What is the relative value of growth?
2. Example of the relative value of growth calculatio
Let’s assume that management of Cibo Company (a fictitious entity) wants to increase the shareholder value. The company can either concentrate on increasing revenue or decreasing costs. The following information is available to the management:
Current firm value |
$4,000,000 |
Current revenue |
$10,000,000 |
Sustainable cash flow |
$200,000 |
WACC |
10% |
Tax rate |
30% |
Investors’ growth expectations |
7% |
Based on the information provided above, we can determine both the value of revenue growth and value of margin improvement.
Value of Revenue Growth = |
$200,000 |
– $4,000,000 = $6,000,000 |
10% WACC – 7% Expectations – 1% |
That is, 1% increase in revenue will results in $6,000,000 increase in shareholder value.
Value of Margin Improvement = |
$10,000,000 x 1% x (1 – 30% Tax Rate) |
= 2,333,333 |
10% WACC – 7% Expectations |
That is, 1% increase in margin will result in $2,333,333 increase in shareholder value.
Right away, we can see that in this case the revenue growth will contribute more to the increase in shareholder value than the margin improvement.
Relative Value of Growth = |
$6,000,000 |
= 2.57 |
$2,333,333 |
The relative value of growth ratio is above 1. Again, this indicates that revenue growth can better increase shareholder value than margin improvements.
Now, what if the investors’ expectations were higher than 7%? Let’s say, the shareholders expect 20% growth. In such a case, neither revenue growth nor margin improvements can meet the expectations of the investors. In this case, the firm could repurchase its own stock (i.e., stock buyback): the cash will be exchanged for the reduction in the number of shares outstanding. Stock buyback mechanism can increase shareholder total returns. Also, in contrast to cash dividends, stock buybacks have potential tax advantages for shareholders.
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