fact that creating long term shareholder value is seen as the most important task of the company does not mean that creating value for other stakeholders is unimportant. If a business neglects customer value it will soon not have any customers; poor treatment of employees will lead to them leaving, denuding the company of their skills; neglecting broader concerns such as environmental or human rights issues can lead to consumer protest, as demonstrated with Shell over Brent Spar or with the ongoing anti-globalization campaigns against high profile companies for their sourcing practices in underdeveloped countries. All of these constituencies are important to a company, but the long term shareholder interest has the highest priority.