Growth as key driver for value creation

As a follow up from the previous post, about  Value: The Four Cornerstones of Corporate Finance, Tim Koller, Richard Dobbs and Bill Huyett from McKinsey & Company, we talk about growth that is the second main driver for value creation (the other is return on capital).

Growth does not lead to value creation unless returns on capital are adequate. And different types of growth come with different return on capital. In the book there are 3 main categories of types of growth, Above Average, Average, Below Average.

Type of growth that gives  Above Average value creation (according to the book):

  • Create new markets through new products
  • Convince existing customers to buy more of a product
  • Attract new customers to the market

Type of growth that gives  Average value creation (according to the book):

  • Gain market share in fast-growing market
  • Make bolt-on acquisitions to accelerate product growth

Type of growth that gives Below value creation (according to the book):

  • Gain share from rivals through incremental innovation
  • Gain share from rivals through product promotion and pricing
  • Make large acquisitions

What drives return on capital?

In the new very interesting book, Value: The Four Cornerstones of Corporate Finance, Tim Koller, Richard Dobbs and Bill Huyett from McKinsey & Company  cite return on capital as one of the two key drivers of value creation (the other is growth).

Return on Capital can be defined as (Operating Profit/ Capital) or (Price – Cost)/Capital

Basically, you can increase your Return on Capital by increasing the price you sell the products or  by improving the efficiency in which you produce them, or even better by doing both.

The Price Premium advantages can be disaggregated, according to Koller et al., into five subcategories:

  • Innovative products
  • Quality
  • Brand
  • Customer lock-in
  • Rational
  • Price discipline

Cost/Capital efficiency can be disaggregated into four subcategories:

  • Innovative business methods
  • Unique resources
  • Economies of scale
  • Scalability/Flexibility

From Corporate Social Responsibility to Creating Shared Value

The current school of thought on the scope of Business has focused on profits.  On September 13, 1970 Milton Friedman writes in The New York Times Magazine the influential article The Social Responsibility of Business is to Increase its Profits.  See the past blog post The Social Responsibility of Business is to Increase its Profits.

But something is changing and the idea of Business of just creating shareholder value is not considered valid or at least it is now conceived restrictive and not good for a long term approach to business. I totally support this view and a nice article, of Porter and Kramer on HBR, nicely describes the challenges and the new objectives that the business world should look at.

From the article The Big Idea: Creating Shared Value:

The capitalist system is under siege. In recent years business increasingly has been viewed as a major cause of social, environmental, and economic problems. Companies are widely perceived to be prospering at the expense of the broader community.

A big part of the problem lies with companies themselves, which remain trapped in an outdated approach to value creation that has emerged over the past few decades. They continue to view value creation narrowly, optimizing short-term financial performance in a bubble while missing the most important customer needs and ignoring the broader influences that determine their longer-term success. How else could companies overlook the well-being of their customers, the depletion of natural resources vital to their businesses, the viability of key suppliers, or the economic distress of the communities in which they produce and sell? How else could companies think that simply shifting activities to locations with ever lower wages was a sustainable “solution” to competitive challenges? Government and civil society have often exacerbated the problem by attempting to address social weaknesses at the expense of business. The presumed trade-offs between economic efficiency and social progress have been institutionalized in decades of policy choices.

The solution lies in the principle of shared value, which involves creating economic value in a way that also creates value for society by addressing its needs and challenges. Businesses must reconnect company success with social progress. Shared value is not social responsibility, philanthropy, or even sustainability, but a new way to achieve economic success. It is not on the margin of what companies do but at the center. We believe that it can give rise to the next major transformation of business thinking.