What is the relative value of growth?

September 18, 2012

Have you ever wondered if increasing revenues provides more value to shareholders of a company than decreasing costs (i.e., margin improvements)? In this article we look at a ratio called Relative Value of Growth that can help answer this question.

1. Definition of the relative value of growth (RVG)

Relative value of growth is a measure used by management to decide whether revenue growth or margin improvements (e.g., cost cuts) should be used to improve shareholder value. This ratio was invented by Nathaniel J. Mass.

In general, this measure is represented as a ratio between value created through revenue growth and value created though margin improvement (i.e., cost cuts): that is, the value of revenue growth is relative to the value of margin improvements.

 Relative Value of Growth =

Value of Revenue Growth

Value of Margin Improvement

When the relative value of growth is less than 1, the shareholder value is better increased via margin improvements instead of revenue growth because margin improvements will do a better job.

On the other hand, when the ratio is greater than 1, it indicates that management should emphasize revenue growth in order to increase the shareholder value.

So how can we measure the value of revenue growth vs. margin improvement?

The value of revenue growth depends on such factors as:

  • Sustainable cash flow
  • Weighted average cost of capital (WACC)
  • Investors’ growth expectations

The value of margin improvement depends on the following factors:

  • Current revenue
  • Tax rate
  • Weighted average cost of capital (WACC)
  • Investors’ growth expectations

The value of revenue growth measures the percentage increase in the shareholder value with 1% increase in revenue. Similarly, the value of margin improvements measures the increase in shareholder value with 1% improvement in margin.

The following formulas can be used to measure the value of revenue growth and margin improvement:

Value of Revenue
Growth

=

Sustainable Cash Flow*

– Current Firm Value

WACC – Investors’ Growth Expectations – 1%

(*) For a business to survive, it must generate sustainable cash flows. Sustainable cash flows do not include cash flows from one-time changes in cash flows.

Value of Margin Improvement

=

Current Revenue x 1% x (1 – Tax Rate %)

WACC – Investors’ Growth Expectations

The relative value of growth can be calculated in two steps: first, calculate the value of revenue growth and value of margin improvement, and second, divide the value of revenue growth by the value of margin improvement.

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