Smart Corporate Growth Versus Irrational Growth
In general, growth is an investors friend. A growing company can create ever higher earnings per share and which leads to ever higher share prices and (where applicable) dividends.
But, there is a right way and a wrong way to grow.
How Smart Companies Grow:
Successful companies with smart rational management grow by investing internally generated profits and cash flow as well as judicious amounts of borrowed funds into new projects. This is called “organic” growth and includes expanding the business by investing in larger production facilities, increased research and development, increased advertising and sales efforts and similar initiatives.
In this scenario the company issues very few or (ideally) no new shares. Therefore, increases in corporate earnings translate directly into increases in earnings per share which (all else being equal) leads directly and inexorably to a higher share price.
In addition, the company ideally issues only a limited number of stock options so that its number of shares is held reasonably constant. In some cases the company uses share buy-backs to offset the options and may even decrease its number of shares outstanding.
Loblaw Companies Limited is an example. In the 5 years from the end of 1995 through the end of 2000, the company invested heavily in new stores and doubled revenue. Meanwhile the number of shares grew by a modest 13%. Earnings per share grew by 207% and the share price increased from $10.29 to $50.50.
CIBC is another example. In the same 5 year period it continued to invest and grow. It actually decreased the number of shares outstanding by 10%. Revenues and earnings per share doubled and the share price more than doubled.
It is extremely rational for companies to grow by investing retained earnings in attractive projects because it is tax efficient (to investors) compared to issuing dividends and because investors would not otherwise have an opportunity to invest in those particular attractive projects.
There is a formula that tells us how fast a company can grow without issuing new shares. The sustainable growth rate is equal to the Return on Equity times the percent of earnings retained (as opposed to paid out as dividends). Therefore a successful company that has an R.O.E. of 15% and which pays out 25% of earnings as dividends retains 75% of the earnings and can sustain growth at 15% * 0.75 = 11.25%. A company growing at a compounded rate of 11.25% per year will increase earnings by 70% in 5 years and 190% in ten years. If no new shares are issued then the Earnings Per Share will grow at the same rate.
A higher growth rate would require an increased proportion of debt or the issuance of new shares. But rational managers know that increasing the number of shares outstanding has the potential to dilute and decrease the growth in earnings per share.
How Irrational Companies Grow
Irrational company managers seek and congratulate themselves on absolute growth in revenues and disregard the all important growth per share.
Nortel grew enormously from the end of 1995 through the end of 2000. But its earnings went from positive to negative and the number of shares increased by 47%. In retrospect it seems clear that in return for the stock issued, Nortel received grossly over-valued assets that often were ultimately worth little or nothing.
It is “interesting” that during its glory days, Nortel would brag of 30% plus increases in (pro-forma) earnings while not focusing on the fact that (pro-forma) earnings per share were growing at less than about 20%. 20% is still very robust, but the point is that the 30% on which management focused was essentially irrelevant to the investor.
Another possible example is Telus. The company touts itself as a “growth” company. In the five year period from the start of 1997 through the end of 2001, I calculate that its share base has increased by 26% as it issued shares to fund acquisitions. Meanwhile normalized earnings have also increased by 26%. This is a compounded annual normalized earnings per share growth of just 4.8%. I also calculate that even revenue per share grew by only 4.8%.
And yet by focusing on growth in number of customers, Telus considers itself to be a growth company. Telus wanted to grow at a rate faster than its retained earnings could fund. This growth came at the expense of diluting the share base, cutting the dividend and also having to sell off valuable assets such as its directory services and even its office buildings to raise cash. Possibly, accelerated earnings per share growth in the future will result and this will prove their strategy to be correct. But meanwhile the stock price was recently down about 60% from its high and the strategy so far appears less than rational.
The Folly of Growing By Purchasing Other Companies with Shares instead of Cash
In the great growth-by-acquisition boom of the late 90’s it was often said that a company could use its shares “as a currency” to buy other companies. And this was accepted as a good thing.
But if company “A” doubles in size by purchasing similarly sized company “B”, but in the process doubles the number of shares outstanding, then I fail to see how this represents real growth for shareholders.
In fact, the only time this makes a lot of sense is when company “A”s shares are actually highly overvalued. In that case it might get exceptional value in buying company “B” in return for a relatively few of its over-valued shares. But, this should be a clear signal to investors sell their shares rather than wait for the almost inevitable share price correction.
The Folly of Public Companies Buying Other Public Companies:
When a public company buys another publicly traded company, it is implicitly saying that it is smarter than the market and its investors. After all if company “A”s investors had wanted to buy company “B” shares , they were free to do so in the market. Instead company “A” then buys company “B” at some premium to the market and thereby forces its investors to become owners of company “B”. There is a certain arrogance in this.
In general, companies should instead invest in non-public assets and projects that its investors are not otherwise able to access.
The Dangers of Issuing Shares to fund Growth:
Anytime a company issues shares for cash or assets it implies that it values the cash or the assets more than its own shares. Typically shares are issued at a slight discount to the prevailing market price in order to insure they are sold. But this immediately suggests that this is (at most) what the shares are worth. The immediate message is that the shares are either fully valued or possibly over-valued since the company is willing to sell them for that price.
If a company thinks that its shares are under-valued then it should be buying them in the market, not issuing new ones.
The Folly of excessively Promoting and Talking Up the Share Price:
Many growth oriented managers crave a higher share price in order to facilitate acquisitions and will endlessly talk up and tout their shares in an attempt to raise the price.
This is acceptable behavior as long as the higher share price is justified. But if the share price is artificially raised too high, then new investors are almost bound to lose money. Ethical managers should attempt to make money for investors, not from them.
Exceptions to the Rules:
Sometimes it does make sense to issue shares to fund growth. If a company is certain that it has a very attractive investment opportunity then the dilutive impacts of a share issue might be quickly over-come.
For example Precision Drilling increased its share base by a hefty 69% in the period from late 1996 through the end of 2001. But it also increased earnings per share by 169%.
Conclusions:
“Organic” growth is often preferable to growth that is funded by share issues since organic growth does not dilute earnings. Be very cautious of managements that focus on absolute growth (to which their pay is usually tied) rather than per share growth (to which your return is tied). Issuing shares can be a rational growth strategy but be wary of companies that do so wantonly and then focus on absolute growth. Always focus on earnings per share rather than on absolute earnings. Be skeptical of companies that grow by buying public companies, rather than by investing cash into new or private assets. Finally, remember that the phrase “our shares are a valuable currency” is a clear danger signal that often means – “our shares are grossly over-valued, Sell!, Now!.
(c) Shawn Allen, Editor
March 1, 2002