Growth in profits have LITTLE role in determining intrinsic value.

 

Growth in profits have LITTLE role in determining intrinsic value.

https://myinvestingnotes.blogspot.com/2010/04/growth-in-profits-have-little-role-in.html

Growth in profits have LITTLE role in determining intrinsic value.  It is the amount of capital used that will determine value.  The lower the capital used to achieve a certain level of growth, the higher the intrinsic value.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor."

If understood in their entirety, the above paragraph will surely make the reader a much better investor.

Growth in profits will have little role in determining value. It is the amount of capital used that will mostly determine value. Lower the capital used to achieve a certain level of growth, higher the intrinsic value.

There have been industries where the growth has been very good but the capital consumed has been so huge, that the net effect on value has been negative. Example - US airlines.

Hence, steer clear of sectors and companies where profits grow at fast clip but the return on capital employed are not enough to even cover the cost of capital.

=====:

 It captures a fundamental, yet often misunderstood, principle of value investing. Let's break it down, discuss its implications, and summarize.

Core Thesis: Growth is Not a Free Good

The central argument is a direct challenge to conventional market thinking, which often equates "growth" with "value." The passage asserts that growth in profits is not inherently valuable. It only becomes valuable under a specific condition: when the capital required to generate that growth earns a return above the company's cost of capital.

• Growth that Destroys Value: If a company (or an entire industry) must invest massive amounts of capital at low returns (e.g., 4%) to grow profits, but its cost of capital is 8%, it is destroying shareholder wealth with every new dollar invested. The profit number goes up, but the economic value per share goes down.

• Growth that Creates Value: A company that can grow profits by reinvesting minimal capital at high returns (e.g., 25% on capital) is a value-creating machine. Software companies, certain branded consumer goods firms, and platforms with network effects often exemplify this.

Key Concepts Explained

1. "The amount of capital used will determine value."

   • This refers to the Return on Invested Capital (ROIC). Value is a function of cash flows, and high ROIC means the business generates more cash flow per dollar of capital locked up in the business. A business with a 30% ROIC is far more valuable than one with a 10% ROIC, even with identical current profits, because its future profit growth will require less dilution or debt.

2. "Each dollar used to finance the growth creates over a dollar of long-term market value."

   • This is the value creation test. The "dollar of long-term market value" is the present value of all future cash flows that dollar of investment will generate. If that present value exceeds $1, management has created value. This is directly linked to investing at a spread above the cost of capital.

3. The Example of US Airlines:

   • This is a classic case. The industry has seen consistent growth in passenger traffic and, at times, profits. However, it is fiercely competitive, requires enormous ongoing capital expenditures (planes, maintenance, gates), and has historically earned returns below its cost of capital. The net effect over decades has been wealth destruction for equity investors, despite being a vital and growing service.

Commentary and Nuance

• Echoes of Great Investors: This philosophy is pure Warren Buffett (inspired by his mentors Ben Graham and Charlie Munger) and Michael Mauboussin. Buffett famously said, "The best business is one that can employ large amounts of incremental capital at very high rates of return." He also warned about "the institutional imperative" that pushes managers to pursue growth at any cost, even value-destructive growth.

• Link to "Economic Moats": A business's ability to reinvest at high rates over time is protected by its competitive advantage or "moat." Wide-moat businesses (strong brands, patents, network effects) can sustain high ROIC as they grow. No moat means competition will quickly drive returns down toward the cost of capital.

• The Investor's Practical Takeaway: The passage instructs investors to look beyond the headline "profit growth" figure.

  1. Primary Metric: Focus on Return on Capital Employed (ROCE) or ROIC.

  2. Compare: Weigh the ROIC against the company's estimated Weighted Average Cost of Capital (WACC).

  3. The Rule: Seek companies where ROIC > WACC, and where this spread is sustainable. Be deeply skeptical of high-growth companies with low or declining ROIC.

  4. Sector Selection: As advised, be wary of sectors prone to value-destructive growth cycles—airlines, traditional telecom, capital-intensive manufacturing—unless there is a clear, structural shift toward discipline and higher returns.

Summary

In essence, the passage makes a critical distinction:

• Naive View: Growth in Profits → Higher Intrinsic Value.

• Sophisticated View: Growth in Profits at High Returns on Capital → Higher Intrinsic Value. Growth in Profits at Low Returns on Capital → Can Actually Destroy Intrinsic Value.

The ultimate determinant of value is not growth itself, but the quality of that growth as measured by the return on the capital required to achieve it. An investor who internalizes this shifts their focus from the top-line growth story to the economics of the business model, thereby avoiding value traps disguised as growth stories and identifying truly exceptional compounding machines. This is, indeed, what makes a "much better investor."

Creating new S-curves - developing new engines of growth - ideally before the current cycle of growth reaches maturity.

Every business goes through the S-curve cycle of growth: 

• infancy (low growth), 
• expansion (rapid growth) and 
• maturity (slow growth).

No matter how successful the product is, growth must slow at some point (maturity phase), due to a number of reasons:

• increased competition, 
• market saturation, 
• technology disruption, 
• regulatory changes and 
• changing consumer preferences.

VALUE CREATION OR DESTRUCTION:  MANAGEMENT'S ROLE

Ultimately, whether a company remains VALUE CREATIVE OR DESTRUSTIVE, depends on how well management understand this inevitability, its mindset and how successful it is in creating new S-curves - developing new engines of growth - ideally before the current cycle of growth reaches maturity.

New S-curves could include 

• tapping into new selling channels and geographies for the existing products, or 
• it could be expansion into a related business - for instance, starting a new product line and going upstream or downstream, or 
• diversification into something entirely different and unrelated.

In short, the S-curve is dynamic over the company's life, that is, the company should continuously reinvent, reinvest and create new S-curves to start new growth cycles. 

We see real-life examples of how this is done every day.

Companies starting new S-curves to start new growth cycles:

QL started Family Mart

YTL Power entered a new S-curve selling power to Singapore and enters the AI related sector.

Padini started Brands' Outlets.

Scientex growing its manufacturing business organically and through acquisitions and entering the property development sector business successfully.

KGB supplying its products to many industries and to many countries.

Facebook promoting Metaverse (but unsuccessfully).

Microsoft branching into cloud computing and AI.

Amazon continues to reinvent itself, selling books initially, and now selling almost everything. (Many new S-curves)

Of course, growth comes with a price too. 

Some growths can be good and some can be very bad for the companies.

Shareholder wealth in a company is destroyed with failure to find new S-curve.

With no growth or business in decline, value of company shrinks (contracting PE x lower EPS); value is destroyed.

There are many companies in Bursa Malaysia in this category. 

Corporate Portfolio Strategy. Constructing a portfolio of businesses.

Each firm should manage its portfolio of businesses by determining whether it is the best owner of each business in the portfolio.

• That is, whether it can create the most value from each business it owns.
• If so, then the firm should keep the business.
• If not, the firm should divest the business for a value that exceeds its value to the firm.

It should use the same basic philosophy when considering adding businesses to the portfolio.

Firms that can add the most value to a business usually have one of five advantages:

1. unique links with other businesses within the firm,
2. distinctive skills, 
3. better governance,
4. better insight and foresight, and 
5. an influence on critical stakeholders.

The firm that can offer one or more of these advantages can change over time as the firm, business, or economy changes.

• At the beginning of a business, for example, the founders are the best managers, but this will usually change.
• The needs of the business change as it expands and needs additional capital, a wider variety of management skills, and more connections to other businesses such as buyers and suppliers.
• A typical path of a business begins with the founders and end in a conglomerate corporation.

When constructing a portfolio of businesses, the firm should take five steps:

1. assess the gap between a firm's current value and its as-is-value,
2. identify internal opportunities to improve operations,
3. determine if some businesses in the firm should be divested,
4. identify potential acquisitions or the initiatives to create new growth, and 
5. assess if the company's value can increase from changes in capital structure.

Diversification considerations are not part of the list.

• The purported benefits of diversification are illusive, while the costs are real.
• For instance, diversification can hurt the value of the firm it it lowers the ability of the managers to focus on how to create value for each of the various businesses.

The Stock Market is Smarter than We Think

The only 2 drivers of value creation are:

1. Return on Invested Capital (ROIC) 
2. Growth

Return on invested capital (ROIC) and growth are the only drivers of value creation.



Activities that do not drive value creation

Managers often spend time and resources attempting to:

• smooth earnings, 
• meet earnings targets,
• stay listed in a stock index,  
• become cross-listed,
• change the accounting rules, and 
• do stock splits.

The evidence shows that the stock market does not reward these efforts.  

Changes in accounting rules and stock splits do not have lasting effects.

ALL the above issues do not have an effect on stock returns unless they reflect a change in fundamental value.

Listing and delisting from an index and cross-listing

Listing and delisting from an index do not seem to have long-term effects for any given firm.

Although there can be a negative effect initially from delisting, the effect usually reverses in a few months.

Furthermore, cross-listing within developed markets does not have an effect; however firms in emerging markets may benefit from cross-listing in a developed market.



Accounting Changes

Investors apparently see through accounting changes.

If investors focused on earnings, for example, a move from FIFO to LIFO would lower the share price, but it generally does the opposite because of the increase in cash flows.

Another example, mere changes in goodwill do not affect share price; however, a change in goodwill that is associated with a real change in the firm produces a reaction from sophisticated investors.




Mispricing in the Market

Two possible sources of mispricings are:

1. the combinations of overreaction, underreaction, reversal and momentum, and
2. bubbles and bursts.

Unrealistic expectations of continued growth, which led to excessively high P/E ratios, caused the tech bubble in the late 1990s.

High earnings that were not sustainable caused the credit bubble a decade later.  In this case, it was not that the P/E ratios were too high, but that the earnings in the ratio eventually had to fall.

Growth

The two sources of organic growth are:

1. increase in the size of the market, and 
2. increasing market share.

The drivers of growth of business, in order of size, from largest to smallest, are:

1. Market growth
2. Mergers and acquisitions
3. Market share growth

Incremental Innovation and Growth

Incremental innovation will rarely create lasting value, because competitors can easily retaliate.

Competitors can either

• lower the prices on their existing products, or,
• if the innovator raises the price of the improved product, keep their prices the same.

Also, the rivals can also come up with their own incremental innovations, which is easier than coming up with a new product or service.



Product Development and Growth

With respect to product development, growth is difficult to maintain because for each product that is maturing and reaching its peak in revenue, the company must develop a new product that will grow faster to replace it.

This is called the portfolio treadmill effect.




Why have publicly traded firms grown at a higher rate than GDP?

The two reasons for this are:

1. Publicly traded firms can grow faster because of their ease in raising capital, so their growth can be higher than the overall economy at the expense of nonpublic firms.
2. Public firms have experienced higher growth from expanding sales to overseas markets, and expanding markets and bringing in new consumers are the most effective means of growing and creating value.

Factors Affecting Industry Growth, Profitability and Risk

• Macroeconomic influences
• Technological influences
• Demographic influences
• Government influences
• Social influences

The Five Rules for Successful Stock Investing 7

Analyzing a Company – The Basics

Because [analyzing companies] can be a daunting task, I suggest that you break down the process into five areas:

1. Growth: How fast has the company grown, what are the sources of its growth, and how sustainable is that growth likely to be?
2. Profitability: What kind of returns does the company generate on the capital it invests?
3. Financial health: How solid is the firm's financial footing?
4. Risks/bear case: What are the risks to your investment case? There are excellent reasons not to invest in even the best-looking firms. Make sure you look at the full story and investigate the negatives as well as the positives.
5. Management: Who's running the show? Are they running the company for the benefits of shareholders or themselves?

You can't just look at a series of past growth rates and assume that they'll predict the future [...]. It's critical to investigate the sources of a company's growth rate and assess the quality of the growth. High-quality growth that comes from selling more goods and entering new markets is more sustainable than low-quality growth that's generated by cost-cutting or accounting tricks.

In the long run, sales growth drives earnings growth. Although profit growth can outpace sales growth for a while if a company is able to do an excellent job cutting costs or fiddling with the financial statements, this kind of situation simply isn't sustainable over the long haul – there's a limit to how much costs can be cut, and there are only so many financial tricks that companies can use to boost the bottom line. In general, sales growth stems from one of four areas:

1. Selling more goods or services
2. Raising prices
3. Selling new goods or services
4. Buying another company

If you don't know how fast the company would have grown without acquisitions, don't buy the shares – because you never know when the acquisitions will stop. Remember, the goal of a successful investor is to buy great businesses, not successful merger and acquisition machines.

The first component of ROA (Return on Assets) is simply net margin, or net income divided by sales, and it tells us how much of each dollar of sales a company keeps as earnings after paying all the costs of doing business. The second component is asset turnover, or sales divided by assets, which tells us roughly how efficient a firm is at generating revenue from each dollar of assets. Multiply these two together, and you have return on assets, which is simply the amount of profits that a company is able to generate per dollar of assets. Think of ROA as a measure of efficiency. Companies with high ROAs are better at translating assets into profits.

ROA helps us understand that there are two routes to excellent operational profitability: You can charge high prices for your products (high margins), or you can turn over your assets quickly.

Return on equity (ROE) is a great overall measure of a company's profitability because it measures the efficiency with which a company uses shareholders' equity – in other words, it measures how good the company is at earning a decent return on the shareholder's money.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

Examine growth expectations

Understand what kind of growth rates are incorporated into the share price.

If the rates of growth are unrealistic, avoid the stock.

How to Pick Fundamentally Strong Stocks

Look at growth from the perspective of investment required to support the growth. Profitable Growth Occurs Only Within a Franchise.

Summary 
Now to summarize about growth:

1. growth at a competitive disadvantage destroys value,
2. growth on a level playing field neither creates nor destroys value, and
3. it is only growth behind the protection of barriers to entry that creates value.

Growth 
 

The standard view of short term analysts is that growth is your friend. Growth is always valuable.  That is wrong!  
 

Growth is relatively rarely valuable in the long run. And you can see why with some simple arithmetic.  I am not going to look at growth from the perspective of sales, I am going to look at it from the perspective of investment required to support the growth. 

• Now the investment required to support the growth is zero then of course it is profitable—that happens almost never (For Duff & Phelps or Moody’s perhaps). 
• At a minimum you have A/R and other elements of working capital to support growth. 

Suppose the investment required is $100 million, and I have to pay 10% annually to the investors who supplied that $100 million dollars.   The cost of the growth is 10% of $100 million or $10 million dollars.   

1.  Suppose I invest that $100 million at a competitive disadvantage. 

• Suppose I am Wal-Mart planning to compete against a well-entrenched competitor in Southern Germany, am I going to earn 10% on that investment?  Almost never.  In that case, I will be lucky to earn anything; perhaps I earn $6 million. 
• But the net contribution of the growth is the $10 million cost of the funds minus the $6 million benefit which is minus $4 million dollars for every $100 million invested. 
• Growth at a competitive disadvantage has negative value.  

 

2.  Suppose it is like the automotive industry or like most industries with no barriers to entry, it is a level playing field so the return will be driven to 10% cost by the entry of other competitors. 

• So I am going to pay $10 million, I am going to make $10 million so the growth has zero value.   

3.  Profitable Growth Occurs Only Within a Franchise 

• The only case where growth has value is where the growth occurs behind the protection of an identifiable competitive advantage. 
• Growth only has value where there are sustainable competitive advantages. 
• And in that case, usually, what barriers to entry means is there are barriers to companies stealing market share from each other.
• There is usually stable market share which is symptomatic of that last situation that means in the long run, the company will grow at the industry rate. 
• And in the long run, almost all industries grow at the rate of global GDP.   

So in these three situations, the growth only matters in the last one where its profitable (growing within a franchise) is.

• And the critical issue in valuation is either management or the G&D approach will tell you the extent to which that is important or you have a good reliable valuation and there is no value to the growth because there are no barriers to entry. 
• Or it is down here (growth is profitable) and there obviously you want to get the growth for free.
• You could pay a full earnings power value and get a decent return. (Buffett with Coke-Cola in 1988).  

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School 
Edited by John Chew at Aldridge56@aol.com                           
studying/teaching/investing Page 27

Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

Growth can either ADD or DETRACT from an investment's value/

Growth in sales, earnings, and assets can either add or detract from an investment's value.

Growth can add to the value when the return on invested capital is above average, thereby assuring that when a dollar is being invested in the company, at least a dollar of market value is being created.

However, growth for a business earning low returns on capital can be detrimental to shareholders.  For example, the airline business has been a story of incredible growth, but its inability to earn decent returns on capital have left most owners of these companies in a poor position.

The First Secret of Small-Cap Investing: DEMAND PROOF OF MANAGERIAL EXCELLENCE

Great businesses are made, not born. And the secret to making a great business is having solid leadership in place — a management team that can drive a company on the route to sustainable excellence.

As with any stock investment, it’s imperative to establish that a small company’s leaders are more than competent — they have the skill and expertise to deliver profits to shareholders. Although there are many ways to determine whether a company’s management team is up to the task, a few factors rise to the top.

First, a company should have an operating history of at least three years. For companies that have recently gone public, this period could include years before its initial offering. There should have been no jarring changes of management during the company’s recent past as well. A company’s management can’t be evaluated without evidence, so the team responsible for the success of the venture to date must still be in place in order to make judgments.

Second, a company must be profitable to be considered for investment. The promise of future profits is not sufficient. Nor is it enough for a company to have recently turned the corner and posted positive earnings for the first time in its history. If a company has been able to deliver several recent years of profitability, management has passed the most important test of its skills.

But it’s not enough that a business’s management is merely competent. Our third suggestion is that stock investors strive for excellence — seek companies that meet or surpass the performance measures of their peers and competitors.

Fourth, the strength and consistency of historical growth is certainly area where investors can discern the hand of management in building a business poised for long-term future success.

Fifth, the trend and level of a company‘s pretax profit margins is perhaps the single most important comparative factor. Successful, quality companies can be identified by the margins they eke out on each dollar of revenue. Higher margins than competitors are almost always a sign of management expertise. Relatively stable annual margins are demanded of all companies. Growing margins are a positive.

To be sure, smaller companies may be in the phase of building their business, investing now to support greater success in the future, so the analysis of margins when compared with more established competitors should keep this possibility in mind.

A company’s return on equity should be reviewed carefully, but this measure not be less useful as a quality consideration for newer-stage businesses. Smaller companies can earn higher returns on initial equity, but these levels are not sustainable. Caution must again be exercised when comparing small businesses with established enterprises. Finally, any company included in a growth stock portfolio must have identifiable drivers of future growth. Tailwinds should be stronger than headwinds. No business can coast to success on the coattails of its past success, so management must be able to present a viable vision for how it intends to grow the business in the years ahead.

http://blog.betterinvesting.org/?p=2417

Growth in profits have LITTLE role in determining intrinsic value.

Growth in profits have LITTLE role in determining intrinsic value.  It is the amount of capital used that will determine value.  The lower the capital used to achieve a certain level of growth, the higher the intrinsic value.


Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor."

If understood in their entirety, the above paragraph will surely make the reader a much better investor.

Growth in profits will have little role in determining value. It is the amount of capital used that will mostly determine value. Lower the capital used to achieve a certain level of growth, higher the intrinsic value.

There have been industries where the growth has been very good but the capital consumed has been so huge, that the net effect on value has been negative. Example - US airlines.

Hence, steer clear of sectors and companies where profits grow at fast clip but the return on capital employed are not enough to even cover the cost of capital.

Also click:

https://myinvestingnotes.blogspot.com/2025/12/growth-in-profits-have-little-role-in.html

Sources of Finance for financing growth

WHAT CHOICES DO YOU HAVE TO RAISE FUNDS?

1.  DEBT FINANCING involves a loan that will accumulate future interest.
2.  EQUITY FINANCING involves accepting a lump sum in exchange for selling the future benefits and profits of your business to investors.

WHAT MIX OF DEBT/EQUITY IS USED IN A BUSINESS LIFE CYCLE?

1.  SEED STAGE
WHAT IS IT?  When your business is just a thought or an idea
FINANCIAL SOURCES:

• Family and friends
• Private savings
• Credit cards:  usually much quicker than waiting for a loan approval.

2.  START-UP STAGE
WHAT IS IT?  When the company has officially launched.
FINANCIAL SOURCES:

• Banking, typically the first option of small business owners.
• Small, community banks.
• Leasing:  paying a monthly payment for renting assets like equipment or office space.
• Factoring:  paying an advance rate to a third party (factor) in exchange for cash.
• Trade credit:  when a supplier allows the buyer to delay payment.

3.  GROWTH-STAGE
WHAT IS IT?  When a business has successfully traded for a period.
FINANCIAL SOURCES:

• Angel investor: a wealthy individual who hands over capital in return for ownership equity.
• Venture capital funds: large institutions seeking to invest considerable amounts of capital into growing businesses through a series of investment vehicles.
• Initial public offering (IPO):  the sale of equity in a company, generally in the form of shares of common stock, through an investment banking firm.

4.  MATURE STAGE
WHAT IS IT?  When its business has an established place in the market.
FINANCIAL SOURCES:

• Capital market securities such as common stock, dividends, voting rights.
• Bonds - loans that take the form of a debt security where the borrower (known as the issuer) owes the holder (the lender) a debt and is obliged to repay the principal and interest (the coupon).
• Commercial paper -  a money market security issued by large banks and corporations for short-term investments (maximum nine months) such as purchases of inventory

Key terms

Angel investor:  a wealthy individual, often a retired business owner or executive, who hands over capital to a new business in return for ownership equity.

Venture capitalists:  commonly large institutions seeking to invest considerable amounts of capital into growing businesses through a series of invesmtent vehicles that include state and private pension funds, university endowments, and insurance companies.

Commercial paper:  a money market secuirty issued by large banks and corporations for short term investments (maximum nine months) such as purchases of inventory.  These unsecured IOUs are consideed safe, but returns are small.

Factoring:  describes a loan by a third party (factor) given in the form of cash (often within 24 hours) for accounts receivable.  The borrower pays a percentage of the invoice.

External Form of Growth: Could your business benefit from these?

Business can grow by:

• Internal growth:  By paying attention to the internal affairs of the company, and diversifying into new products and new markets. 
• Go-it-alone option: 
• External growth:  Through mergers and acquisitions.

EXTERNAL FORMS OF GROWTH

Could your business benefit from an acquisition or a merger?

Again, you need to take a good look at the business to understand just where it is at the present time. 

• What are the strengths that you can build on? 
• What do you have that would make your company attractive to other companies? 
• Are there areas of weakness in the business? 
• Could these be strengthened by acquiring another company or merging your business with another?

SOME OF THE QUESTIONS TO ASK ARE:

1. Should we obtain more quality staff with different skils?
2. What do we know about our sector of the industry or service?  Could we improve our business intelligence to our advantage?
3. Is our business underperforming and, if so, in which area(s)?
4. Can we access funds for further development without endangering the normal business cash flow?
5. Could we access a wider customer base and increase our market share without outside help?  How much would it cost in extra resources?
6. Could we diversify into other products or service areas?  What would be the long-term effects?
7. Can we reduce our cost and overhead structure without damaging our product, service, or customer base? Would there be an adverse effect on performance and quality?
8. What would be the effect if we could reduce the competition?
9. Would "organic growth" take too long?

The answers to the above questions will be a good guide to future planning of the business.  But a lot depends on how the management team sees the future of the company.


FACTORS TO CONSIDER

So what would be the reasons for considering growth either through a merger or by an acquisition?

1. Bigger is better?
2. Image enhancement?
3. Market expansion?
4. Product range expansion?
5. Diversification? 

Among the forms of external growth are:

1. Mergers
2. Acquisitions
3. Joint ventures
4. Partnerships
5. Collaborations

External growth - Acquisition

What is an acquisition?

Meaning "to gain possession of," the acquisition of all parts of another business is an alternative method to develop or expand your own business.

1.  An acquisition is the most apposite option where you need specialist skills and knowledge or facilities for your own future development.

2.  This is a way of filling "holes" in a company's current or future straegy; it can be very successful as long as there is a good understanding of what the knowledge gaps are and how they cna be filled effectively.

3.  As is the case with mergers, the relevant questions should be asked and answered, and the correct business fit must be achieved.

Most acquisition involve businesses of unequal size with, usually, the larger or more powerful company purchasing or acquiring the smaller.  In recent times, this has not always been the case, and examples can be found of relatively small companies buying out much larger ones, either to obtain resources or to gain additional assets to supplement those currently owned.

Such deals are usually financed quite heavily with loasn and other deals and are often followed by a very vigorous pruning of parts of the acquisition to repay the financing involved.  This is known as asset stripping and is rarely intended to achieve growth of an established business, but rather functions as a financial dealing that will generate cash for further enlargement.

HOSTILE ACQUISITIONS OR TAKEOVERS

Many acquisitions are known as "hostile takeovers" where the management of the company being purchased actively resists the unwanted overtures of the predator company.

When talking about mergers, such phrases as: "teamwork," "sharing," and "mutual benefit" are appropriate; some expressions used when considering hostile takeovers might be:

• "We have bought you."
• "Do as you are told."
• "Our way is best."

One of the keys to success is not to keep the newly purchased company at "arm's length" but to actively create value from the new relationship.   The underlying idea of growth through acquisition is to utilize the resources you targeted at the investigation stage as quickly as possible to enable your own business to grow and flourish. 

Before any acquisition (or merger) it is essential to establish that what you think you are acquiring is real and worthwhile and to use a process such as due diligence.  This includes complete studies of the business you seek to acquire, which should be carried out by specialist, univolved, third parties, who look at every part of the business and report on its viability to meet the requirements you have set before you take irrevocable action.

Using the due diligence procedure to arrive at incisive answers to the many questions needed, to making the decision to acquire, represents the exemplary use of due diligence.

VALUING THE ACQUISITION

There are several valuation methods that can be used, and it is always best to seek professional expert advice before making the final decision.  You will need to consider many relevant factors to obtain an overview of how healthy the business might be, these include:

• The history of the business
• The current performance
• The financial situation
• The condition of the premises
• Intangible assets
• Employees

Once you have considered all of these factors, you can then decide

• how much you think the business is worth, and
• how much you are prepared to offer, if you decide to proceed.

THE FINANCIAL STRUCTURE OF AN ACQUISITION IS:

Company "C" shares ----> ----> ----> Company "A" shares ---->> Larger company "A" shares

External growth - Merger

What is a merger?

The dictionary definition of a merger in the business or commercial context is "the combination of two or more companies, either by the creation of a new organization or by absorption by one of the others." 

The underlying logic of mergers is that the resulting enterprise will be stronger than the combined resources of the individual companies.  This is described as synergy, and it offers more business possibilities.  It also has the advantage that there will be less competition as a result of the merger, although this depend on the guidelines of a monopoly commission.

WHAT ARE THE MAJOR ATTRIBUTES OF A TRUE MERGER?

1.  TEAMWORK
2.  SHARING
3.  NONDOMINATION
4.  MUTUAL BENEFIT


THE FINANCIAL STRUCTURE FOR A MERGER IS:

Company "A" Shares ----->  COMPANY "C" SHARES

Company "B" Shares ----->  COMPANY "C" SHARES


IS THE TIME RIGHT FOR A MERGER?

Ascertaining whether the time is right for a merger depends on the state of your business relative to the market and to the competition.

The practicalities of growth in your business

There are many resources that need to be considered when deciding to grow the business.  Among these are:

FINANCE
It is unlikely that the business will have generated large reserves of cash that will enable expansion to be paid for from internal sources.

STAFF
Do you have sufficient staff to undertake the extra work, or will you need to employ more people?

PREMISES
Do you have sufficient rooms for the new production facilities and increased stock levels of both materials and finished parts?

MARKETING
Can your current marketing arrangements cope with increased sales and the new product or service?


Having posed some questions regarding the availability of finance, staff, and premises, it is necessary to know where to look for sources of supply of these.

The "go-it-alone" option for growth

One option for growth that falls between internal and external growth is the go-it-alone option.

1. The major benefit of this option is that the business retains full control with all profits (or losses) retained in-house, as are all designs, manufacturing and marketing knowledge.
2. It presupposes the business is in good financial and operational "health": and that it can supply all of the necessary resources to launch and supply into the market.
3. Although the title of the option suggests that all the work is carried out in-house, this will depend on the manufacturing strategy that is operating within the company.
4. Even though most businesses would like to keep control of all the processes involved in manufacturing their products or the services they offer, economics and common sense decree that some processes are best performed by outside contractors.  This is referred to as a "make or buy policy" and will determine where work is performed.
5. The work of the contractors is controlled to advantage through agreements and contracts.

Internal Growth through Diversification into other related products or services

Many small businesses can grow by diversifying into other related products or services.  For example, an office stationery supplier might decide to add a range of computer consumables to its portfolio.  This could result in existing customers now buying these items as well.

Diversification can occur in different forms, such as:

1. Selling similar or related new products to exisitng customers.
2. Selling existing products into new markets, even overseas.
3. Selling new products to new markets.

Before deciding on diversification, take the following actions:

1. Thoroughly research both markets and customers for the new product or service.
2. Decide on a clear development strategy.
3. Do a trial run with a limited output of prototypes to test the market before committing to the new product or service.
4. Ensure that the internal departments and outside suppliers can maintain a steady throughput to provide continuity.

It would be damaging if the customer orders are plentiful but the supply of the product or service is intermittent. 

In early stages, diversification will rate highly in your risk assessment program, and in order to mitigate some of the risk, it is advisable to try to secure customer orders or commitments in advance of stepping up production.