Manage-Wise

Why is organic growth important?

Growth achieved through a commitment to customer satisfaction, employee engagement, and core profitability—organic growth—is a smart long-term strategy for any company. Organic growth represents the underlying strength and vitality of the core business and is created through economic value added; strong, increasing sales; and cash flow from operations above industry averages.

This is not to say that growth through mergers and acquisitions—nonorganic growth—is negative but that growth generated internally frequently results in better returns on investment, stock value improvements, lower employee turnover, and numerous other benefits you will hear more about in the coming chapters.

How do I know this? I studied hundreds of companies to learn what differentiated those with consistent, organic high growth from those with sudden but often short-lived growth spurts. Long term, the companies that succeeded to a greater degree than their peers were found to follow an organic growth strategy.

Not all earnings are equal

Surprisingly, few analysts and researchers have studied the merits or quality or character of organic growth versus growth through acquisitions. Some academic researchers looked at increasing revenues or increasing numbers of employees as evidence of growth. However, almost all academic research has counted every cent of earnings as equal, no matter how it originated, assuming the quality to be the same.

The first major attempt to evaluate the quality of business operating results was the Stern Stewart economic value-added computation, also known as the EVA computation, which is a proprietary formula that measures the value created by an asset or investment. A key component of the EVA calculation is a firm’s net operating income after taxes. While analysts may argue that all earnings are equal, the EVA computation has been criticized because it relies on data that can be managed. However, its use has spread to the corporate world.

In an effort to restore confidence in corporate earnings statements following the all-too-familiar financial scandals of the early 2000s, in 2002, two Wall Street firms attempted to evaluate the quality and character of earnings. On May 14, 2002, Standard & Poor’s (S&P) released its core earnings test, a methodology that separates a company’s earnings into core and noncore classifications. While core earnings represented a significant step forward in evaluating earnings quality, it was criticized widely in the financial community and by some academics.

Merrill Lynch entered the fray with its quality of earnings report, created with Professor David Harkin of the Harvard Business School, that used four financial discriminating screens to evaluate the quality of earnings.

In 2003, my colleagues and I built the organic growth index (OGI), designed to identify companies with earnings generated organically rather than through earnings management or manipulation or through investment or financial engineering transactions (noncore) or acquisition.

Building our model

To start building the model, we studied in detail EVA, S&P’s core earnings test, and Merrill Lynch’s quality of earnings report. Then we talked to financial analysts at each of the respective firms. Next, we researched the academic literature on growth, earnings management, and earnings manipulation. We also talked with senior audit partners at major accounting firms to learn the common issues they faced in determining GAAP earnings. We then spent one year creating, assessing and revising different tests to create the organic growth index (OGI), which is our extension of the work by Stern Stewart, S&P, and Merrill Lynch. We adjusted or incorporated into our model what we thought were the best parts of their work, and we added four new tests.

The reason for creating the OGI was multifaceted: we wanted to expand the definition of growth to include both sales growth and growth in cash flow from operations (CFFO). Second, we wanted a way to normalize results across industries, negating high margins resulting solely from industry choice. Third, we wanted to include an accounting manipulations test to highlight potential income adjustments, and last, we wanted to add a merger and acquisitions test to discriminate between serial acquirers who repeatedly purchased significant revenues from companies that grew internally or organically.

The OGI studies

Each of the three OGI studies consisted of six tests designed to identify value creators who outcompeted their industry competition primarily through organic growth. We started with the top 1,000 EVA companies for the base years 1996, 1997, and 1998, according to Stern Stewarts’ EVA database and methodology. Our intent was to study the companies’ growth performance during three five-year intervals: 1996-2001, 1997-2002, and 1998-2003.

We eliminated banks, diversified financial firms, real estate investment trusts (REITs), and insurance companies because of accounting and industry idiosyncrasies. After excluding those businesses, we were left with 834 companies in the 1996-2001 interval, 862 companies in the 1997-2002 interval, and 860 companies in the 1998-2003 interval.

We then applied our first of six tests to companies in the study, computing an annual EVA per capital invested for each company and narrowing the list to the top 300 performers for each of the three time periods. We did this to adjust for size bias.

In our second test, we examined both top-line and bottom-line growth, or sales growth and cash flow from operations growth. We determined the compound annual growth rate (CAGR) of sales for each company and compared it with the industry average. Then we looked at CFFO growth, determining which companies were increasing their cash flow from operations at rates greater than their industry’s average; comparing performance against the companies’ respective industries ensured that companies in high-margin industries were given no advantage over those in low-margin industries. This test assumed that reported CFFO is both an accurate measure of a company’s growth and is less likely to be manipulated than financially reported net income.

We then calculated an industry-normalized statistic for both sales and CFFO growth and averaged the two. Companies with positive average z-statistics moved to the next test. After the second test, we were left with 170 companies from 1996-2001, 189 companies from 1997-2002, and 204 companies from 1998-2003.

By using EVA/capital invested and sales CAGR and cash flow from operations CAGR, we applied commonly accepted definitions of growth and economic value creation to identify growth companies. Now, having culled the top growth companies overall, we proceeded to test to eliminate nonorganic growers.

Excerpt from ‘The Road to Organic Growth’ by Edward D Hess. Reproduced with permission © 2007, Tata McGraw-Hill Publishing Company Limited. Price: Rs 350. Vishwanath_Ghanekar@mcgraw-hill.com