To grow the business in a value-creating manner, companies have five common options available. Koller et al. (2015) rank them as follows, in order of efficiency: 1) Introduce new products or services to the market; 2) Expand an existing market; 3) Increase share in a growing market; 4) Compete for share in a stable market; and 5) Acquire investments.
According to financial theory, a company’s intrinsic value is derived from its ability to consistently generate future cash flows. Value is created when companies deploy dollars in cash flow generating investments that are more efficient than the next best option with an equivalent risk profile. The efficiency of invested dollars is known as return on invested capital (ROIC), and the next best option is typically referred to as the opportunity cost. When the ROIC of a project is higher than the opportunity cost, companies should typically invest. If no such projects are available, they should return capital to owners. But most managers prefer to retain the capital they’ve been endowed with and find ways to use it to grow. Here’s how they can do it:
Growth strategies based on organic new product development frequently have the highest returns because they don’t require much new capital; companies can often conveniently add new products to their existing factory lines and distribution systems. In addition, new product development provides flexibility. Management can test new products with a small commitment of capital, leaving the option to scale back the project or exit the market altogether if it doesn’t work out. There are also external factors at play. When a product is truly new, it operates in a blue ocean where there may be few or no competitors or substitutes, leading to a wide moat that allows a company to extract more value from customers. However, the high returns for this option are explained, in part, by the high risk. New business line ventures may never lead to a viable product, in which case the original investment may be lost (think Google Glass) or the company’s reputation may be damaged (think Samsung’s spontaneously combusting folding phones).
The second most efficient way to create value is to grow the total pie for the benefit of one’s own company. This method may require significant investment in marketing, innovation, or physical assets, but the reward for success is substantial. The quintessential example from the airline industry is Allegiant Air. Allegiant was able to expand the market for commercial flying by offering point-to-point flights from certain northern cities to vacation destinations. This expansion of the market required significant investment in infrastructure at smaller airports, but more than paid for itself by making Allegiant the airline of choice for vacationers in underserved markets.
Natural industry growth provides a valuable tailwind to companies. In a growing market, companies can find new customers without battling tooth and nail with the competition. In addition, growth often signifies a younger or changing market where products have not yet become commoditized, allowing for healthier ROICs.
As growth runs out, markets become a crowded battleground, turning the once blue ocean red with blood. Competing for market share becomes a challenging approach that often leads to value destruction. Without innovating, the only way to steal market share from competitors is to offer more for less. In other words, a company must increase spending in order to improve quality, or it must lower prices. Either way, the common result is lower profit margins and a lower ROIC. Few are the instances where battling for market share can create significant value. Only top-tier companies can take market share economically - and they must be in industries where economies of scale matter (e.g. Amazon), network effects are achievable (e.g. AirBnB or Visa), or product differentiation is persistently meaningful (e.g. Apple or Nike). Don’t expect your company will be one of those on this short list.
Acquisitions are often the least risky option for growth, as the investment brings in existing revenues generated by a proven business model. However, the reward is also often the lowest as acquiring is expensive. Acquisitions typically require paying a premium above the market value for the target, and the perceived synergies are rarely realized to the extent originally estimated. Acquisitions with a compelling story around the future path of the business – Disney acquired Pixar in order to revitalize and bring technology to one of its core business, Disney Animation – tend to be more successful than those that occur simply for sake of growth.
In sum, the most efficient means of creating value via growth (#1 and #2 above) require innovation. To be fair, the above rankings do not reflect the risk of failure. As noted, most new product ideas fail before reaching the market, while acquisitions typically bring existing cash flows that limit downside risk. As such, developing new products, services, or markets may not be the right path for every organization. But the numbers show that innovation is extremely valuable, if not crucial to survival. Investments in R&D correlate powerfully with positive long-term returns (Koller, et al). Despite the risks, the case for pursuing innovation is compelling.