Growth, Corporate Profitability, and Value Creation

Associating corporate performance and shareholder value creation with growth in earnings (or sales) has been the modus operandi in the investment industry. It has greatly influenced managerial compensation schemes and portfolio decisions. We shed light on the relationship between growth and performance by addressing two broad questions. First, what is the relationship between corporate profitability metrics, such as economic value added, and the company's earnings or sales growth rate? Second, does maximizing corporate profitability necessarily enhance shareholder value (as measured by Jensen's alpha)? Using multivariate analysis, we show that, although the corporate profitability measures generally rise with earnings and sales growth, an optimal point exists beyond which further growth destroys shareholder value and adversely affects profitability. Associating corporate performance and shareholder value creation with growth in earnings or sales has been the modus operandi of the investment industry. It has greatly influenced managerial compensation schemes and portfolio decisions. Yet, the financial press is replete with examples of once rapidly growing companies that have “gone south” (Enron Corporation is only one recent example). Indeed, growth without profitability cannot be sustained.We shed light on the relationship between growth and performance by addressing two broad questions. First, what is the relationship between corporate profitability metrics, such as economic value added (EVA) or return on investment, and the company's earnings (sales) growth rate? Second, does maximizing corporate profitability necessarily enhance shareholder value (as measured by Jensen's alpha)?First, to investigate the link between growth and performance, we examined the unconditional distribution of several performance metrics across quartiles of sales growth and earnings growth rates. We used annual Compustat files on U.S. companies for the period 1990 through 2000. Next, with a common set of data as conditioning variables, we estimated a multivariate regression model for each growth measure. We then explored how management's use of EVA, for compensation and resource allocation, relates to shareholder value creation. For this analysis, we estimated a regression model augmented to control for growth, company size, and idiosyncratic risk.Our analysis shows that, although these measures of corporate profitability and shareholder value generally rise with earnings and sales growth, an optimal point exists beyond which further growth destroys shareholder value and adversely affects profitability. Moreover, companies with moderate growth in earnings (sales) exhibit the highest rates of return and value creation for their owners.Our empirical results indicate that corporate managers need to abandon the habit of blindly increasing company size and investment managers need to carefully consider the drawbacks of diseconomies of scale. Company managers need to make a fundamental shift in their strategic orientation from “growth now, profitability later” to “profitable growth now.” That is, growth should not be the input to strategic planning but the outcome of a sound investment strategy that is geared to accepting value-creating projects. Investors and portfolio managers should be aware of the dangers of conforming to market pressures for growth for growth's sake.