Nathaniel Mass, wrote an article named the Relative Value of Growth(RVG) in which he argued that most management teams do not have an understanding of whether a 1% increase in revenue growth would be more or less valuable than 1% increase in earnings (Margin). He argues that understanding what % of your share price is driven by the value of internally driven cash-flows and what % by growth (expectation) in future revenue has implications for strategy making. Building strong bottom line disciples and bolstering cash flow requires different skills, operating habits and values to revenue growth plays which he argues is a much harder proposition. (This is probably best attested to by turnaround management). That said, for most companies investments in top line growth generates more shareholder value than cost cutting, so long as the returns are cash-flow accretive and exceed your WACC. Any growth that does not at least achieve the latter, destroys value and the greater the growth the greater the destruction.
The RVG combines standard financial metrics with particular emphasis on sustainable cash-flows. The inputs include; Current and projected growth induced cash-flows, revenue, enterprise value, WACC and expected growth rate. Some of these require determination e.g. expected future growth rate. The simplified RVG equation divides the value of a 1% improvement in Rev by the 1 % improvement in margin. A positive number indicates a preference for revenue growth. The higher the multiple the greater the “growth play” expectations of the market.
He argues that there are 4 drivers of RVG:
- Operating margin – growth must be profitable to be valuable. The greater the margins the more valuable each additional rand of revenue is and potentially the greater the positive impact on cash-flow
- Capital intensity – How much working capital is required, or tied up, to generate every additional rand of revenue. The greater the intensity the less valuable the growth
- Expected growth rate vs cost of capital – Higher expected growth rates reduce the rate at which future cash-flows are discounted into value. (Future CF/WACC – Expected Growth Rate). Not meeting embedded high revenue growth expectations can have material effects on share prices
- Synergistic effects of all 3 – Mass suggests that there are significant synergy effects. Combinational differences between i.e. operating margin, capital intensities and net discount rates can provide significantly different RVG multiples. Working on margins and capital intensities can increase ROIC values which is a big driver of ultimate growth value
The RVG metric also gives guidance to organic vs acquisitive growth decisions by suggesting that acquisitions that improve revenue but that are margin neutral do not add value. The model has received some criticism in that growth giants do not seem to have traded off margins for revenue growth (in the long run) and that the calculations need to be time boxed into 3-5 year forecasts in order to be effective.
Mass argues that the RVG tool should be part of all management teams strategic arsenal. The tool does provide insight into the right to grow debate. It reinforces the fact that not all growth options are equal in value. New products into existing markets may require significantly less invested capital and may be much cheaper to execute on than new products into new geographical markets. One additional rand in revenue will have different output value given the underpinning margins, capital intensity and shareholder expectations.
Given your current margin levels and capital intensities required to generate additional growth, what’s more valuable to you at this juncture? Revenue at current margins or flat revenues but higher margins.