The Relative Value of Growth

Over the past year, I’ve been conducting a simple, informal survey of friends and colleagues in business, consulting, and investment banking. I ask just one question: “Which do you believe is more valuable for your company—achieving an extra percentage point of growth or gaining a percentage point of margin?” On the face of it, a point of margin looks much more valuable: 100% of extra margin drops to the bottom line, while, most respondents agree, only 7% to 8% of an extra point of growth turns to profit—and that’s assuming the profit margin is sustained. But experienced businesspeople also know that growth has a compounding effect over time that amplifies the long-term benefit. So most of the 30 or so people I spoke with concluded by estimating that a point of growth and a point of margin probably contribute about equally to shareholder value. I admit that my survey is not scientific. Nevertheless, I find it striking that experienced business leaders and advisers don’t have a clear sense of the relative impact that growth and extra margin have on shareholder value. My more formal research suggests that growth and margin are anything but equivalent. Growth often is far more valuable than managers think. And it’s a mistake to assume that profitability always has to be sacrificed to achieve growth (though there certainly are cases where it does). For some companies, convincing the market that they can grow by just one additional percentage point can be worth six, seven, or even ten points of extra margin. For some companies, convincing the market that they can grow by just one additional percentage point can be worth six, seven, or even ten points of margin improvement. In practice, the choice of whether to adopt a growth strategy or a margin improvement strategy is seldom obvious and depends very much on industry and company-specific factors. Some firms routinely underweight the value of growth and therefore risk compromising their performance and sustainability. Others pull growth levers when shareholder value is best served by boosting margins and cash flow. And some doggedly fight the last war, staying with an approach whose time has passed. If managers are to make the right decisions in allocating their resources and energies across growth projects and margin improvement initiatives, they will need to better understand the relative value of growth. With that information, they can identify the appropriate targets for their companies and build the right organizational skills to achieve those goals. In the following pages, I present a new metric, called the relative value of growth (RVG), and the analytic framework that supports it. First, I will examine the RVGs of several well-known companies and explain why the numbers differ and what they say about the strategies of those companies. As these analyses will show, many organizations would benefit more from giving the market reason to expect extra growth than from improving their cost structures. Next, I will address the unspoken assumption that growth and profitability are incompatible over the long term and show that many companies are effective at delivering both. Finally, I will show how managers can use the RVG framework to help them define strategies that balance growth and profitability for their organizations at both the corporate and business-unit levels. Measuring the Relative Value of Growth The RVG metric expresses the value of an extra percentage point of growth as a multiple of the value of a percentage point increase in a company’s operating profit margin. The higher the multiple, the more valuable growth is to a company. A multiple of 6, for example, means that a firm would generate six times more shareholder value from adding 1% of growth than it would from boosting operating margin by 1%. RVGs for quoted companies can be estimated entirely on the basis of publicly available data. The process takes six steps: Step 1: Calculate the company’s weighted average cost of capital. This requires using standard balance sheet and income sheet data to determine the company’s debt-to-equity ratio and cost of debt. I usually estimate cost of debt from the P&L and from contractual interest rates sometimes presented in 10-K reports. The cost of equity can be estimated from historical share-price data using the standard capital asset pricing model (CAPM). Step 2: Build a basic discounted cash flow (DCF) valuation model. This involves determining a company’s sustainable cash flow, a number that captures the ongoing earnings power of the business. The sustainable cash flow number is undistorted by onetime charges or by unsustainable balance sheet changes (like delaying payments to creditors to free up cash) and ideally is adjusted for industry cyclicality. Next, reverse engineer the growth expectations of shareholders by combining the DCF model with the current stock price. This will yield an equation in which the expected growth rate is the only unknown. Step 3: Use standard algebra to solve the equation to determine the expected growth rate. Step 4: Taking that growth rate as a starting point, calculate the gain in shareholder value that would result if you increased the growth rate by an additional percentage point. Step 5: Calculate the impact an additional point of margin would have on shareholder value. Step 6: Determine the relative value of growth by dividing the value of growth by the value of margin. Let’s look at a simplified example in which I calculate the RVG for a real (but disguised) company in the financial services sector. The company has a market capitalization of $700 million, and the value of its outstanding debt is $300 million, giving it a total enterprise value of $1 billion and a debt-to-equity ratio of 3:7. Annual revenues in the past year were $400 million, and earnings before interest and taxes (EBIT) were $68 million, implying an operating margin of 17%. The company’s cash flow available for distribution to shareholders was $40 million (EBIT on an after-tax basis, plus depreciation, less capital expenditures). A summary of the six-step RVG calculation for the company is shown in the exhibit “Calculating the Relative Value of Growth.” Calculating the Relative Value of Growth Managers need a clear understanding of the relative impact of growth and extra margin on shareholder value in order to make appropriate strategic choices. The tool presented here allows managers to measure the relative value of growth (RVG) for their own companies—and for their competitors. Using basic balance sheet and income sheet data, as well as standard financial tools, managers first determine the rate of growth that the market expects a company to deliver. Next, they calculate the relative value of growth: the extent to which one extra percentage point of growth affects shareholder value as compared with one additional point of margin. The first step in determining RVG is to apply the CAPM formula. This gives us a cost of equity for the company of 12.5%. We determine the cost of debt to be an average of 6% (calculated from the debt cost on the P&L and reflecting the maturities of the company’s debt). With a 3:7 debt-to-equity ratio, and assuming a standard corporate tax rate of 35%, these numbers give us a weighted average cost of capital of 10%. (See Step 1 of the exhibit.) In Step 2, we build a simple discounted cash flow model that enables us to infer what growth rate the market expects of this company. For simplicity’s sake, we will use a standard perpetuity formula, in which a company’s enterprise value equals its cash flow discounted by the weighted average cost of capital (WACC) minus the expected growth rate, or g. Using the assumptions given above, we arrive at the following valuation equation: $1 billion = $40 million / (10% – g). In Step 3, we solve this equation, giving us an expected growth rate of 6%. Now we are ready to calculate the value of an extra point of growth (Step 4). We simply add a percentage point to our expected growth rate and feed it back into our valuation equation to see what impact it has on enterprise value. We divide $40 million by 3% (10% less 7%), which gives us an enterprise value of $1.333 billion. The extra point of growth, therefore, generated $333 million in enterprise value, of which 70% (remember that the debt-to-equity ratio is 3:7) is equity value, yielding $233 million. Moving on to Step 5, we calculate the value of an extra percentage point of margin. With revenues of $400 million, an extra point of margin is worth $4 million before taxes. Adjusting for a 35% tax rate leaves us with a net increase in cash flow of $2.6 million a year. We now use our basic DCF model to see what that cash flow represents in terms of added enterprise value. We discount the $2.6 million at the cost of capital less the expected growth rate ($2.6 million / 4%), giving us $65 million in added enterprise value or $45.5 million in shareholder value (again reflecting the 3:7 debt-to-equity ratio). The final step is to calculate the company’s RVG by dividing the value derived from growth (Step 4) by the value derived from margin (Step 5). The RVG of 5.1 tells us that one extra point of growth yields as much in value as 5.1 extra points of margin. This calculation is a simple way to assess the relative value of growth for your company and also to provide a quick “outside-in” view of any public company. There are, of course, numerous and more precise ways to get to the number. For example, it is sometimes valuable to extend the basic perpetuity growth model to a more complex DCF model that distinguishes near-term versus long-term growth prospects. Or, company data on cost of capital and growth-return prospects for specific business units can be incorporated. It is also possible to break down the market’s expected growth rate into numbers that reflect acquisition-driven growth on the one hand and organic growth on the other. But in my experience, the simple approach is usually quite revealing. Based on the data, you can make important decisions about your firm’s strategy. And by using publicly available information, you can look at any number of different companies on more or less the same terms and thus establish a sound basis for comparison. The exhibit “The Corporate Growth Parade” shows the RVGs for a number of leading publicly listed U.S. companies, including some mentioned in this article, and highlights interesting discontinuities between where the real value lies for some companies and their strategies. The Corporate Growth Parade I studied a number of well-known U.S. companies to determine what their relative value of growth (RVG) numbers say about their stated or implied strategic priorities. The higher the RVG, the more valuable growth is to a company as compared with margin. In this sample, some companies, like Pfizer, are clearly on the right track, while others, like Merrill Lynch and Office Depot, show potentially alarming disconnects between their strategies for improving shareholder value and where the real potential lies. What RVG Tells Us Calculating RVGs gives managers insights into which corporate strategies are working to deliver value and whether companies are pulling the most powerful levers for value creation. Let’s now consider four well-known companies to see what their RVGs tell us about them. The analysis in these examples is not precise, but it does suffice to indicate where these companies’ managers should be looking for value—and how successful they currently are at extracting it. Procter & Gamble. Until the announcement of its $57 billion takeover of shaving giant Gillette, P&G was best known as a turnaround story. In 2001, the company eliminated 9,600 jobs and carried out its first overhead reduction in more than five years. Capital spending was also reduced by 1.5% of sales as part of the company’s effort to achieve operating efficiencies. The market seemed to reward these initiatives handsomely. Over the past four years, P&G’s market capitalization increased by around $70 billion. But look at the numbers closely and you’ll see that Procter & Gamble’s success had a lot more to do with the company’s growth initiatives than with its cost-cutting measures. P&G’s stock price (around $55 at the time of this writing) implied that investors expected the company to grow approximately 4.4% a year. (I used the perpetuity growth model shown in Step 2 of the RVG methodology to derive the expected growth rate, assuming an enterprise value of $157 billion, a sustainable cash flow of $5.6 billion, and a weighted average cost of capital of 8%.) This was well below recent quarters’ average earnings growth rate of around 10% but well above GNP growth, indicating that investors expected P&G to generate real earnings growth over the long haul. More than half of P&G’s market capitalization reflected these expectations about the company’s growth prospects. At the time of the Gillette announcement, P&G’s enterprise value due to current performance equaled the $5.6 billion cash flow divided by its 8% cost of capital, yielding $70 billion. The remaining $87 billion of enterprise value, roughly 55% of the $157 billion total, reflected investors’ growth expectations. By contrast, four years ago (when, to use July 2000 data in the perpetuity formula, enterprise value was $85 billion, WACC was nearly 7.7%, and cash flow for the previous 12 months was $5 billion), investors were expecting the company to grow by just 1.7%, and less than 25% of the market value could be attributed to expectations about growth. That means investments in growth have delivered over 90% of the more than $70 billion increase in P&G’s enterprise value, while the much touted operational improvements have accounted for less than 10%. What did Procter & Gamble do to elevate share price performance over the past four years? While it did execute several large-scale (and high-premium) acquisitions including those of Clairol and Wella, the real source of P&G’s added value was probably the company’s reinvigorated commitment to product innovation and its success in building larger business platforms. A good illustration is the company’s expansion of its oral care business, which was initially driven by organic innovation in Crest Whitestrips and then reinforced by the small acquisition of Dr. John’s Spinbrush, whose revenues P&G was able to grow dramatically thanks to its marketing clout. The creation of additional new product categories, such as Mr. Clean AutoDry Carwash, also added to P&G’s luster as a growth company. The results from the RVG calculations suggest that P&G should continue on the same track. If P&G were to improve the combined company’s margin by just a single point, the result would be about $7.35 billion in added shareholder value—a solid boost of nearly 5% to total enterprise value. But if management can convince the market to expect an extra point of revenue growth from P&G, the company will create more than $52 billion in added shareholder value—boosting current enterprise value by a full 34%. The RVG of 7.2 means that P&G would have to wring out 7.2 points of additional operating margin (giving the company an operating margin of 25%) in order to deliver the benefits of just one more point of growth. That would constitute a huge, if not impossible, execution challenge. Delivering value through raising growth expectations is clearly the easier option. On the face of it, therefore, the acquisition of Gillette looks like a move in the wrong direction. Reverse engineering Gillette’s stock price just prior to the acquisition yields an embedded growth rate of 3.1%, more than a full point below P&G’s existing rate. However, if the current expectations for Gillette’s growth are poor, the value to be unlocked from raising those expectations is anything but. Thanks to the company’s already strong profit margins and cash flow, Gillette has an RVG of 10.4, more than three points above P&G’s. An additional point of growth would add over $20 billion to Gillette’s enterprise value—roughly four times the nominal acquisition premium of $5 billion. In other words, if P&G can apply its marketing skills to boost growth from Gillette’s operations by just a third of a percentage point—hardly an impossible task, given the company’s success with its own operations—the deal will pay off for P&G’s shareholders. And that, of course, does not take into account the margin benefits that P&G can easily squeeze out of the deal by eliminating redundancies across both companies after the deal’s completion. Indeed, if P&G improves margins by just one point, delivering $2 billion in value, then all it needs to do to cover the acquisition premium is deliver less than 0.2% a year of additional growth, worth $3 billion. Procter & Gamble also provides a striking illustration of another advantage of growth—that it has a multiplying effect on value. The value of two extra points of growth is about three times the value of the first point. That’s not the case with margin, where the value of two extra points is just twice the value of one point, the value of three extra points is three times the value of one point, and so on. In other words, increases in growth have a compounding effect on value while improvements in margin have a linear effect. For all the publicity around its cost-cutting and efficiency initiatives (both before and after the Gillette announcement), P&G’s continued investments in growth and innovation capacity will be the real driver of value creation at the company. Exxon Mobil. This company has nearly $250 billion in global energy-related sales, including a chemicals division that is the same size as DuPont. Over long periods of time, the total return to shareholders has exceeded both the Dow and the S&P indexes, even though Exxon Mobil’s revenue growth has been below the average of other major oil companies. I estimate that the company’s cost of capital is around 7.2%—nearly a point below P&G’s, even though Exxon Mobil essentially uses no debt to reduce its cost of capital. Enterprise value is around $260 billion. Estimating Exxon Mobil’s sustainable cash flow yields a range for the company’s embedded growth rate of 1.8%. I find that less than 25% of Exxon Mobil’s valuation is driven by expectations of future growth. These results reinforce the image of a company with extremely strong cash flow that has grown earnings slowly but consistently through intense bottom-line discipline. Shareholders clearly benefit from a continued focus on the bottom-line. Each point of margin improvement is worth about $28.5 billion in shareholder value, which is nearly an 11% boost to enterprise value. But shareholders would benefit much more if the company were to raise investors’ growth expectations. My calculations show that expectations of an added point of corporate growth would be worth nearly $59 billion, adding 22.5% to enterprise value. Exxon Mobil’s relative value of growth is thus 2.1. Two extra points of growth would add more than $150 billion in shareholder value, close to a 60% boost—once again showing how increasing growth is increasingly valuable. Exxon Mobil shouldn’t change its stripes overnight and definitely shouldn’t move away from operational excellence, but the company could clearly add a growth goal to its core management metrics. Perhaps that’s why Exxon Mobil chairman Lee Raymond recently said he wanted to raise the company’s growth rate to around 3%. Upgrading growth performance by 1.2 points would contribute shareholder value equivalent to nearly three points of margin improvement—making growth a compelling option given that the company’s current operating profit margin of 12% is already healthy for the sector. Kellogg. An RVG analysis of Kellogg reveals a striking case of potentially misdirected strategic effort by the cereal and snack giant. Over the past year, the company’s stock price has risen by 20%, comfortably outperforming its competitors’. The gain has been driven by Kellogg’s investment of time and effort into improving operations. Impressive as it sounds, this performance should be put into perspective. The company’s stock price is only back to where it was about five years ago after a rocky few years. Moreover, the RVG formula reveals that Kellogg has barely 0.4% of annual growth built into shareholder expectations—even after the recovery in the share price. As a result, fully 91.5% of Kellogg’s market capitalization can be accounted for by currently generated cash flows, and only 8.5% is attributable to growth expectations. Clearly, Kellogg’s investors do not see the company as a growth stock. Continuing the RVG calculation reveals that an extra point of operating margin is worth $1.05 billion to Kellogg, conferring a respectable 6.2% boost in market capitalization. But that number pales in comparison with the $5.3 billion in additional value that would be generated by a point of growth, implying a 31.3% boost to market value and an RVG of 5.04. This mismatch between the company’s potential value creation from growth and market expectations indicates that something is amiss with the company’s strategy. Kellogg has been acclaimed for its “Volume to Value” strategy of upgrading to higher-margin products; for cutting excess capacity; and for strengthening direct store delivery (DSD), especially through its Keebler acquisition. But it looks as if investors believe that Kellogg has strengthened operations more than it has invigorated growth capacity. The company needs to reenergize the growth levers of R&D, product mix, and innovative distribution to deliver a more compelling growth story for investors. EDS. An RVG analysis tells companies not only when to invest in growth, but also when not to. EDS is a $21 billion player in the IT and business-process-outsourcing industry, historically a growth sector driven by economies of scale and scope in managing complex and geographically dispersed networks. CEO Michael Jordan recently ignited controversy when he announced a plan to cut 20,000 jobs as part of an initiative to shave the company’s cost structure by 20%. Critics argued that the aggressive cost takeout would impair the company’s ability to compete in a growth market against the likes of Accenture and IBM Global Solutions. As one industry analyst opined, “In the services business, your people are your assets…so [Jordan] is reducing his chances for future growth…he doesn’t seem to understand what business he is in.” Investors, however, disagree. Despite a run-up in the share price following Jordan’s cost cuts, investors still do not expect that the company will be able to grow very much; the implied growth rate is just 0.2% a year. That means 98% of EDS’s market value can be attributed to prevailing profits and cash flow. The fact that the company participates in an ebullient industry has no effect on the market’s perception of EDS. Turning to the future, the numbers show that EDS could gain about $1.45 billion in market cap for an extra point of operating margin improvement, compared with $1 billion for an additional point of growth, implying an RVG of 0.69. EDS, the numbers suggest, is among those companies that need to earn the right to grow. The company has a razor-thin operating margin (around 3.5% of sales) and a relatively high cost of capital compared with its embedded growth rate. Without first boosting margin and cash flows and creating a more scalable growth model, EDS risks destroying shareholder value by attempting to grow revenues. I estimate that EDS needs to add about two and a half points of extra margin to achieve an RVG of 1, at which point a balanced strategy of growth and profit improvement would become appropriate. Jordan is on the right track, but he has further to go. Not least among his challenges will be changing the company’s ingrained bias toward investment in growth. The Drivers of RVG What are the drivers of a company’s RVG? Why, for instance, is Exxon Mobil’s RVG just 2.1 while Procter & Gamble’s is 7.2? Different RVGs result from variations in four key areas: margin, capital intensity, expected growth rate versus cost of capital, and the synergistic effect of all three of these elements combined. Knowing the drivers of your RVG compared with those of other companies can influence the strategic choices you make. The first driver is margin; growth cannot create value unless it is profitable. With an average operating margin of 18%, P&G has a clear advantage over Exxon Mobil, which has a margin of 12%. If both companies grow without reducing their margins, each point of growth will be more valuable for P&G than it will be for Exxon Mobil. My calculations indicate that the operating margin effect alone accounts for 1.49 points of difference between the two companies’ RVG numbers. Another source of difference between the two companies’ RVGs is that Procter & Gamble’s business is less capital intensive than Exxon Mobil’s and requires lower levels of working capital (turning Tide into liquid Tide costs a lot less than building an oil rig in the Gulf of Mexico). Thus, it costs Procter & Gamble less to get an extra point of growth than it costs Exxon Mobil. By my calculation, the capital intensity effect means that P&G’s business generates $.023 more cash flow per dollar of sales than Exxon Mobil’s does. This translates into 0.78 extra points of RVG. The third factor favoring Procter & Gamble is that it has a higher expected growth rate relative to its cost of capital, which reduces the rate at which future cash flows are discounted into value. So even though Exxon Mobil’s cost of capital is 0.9 percentage points lower than P&G’s, by my estimates, its expected growth rate—that is, the level of growth that investors believe is sustainable—is 2.6 percentage points lower. This means that Exxon Mobil’s cash flows are being discounted at a larger net interest rate than P&G’s. In terms of RVG, this is worth 1.38 points for P&G. In calculating the impact of these three factors, I changed only the variable under review in each case. So in estimating the value of a lower discount rate, for example, I did not assume a higher margin, which allowed me to isolate the impact on value of that variable. But these individual calculations ignore the fact that there are considerable synergies between the three factors. These synergies represent the fourth factor differentiating the RVGs of two companies. The fact that P&G enjoys a higher operating margin plus lower asset intensity plus a lower net discount rate makes the combined value of these advantages more than the sum of their parts. If a company can capitalize a higher operating margin at a lower growth-adjusted discount rate, then the higher margin is all the more valuable. To ascertain the value of the synergy between the lower discount rate and the higher growth rate, I calculated the impact on value of changing both variables together and then subtracted the effect of the two single changes, which I had already estimated. I carried out the same exercise to estimate the synergy value of the lower discount rate and capital intensity and the synergy between capital intensity and growth. Finally, I used essentially the same approach to estimate the synergy value of all three factors changing together. I estimated that the net synergies among P&G’s specific economic advantages contribute an extra 1.5 points to its RVG advantage. Rejecting the Growth–Margin Trade-Off By now it should be clear that, for most companies, investing in growth generates more shareholder value than cost cutting does. So why aren’t more companies aggressively pursuing growth strategies? Part of the reason, clearly, is the one I highlighted at the beginning of this article: Few executives have a clear measure of their companies’ relative value of growth. And that makes it very unlikely that many of them will have compensation packages that are linked to profitable growth targets. Another reason is that the companies that have earned (through financial discipline) the right to grow often lack the management skills to invest in growth. Anyone who has tried to turn around a declining company knows firsthand that taking out costs is challenging, but it’s still much easier than reviving growth, which is harder to execute and requires different skills. For both these reasons, companies often fail to allocate the right quality and quantity of resources to growth programs. This activates a vicious dynamic. If growth programs are not being pursued purposefully and diligently under the eye of top-level management, confidence in the programs erodes, and the organization doesn’t build a solid experience base. As a result, growth projects fail to deliver on their promises, reinforcing the perception that profitable growth is too difficult to achieve. I frequently hear CEOs expressing relief that they didn’t dedicate their best people to their companies’ failed growth programs, not realizing the self-fulfilling nature of the decision. But my experience as a senior executive suggests that there is a third, even more deeply rooted, obstacle to profitable growth. This is the widespread belief that managers have to choose between growth and profitability, that the two goals are somehow incompatible. As with many ingrained beliefs, there is an element of truth in the idea. The two goals often do clash in the short term. If you build a new plant, for instance, especially in a new geographic market, it is virtually certain that your return on capital will be low for several years. It’s hardly surprising that managers under pressure to produce good quarterly numbers find that profits and growth make uncomfortable bedfellows. To get to the bottom of the matter, I’ve analyzed company performance in a number of industries characterized by the perception that companies must trade margin for growth. Let’s look closely at one of these industries—specialty chemicals, a mature, slow-growth business. As the exhibit “Growth and Performance in Specialty Chemicals” shows, profitability and growth are not necessarily conflicting goals. Many companies perform well on both counts. Valspar, for instance, a high-tech industrial and consumer coatings company, has grown profits by nearly 14% a year while maintaining positive EVA (mainly driven by strong margin). What’s more, all the companies that have succeeded at growth have preserved good profitability. In other words, no company in this study had to sacrifice acceptable profitability in order to grow. Growth and Performance in Specialty Chemicals The misguided notion that companies must sacrifice margin for growth can have disastrous implications for companies looking to create long-term value. This chart illustrates that even in a mature, slow-growth industry like specialty chemicals, profitability and growth can go hand in hand. I looked at the performance of a variety of specialty chemical companies in terms of their growth rates and margins. I examined five-year average annual growth rates of EBITDA (the usual proxy for cash flow) on the one hand, and EVA, which mainly reflects margin (since asset intensity and cost of capital are fairly stable over even a five-year period) on the other. As this chart shows, companies like Valspar and Avery were able to both grow and maintain positive EVA due to strong margins. What’s more, no company had to accept subpar profitability in return for growth. Particularly striking is the absence of companies in the upper left quadrant of the chart (with good growth but poor profitability), in contrast to the multiple high performers in the upper right quadrant (with both good growth and profitability). The exhibit does show that a number of companies chose to forgo growth in return for better margins. An analysis of their share-price performance reveals that these companies were generally punished by the markets for making this choice. Lubrizol, for example, consistently earns about 3.5 points above its cost of capital. You would expect Lubrizol to have a relatively high market valuation, but in fact it carries pretty much the same valuation multiple as Eastman, one of the laggards with both low growth and low margins. This emphasizes once again how much importance investors, if not managers, place on growth. Balancing Growth and Margin Strategy, then, is not an either-or decision of whether to grow or to concentrate on margins. To create the most value for shareholders, companies must define more ambitious and ambidextrous strategies to achieve the right balance between cost control and growing revenues. The RVG framework can help managers achieve this balance. Consider the case of a leading enterprise software player I recently advised. An RVG of 3.5 suggested that the market was treating the company as a growth investment. But in analyzing its RVG, the company realized that the growth expectation of 5% built into its stock price exceeded its near-term capacity to grow organically. Once the market saw that the company had not, in fact, earned the right to grow, a collapse in the share price was inevitable. To achieve the growth necessary to sustain its stock price, the company needed to build a solid growth platform. Managers understood that the problem stemmed largely from the fact that the company’s R&D cost structure was bloated by the high support costs required to maintain and tailor older products. This prevented the company from generating a fast enough flow of new products. So the firm took steps to trim R&D costs and accelerate the commercialization of new products. The changes have not only made a target organic growth rate of 7%—which will push the stock price up by 15%—look achievable, they have also increased the value of future growth by pushing the RVG up to 3.8 through a more efficient business model. Determining the balance between cost management and revenue growth also needs to be done at the product level. Here again the RVG framework can help. A particularly useful analytic tool is the value equivalence map (VEM), which allows executives to see how various products should be managed in order to sustain or increase the company’s share price. The VEM for the software company in our example is shown in the exhibit “The Value Equivalence Map.” Products are placed on the map according to their projected growth and the operating margins they deliver. The diagonal lines, or value equivalence curves (VECs), display the margin and growth rate combinations that will deliver given values for the company’s stock price. The slope of the line is the RVG, telling you how many points of margin are equivalent in value to a point of growth. The solid line is the value equivalence curve for the software company’s current stock price and RVG, and the dotted line shows the combinations that would deliver the company’s targets of a stock price 15% higher and a growth rate of 7% as opposed to 5%. The Value Equivalence Map Companies can use the value equivalence map to better understand how individual parts of their businesses balance margin and growth relative to the company’s strategic goals. It can also provide insight into the value creation potential of new business opportunities. In the software company example shown here, managers place products on the map by plotting their projected growth and the operating margins they deliver. The diagonal lines, or value equivalence curves, display the various margin and growth rate combinations that will deliver given values for the company’s stock and RVG. As the exhibit shows, products A and E have serious value gaps. Managers need to intervene if these product lines are to contribute value to the company’s portfolio. Introducing product F, with its attractive underlying growth rate, will dramatically improve the company’s share price. As the chart shows, of the software company’s five main product lines, products A and E have serious value gaps and are detractors for the company. Managers need to intervene if these product lines are to become value neutral and, eventually, higher-value contributors. The VEM analysis can also help managers better understand how new business opportunities would affect share price. Consider product F in the exhibit. At 3.25%, this potential product has a below-average margin for the company, but an extremely attractive underlying growth rate. If the company were to make an investment in F and bring product lines A and E to the same level as B, C, and D, then it could achieve a share price increase of more than 15%, the company’s near-term objective. By continuing to upgrade the portfolio’s organic growth to at least 7% per year and by using its strong cash flow to acquire complementary businesses, the company should be able to fuel larger increases in share price over time. Currently, the company is launching product F in concert with the product performance improvements, and it has already seen the 15% boost in share price. • • • The relative value of growth framework should be part of every top manager’s strategic tool kit. RVG analysis can provide managers with both a sound understanding of where their shareholders expect them to focus their energies and a report card on their performance. In particular, it will help managers avoid the trap of underestimating the potential of growth as a source of value. Adding a point of sustainable growth may be harder to achieve than improving your company’s margin, but as many companies have found, the largest profits usually go hand in hand with the fastest growth. It’s time we put an end to the idea that the two are incompatible. Adding a point of sustainable growth may be harder to achieve than improving your company’s margin, but the largest profits usually go hand in hand with the fastest growth.

The Relative Value of Growth

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