Your investors need to know what profitable growth means

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You might think that by just knowing field hockey stick brands you can proclaim yourself a sports fanatic, but sports also provide many a useful metaphor for the business world. Business leaders who are experienced when they buy shares, are prone to quote the great ice-hockey player Wayne Gretsky’s famous words about “skating to where the puck is”. Have you read Judo Strategy: Turning Your Competitor’s Strength to Your Advantage? There is even a Facebook page called ‘sports to business metaphors’.

But there is one key area where I think all sports metaphors fall short of hitting the mark. I am talking about who actually wins in sports versus business. If you want to win an ice hockey match, then put more pucks in the net than your opponent. But how do you define a ‘win’ in business? Can we actually have an undisputed ‘winner in business’? How would you measure this?

Suppose we assume that the primary goal of a company in the ‘game of business’ is to create – or maximize – shareholder value. Suppose we measure this using the value of a company’s market capitalization, which is its share price times its shares outstanding. Is the winning business the one that has the highest market cap? If so, then the primary job of the chief executive of a publicly traded company is to do whatever it takes to drive up the company’s share price and market cap.

There are a number of financial targets that are used for this purpose. For example, the chief executive could select any number of measures of corporate financial performance, such as: return on equity, return on assets, return on capital, EBIT margin, net profit margin, EBITDA margin, cash flow, and free cash flow. But the challenge is that there is no one agreed measure that will lead directly to an increase in share price. In past years, the measure called ‘economic value added’ or EVA has been a favourite among some companies. Over the past decade I have noticed that the financial objective ‘profitable growth’ has appeared among the top priorities in chief executive letters to shareholders and presentations to stock analysts. Apparently the belief is that companies exhibiting profitable growth are given the most favourable ‘buy’ ratings among stock analysts. Apparently the belief is that companies exhibiting profitable growth are given the most favourable ‘buy’ ratings among stock analysts.

But unlike other measures such as ‘return on equity’ or ‘free cash flow’, ‘proftable growth’ is not based on a i specific formula. Return on equity is net profit divided by equity, and free cash flow is cash flow from operations minus capital expenditures. But what is ‘profitable growth’? I assure you that you will not find a single, universally agreed upon, definition. Based on my experience working with a number of clients who have focused on this measure, I can list at least five different interpretations. Briefly stated, when a company says its goal is to achieve profitable growth it could mean any one of the following:

• Growth in revenue (top-line) and growth in earnings per share that is as fast or faster than the top line growth

• Growth in revenue and expansion in operating profit (i.e. EBIT) margin

• Growth in revenue and EBITDA margin expansion

• Growth in revenue and return on capital greater than the company’s cost of capital

• Growth in revenue and return on capital among the top quartile of companies in the industry

All interpretations have top-line (revenue) growth in common, yet the second part showing profitability differs. In my view it is not critical for all businesses to have the same definition of profitable growth. But it is very important that each company chief executive ensures that everyone involved in the business, including stock analysts, clearly understands its particular definition of this financial goal. How can the players on a team be effective if they do not fully understand what it takes to win the game?

Phil Young PhD is an MBA professor and corporate education consultant and instructor