Tuesday, October 18, 2011

Why does a business have to grow?

Profit growth is an obsession of industry analysts and pundits. Every day there are headlines in the business sections of newspapers and websites along the lines of, "Company X revenue and profit growth disappoints, shares plummet Y%." Another way to state the same thing is, "Firm X had more sales and is more profitable than last year, yet is worth less today than yesterday."

I've never understood the rationale behind why a company must continually grow in order to be considered successful.

Let's assume that a company has revenues of $10 million, and a respectable net profit of $1 million. (Feel free to add or subtract a zero or two to make this company larger or smaller.)

Let's further assume that there is no inflation or, if you prefer, these numbers grow or shrink at the rate of inflation or deflation.

Note that this does not imply a static business model. Our hypothetical company will make investments to reduce its costs and deal with competitive pressures that reduce its margin. It will adjust its product portfolio over time and periodically introduce new services. The net effect of all this change, however, is financially neutral: real revenues remain constant and the firm is consistently but not increasingly profitable.

My question is: What's wrong with making a million dollars of profit on revenues of ten million every year? Why is growth of these numbers deemed a necessary element of success for a corporation?


Such a company would be savaged on the stock market, and I do not understand why.


I asked this question during a class discussion during my MBA studies, and received many responses that made no sense. Only one answer, while still unsatisfactory, was at least coherent. A classmate told me that since this firm's competitors would be striving for growth, it risked being left behind and eventually being swallowed up by its much larger rivals.

There must be something more, though. There must be some justification for an unrelenting focus on growth beyond, "Everyone else is doing it!" But I don't know what it could be, and haven't been able to come up with anything plausible.

Can you help?

14 comments:

  1. The market is not truly effecient, otherwise all companies would trade at equivalent price/earnings ratios. Some companies (technology firms are perhaps the best example, and especially those that do not pay a dividend are "priced" by the market on anticipated further growth. This is the only way the the shareholders will see more value. So if the company doesn't meet "the street's" earnings estimates, then the stock price will suffer because those earnings (or growth as you term it) is already priced into the current stock. Stocks that pay a significant dividend tend to be less volatile because at least the shareholders are still seeing a share of that profit. I think that's at lease part of the explanation, though I suspect there are many more factors at play.

    Geoff

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  2. In my company, a medium-sized engineering firm, the prevailing wisdom is “you can’t move up until you can be replaced”. Meaning: if a junior engineer wants to stop formatting Excel tables and start managing projects or designing systems, they need to find someone new to format the Excel tables. Thus, the logic goes, without growth there can be no personal career development. This is the only satisfying explanation for the “companies must grow” idea I’ve heard that applies to my organization.

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  3. Not all companies should trade at equivalent price-earnings ratios, even in a hypothetical perfectly efficient market. Take the posited company above, and compare it to (say) a biotechnology start up, researching a potential cure, treatment, or vaccine for some disease or medical condition. The former is predictable, and based on historical evidence, performance is unlikely to vary outside a narrow range. The latter has many unknowns, with a large payoff if the research is successful, and zero future profits if (say) severe side-effects result.

    I understand that if "the street" believes profits will increase, and they remain constant, that the stock price will fall.

    Geckoberyl: Company growth may be desirable for, say, a manager wanting to become a Vice President. But there are other ways - an appropriate VP slot may become available as someone leaves the company, or a new position is created due to a reorganization or to retain valuable employees.

    But if one does not see the potential for career development within one's firm, there are always other companies out there, one of which may recognize the skills that currently are under-appreciated.

    But neither point really answers my original question: Why is growth viewed as a *necessity* for a healthy, profitable organization?

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  4. Nigel Blumenthal23 Oct 2011, 20:03:00

    Leslie, I think that the germ of the answer is contained in the question. You ask why growth is seen as a necessity. Like all good Jews, I'm going to answer the question with another question: To whom is it a necessity ? Whose value system are we adopting if we take that point of view?

    I think that humans are pretty well hard wired to want to see things improve over the course of their lifetimes. Maybe it's something about "leaving a better world for our children" or some other such claptrap. Whatever the reasons or excuses, I think we can all agree that most people feel that way.

    Unfortunately, in our western society, that progress is usually measured by money - a higher stock price, increasing profits, greater dividends, etc. But there's no reason why an enlightened society should not measure progress in other ways, maybe improved conditions for workers, less impact on the environment year over year, and so on. I think it's all a question of the value system you adopt to measure this progress and, as I said, an enlightened society might use other methods.

    I leave it to you to work out that that says about this society.

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  5. Nigel,

    I pretty much agree with what you wrote. I do want to change things in some way, hopefully for the better, over the course of my lifetime.

    If you like, I can rephrase the question, as its essence remains unchanged. There numerous ways in which a company can progress: Financially, creating better products, improving the welfare of employees/suppliers/customers, reducing or eliminating any detrimental environmental impacts due to company activities, and/or building or buttressing social institutions/organizations that do good work (among many others). Why is only the first of these measured, analyzed, and discussed by investors, media, and most social circles?

    And why would a company that does some or all of the latter while maintaining a consistent (non-increasing) level of profitability not held up as an example of a successful firm?

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  6. The answer may be fairly simple Leslie, especially for a company that is public. If let's say there was a hypothetical company that was projected to make the same amount of revenue and profits (inflation adjusted, etc.) in perpetuity. Also, let's assume that there is full transparency between company and investors and the market is efficient. In such a scenario the price of the stock (i.e. what the investor will pay today) will already take that into account. Therefore, what they will pay today and what they will recoup over the lifetime of the company will be of 0 NPV. Essentially what we are talking about in the above case is a risk free security and since there is no risk there is no return. As an investor, investing my money in a company, I am taking a certain amount of risk and therefore I want to get paid for it. Therefore, in order for me to continue to get paid for the risk that I am taking (which is what I baked into the initial price that I paid for the stock) the company has to continue growing it's top line and bottom line in line with the expectation of the market. There are a lot of other other factors that effect this since markets are not perfect, investor mood, macro-economic trends, etc. but this is essentially the crux of it. Hope this helps.

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    Replies
    1. Thank you, Anonymous, but your response does not really explain the demand for continual profit growth.

      Let's grant the (unrealistic) assumptions of full transparency, efficient markets, and accurate forecasts.

      Under this scenario, *all* investments will have a zero net present value, because all future profits will be built into the current share price (with some implicit discount value for future income flows).

      So we will relax the forecast assumption, since no one has ever reliably predicted the future. Since past performance does not predict future results, as every prospectus and financial press release states, there is some inherent risk in investing in our company (though presumably less than, say, a biotechnology startup). There's your margin for future profit taking, when the firm reports its million dollars of profit next year, and the year after, despite changing or challenging economic conditions, etc.

      My question stands: When so many companies swing from profit to loss and back again, and several others go bankrupt, why is steady profitability so maligned? Why is *growth* the primary factor that analysts look at?

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  7. Hi Leslie,
    I asked myself the same question many times. I haven't found definitive answers yet, but here's an article that I found useful:
    http://www.cbsnews.com/8301-505143_162-46241133/must-your-business-grow-or-die/
    The author argues that businesses do NOT have to grow or die, that the scenario you propose is economically sound & viable. Unless! Unless the business relies on external funds to survive/thrive; for example, funds from venture capitalists or shareholders. These third parties will systematically choose to invest in those companies who promise the best returns and, if possible, ever-increasing returns.
    In my opinion, when the question of growth is presented, an assumption about the context is often made: that the company is a publicly traded one or is financed by venture capital.
    Your thoughts?

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  8. Hello, Thomas.

    I think there is a bizarre culture among investors that does not understand basic mathematical concepts such as average (everyone wants to beat the market, however that is defined) and regression to the mean (where excpetional positive results simply become the new baseline against which future efforts will be judged).

    And a CEO will be fired if s/he does not meet these arbitrary (and often unrealistic) targets set by shareholders.

    The pressures are so great it fosters the endless restructurings, pointless mergers and acquisitions, and financial jiggery-pokery - much of which is hideously complex, by design, to prevent a straightforward comparison of last year's results to the current one.

    True, that applies only to companies that use external capital, not corporations that are private or fund their capital needs with debt.

    But my question is a bit broader than that. While a consistently profitable non-growing business is possible, and the article you link to provides a few examples, they are never lauded for their business model; no papers are published (to my knowledge) analyzing what factors contribute to their longevity; they are never held up as role models for what a business can be. Why not? Stable revenues and steady profits with a comfortable lifestyle for the owners and employees sounds pretty good to me. Such companies exist; why are they relegated so far into the background of our culture?

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  9. Nominal growth is necessary because of inflation, as you appear to recognize. If pre-inflation cogs is $100M and revs is $120M (profit is $20M). And if post-10%-inflation COGS is $110M and revs is $132M, then profit rises to $22M and all is good. So the company doesn't actually have to do anything to achieve nominal growth to stay on par with inflation other than ensure the effects of inflation are equal among its cogs and price points.

    As to real growth, your question is odd. It's like asking, "Why do people have to get married?" They don't. Many people are just fine single for their entire lifetime. People get married for a variety of reasons. But it's entirely optional.

    Think about a hypothetical neighborhood mom-and-pop grocery store which has been around for 50 years (in my neighborhood, there is such a store, but maybe there isn't in yours), or any similar sole proprietorship. Or think about a local doctor or yoga instructor or similar professional. These are equivalent to businesses in virtually every single respect except probably the way the law assigns liability to them. Now assume that they don't have a "growth" strategy involving "reinvestments" - and that they issue themselves a dividend with every dollar of profit made (i.e., payout ratio of 1). This happens *all the time* - especially with professionals. Millions of tax-preparation-experts, real estate agents, doctors, yoga instructors, SAT tutors, etc., tick along without ever reinvesting their earnings into their own trade. Now, some might reinvest. Like for example, a yoga instructor might reinvest the yoga earnings into the production of a yoga DVD, and future earnings into a website for distributing that DVD - and that would involve scaling up. But this is totally optional.

    The media you consume relating to companies, etc., is obsessed with growth because the only source of investment returns in terms of real money - over the long term - is earnings growth. If you have a company whose earnings grow at 3% per year over 40 years, its stock price isn't going to do a whole lot better than that in nominal terms. That's just not possible - mathematically. Stocks of no-growth companies don't actually "get killed in the market" - if the real growth is 0, the stock behaves as a hedge against inflation and retains real value without any real gains.

    Hell an entire segment of investors makes a gazillion dollars on companies with negative real growth (see e.g. walter schloss).




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  10. This is an excellent question. I have been asking myself the same question for years. What is wrong with making the same money as last year if that is a good amount? Why do companies lay off thousands of people to make their numbers? What is wrong with breaking even in a slow economy or making little?

    My answer is that we live in a material world and people want more and more money, power, etc. For instance; a public company or private company that has investors they want certain amount of return on their stock or investment; when that is not the case they take their money and invest it in another company that they believe will deliver the return that they want so they have to grow to satisfy the shareholders or investors.

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  11. In my company we see growth as a defensive strategy, key to our survival. There will always be a risk to lose customers and to lose markets to competition. But the more we can grow ahead of that risk becoming a reality, especially in terms of diversified growth, the more our company will be able to withstand losing certain customers or markets.

    We started off as a company selling one product and making a profit on it. Now we sell over ten products. If our initial product becomes obsolete by new technology or a competitor comes up with a more efficient way to produce at a lower costs, the survival of our company is still viable given the new markets we have grown in to.

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    Replies
    1. Thanks for your comment, Alex.

      In some circumstances, growth is important. Especially for a small business, growth and diversification can be essential as insurance against losing a large customer or changing market conditions that make your current product/service mix less appealing.

      My point is that even the largest conglomerates that span multiple industries, with billions in revenue and profits, seek to always increase their top and bottom lines, usually with the explicit goal to do so at above market rates.

      It's mathematically impossible for every company to grow at an above average pace; so why do our financial institutions demand it? What's wrong with a corporation making consistent (but not increasing in real terms) profits?

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