Growth, Corporate Profitability and Value Creation

What did they investigate?

▪ Understanding the relationship between earnings (or sales) growth and measures of
corporate profitability
➢ This will shed light on whether there is an optimal growth rate that
maximizes profitability
▪ Investigating whether maximizing performance metrics such as EVA will maximize
shareholder wealth
➢ Stated differently -> Is there a risk-adjusted premium to investing in the
equity of companies that experience high earnings growth rates and generate
positive EVA?

Theoretical Background
• Many years ago, Enron Corporation set out to become the world’s largest company,
and today its goal is survival
• Their rise and fall is a primer on the dangers of out–of-control growth and is
symptomatic of recruitment consolidations in search of growth
• Academic and practitioner literature questioned the virtues of “growth for the sake
of growth”
• “Many managers have a view of their company's future that is strikingly analogous
to the child's view of himself. When asked what they want their companies to
become over the next few years, they reply ‘bigger’.”
• Associating creation of shareholder value with growth in earnings, sales, or other
metrics is commonplace in the investment industry, and the use of such metrics has
greatly influenced managerial compensation schemes and thus provided impetus to
mergers and acquisitions as well as internal growth.
• In traditional incentive schemes compensation is often tied to the manager's ability
to beat budgeted increases in earnings or sales, but a formal mechanism for
determining whether growth activities enhance returns to shareholders is lacking
• Modern value-based approaches remove this ambiguity, and in these approaches,
manager compensation depends on metrics that are consistent with shareholder
wealth maximization
• These metrics, such as EVA, MVA, ROIC and cash flow return on investment, all claim
to align management and shareholder interests

How did they conduct the study

• Data came from the annual Compustat files on U.S. companies for the 11-year period
1990 through 2000
• Excluded:
• Data for American Depositary Receipts, utilities, and financial, governmental,
or unclassifiable institutions
• Companies with annual net sales, total assets, and common equity less than
$1 million
• The 432 companies that appeared in the sample only once
 • The final sample consisted of approximately 2,156 companies a year (23,720
observations
• Considered 2 broad measures of growth:
• Sales Growth -> measured as average of quarterly sales growth rates over the
past 20 quarters
• Earnings Growth -> measured as the average of earnings growth rates over
the past 20 years
• First Objective: To investigate the link between measures of growth and corporate
profitability
• Examined ROE and ROI as two classic measures of corporate profitability
• Newer value-based measures considered were EVA and MVA
• EVA emphasizes the importance of maximizing incremental earnings above
capital
• Expressed as NOPAT – WACC x Capital
• MVA measures difference between what investors put in and what they
expect to take out
• Expressed as (Number of shares outstanding x Stock price) + Market value of
preferred stock + Market value of debt - Total capital
• To facilitate comparisons of companies and comparisons over time they normalized
EVA, MVA and other dollar-denominated variables by the NAV of the company
• NAV = Total assets – cash and marketable securities
• These metrics measure performance from a corporate finance perspective rather
than the point of view of shareholder wealth creation.
• Therefore, they used Jensen's alpha, which measures "abnormal returns" given the
company's systematic risk, to assess the impact of performance on shareholders'
wealth.

Main Conclusions
▪ Their empirical results indicate that maximizing growth does not maximize corporate
profitability or shareholder value
▪ On the contrary, companies with moderate growth in sales or earnings show the
highest rates of return and value creation for their owner
▪ Their results also show that corporate managers need to abandon the habit of
blindly increasing company size and investors need to carefully consider the
drawbacks of diseconomies of scale
▪ Growth should not be the input to strategic planning but the outcome of a sound
investment strategy that is geared to accepting value-creating projects
JSE‐listed companies in the food and drug retail sector: A content
analysis of financial statements to determine their primary purpose.

What did they Investigate?

The overall purpose of the study is to analyse financial statements to determine the primary
purpose of JSE listed companies in the food and drug retail sector. Hence, the purpose is to
identify within a South African context which model that can be followed by businesses,
companies are purporting to follow through an inspection of annual financial reports. The
research objectives linked to this purpose include: to examine the literature on the three
models in order to identify themes or major identifiers of each model, to examine the
financial statements (over five years from 2010 to 2014) of JSE listed companies in the food
and drug retail sector, in particular the non-financial information, for themes that could link
to the identification of any of the three models and to prepare a content analysis based on
this examination to draw a conclusion on which model each company in the population
appears to be following.

Theoretical Background?
There has been much research and published literature on models that can be followed by
businesses but they ultimately boil down to three types of models.

The first of these, the neoclassical model which indicates that the main purpose of an entity
is to make profits and therefore the focus solely on the shareholders. Businesses are profit
maximising and consumers are utility maximising. The main goal of the model is to maximize
profits, market value, and hence shareholder wealth.

The second one, conscious capitalism (CC), is trending in America at present and differs to
neoclassical in that the focus turns from shareholders to all stakeholders and has the
business focusing on a higher purpose, stakeholder orientation, conscious leadership and
conscious culture as opposed to profits.

The last model, entity maximisation and sustainability (EMS), differs slightly to CC in that
only part of the focus is maximising entity wealth (which positively impacts all stakeholders),
the other part of the focus being sustaining the business in the long term. Entrepreneurs
should focus on maximizing their own wealth and maximisation isn’t solely measured
through profits. Also states that if sustainability is not upheld, businesses would not survive
in the long run. Sustainability incorporates a triple bottom line approach.

How did they complete the study?

The methodology used in this paper was content analyses. A detailed literature review was
conducted using secondary data from journals, books and electronic sources that provided
insight into the three models in order to establish themes related to each model. These
themes were then used to perform the content analysis of non-financial information within
published annual reports of the four entities listed within the chosen sector from 2010 to
2014. The listed entities are SPAR, Pick n Pay, Shoprite and Clicks. This analysis led to a
conclusion on the model followed by each company within the sector.
Main Conclusions
All companies considered each of the 6 major stakeholders to different extents, with each
also considering sustainability.

Spars main consideration is their employees with a long term goal of sustainability. They do
not solely focus on shareholder or stakeholder wealth, but on ensuring the company itself is
sustained, therefore EMS.

Pick n Pay has a strong focus on customers, as well as group sustainability. They do not
solely focus on shareholder or stakeholder wealth, but on ensuring the company itself is
sustained, therefore EMS.

Shoprite believes solely focusing on profits cannot be the sole objective of a business. It was
revealed that their main focus was on customers offering low cost solutions to remain
sustainable, EMS is the closest fit.

Clicks has a strong focus on shareholders and creating value and returns for them, however
its focus is not simply to make profits but to make them and sustain the group for the long
term. EMS model applied.

All focus on EMS with differing approaches. Pick n Pay and Shoprite, for instance, focuses
more on customers (although the former through differentiation and the latter through a
low-cost strategy), SPAR focuses on employees, and Clicks focuses on shareholders in
applying its approach.
Do investors overvalue firms with bloated balance sheets?
What do they Investigate?
They propose that the level of NOA measures the extent to which operating outcomes
provoke excessive investor optimism and that the financial position of a firm with high NOA
is less attractive than appears. A high level of net operating assets, scaled to control for firm
size, indicates a lack of sustainability of recent earnings performance, and that investors do
not fully discount for this fact.

What is the theoretical background?

➢ If attention is sufficiently limited, investors will tend to treat an information category
such as earnings uniformly. The operating accruals anomaly of Sloan (1996) is a
natural implication of limited attention; more processing is required to examine each
of the cash flow and operating accrual pieces of earnings separately than to examine
earnings alone.
➢ Past research shows that there is information in operating accruals that makes
earnings more highly correlated than cash flow with contemporaneous stock returns
➢ The level of net operating assets can help identify those operating/reporting
outcomes that highlight the more positive versus negative aspects of performance,
thereby provoking investor errors.
➢ Regardless of whether high investment is associated with high or low future
profitability, if investors are over-optimistic about the relation between investment
and future profitability, they will overvalue high-investment firms.
➢ Selecting firms based on high net operating assets reflects both positive and adverse
aspects of accruals and investment. Rising cumulative accruals can reflect growth
and cash to come, but can also indicate lingering problems in converting accruals
into actual cash flow.
➢ High net operating assets firms are selected not by earnings growth per se, but by
the relative shortfall between free cash flow and earnings. When this shortfall is
large, the favourable cumulative earnings performance receives relatively little
corroboration from cash flow net of investment expenditures. Investors with limited
attention do not put sufficient weight on the possibility that the high cumulative
investment of these firms represents either overinvestment, replacement of
obsolescent fixed assets, or investment with relatively transient payoff. They will
therefore overvalue firms with high NOA and undervalue firms with low NOA

How did they complete the study?

• Started with all NYSE/AMEX and NASDAQ firms in the intersection of the 2002
COMPUSTAT and CRSP tapes, the sample period spans 462 months from July 1964
through December 2002.
• Began by measuring NOA as the difference between operating assets and operating
liabilities. They then move to calculate income from continuing operations as Earnings –
Accruals.
• Then move to the measurement of asset pricing control variables. They employ a
number of known cross-sectional determinants of stock returns in our tests of return
predictability. These include book to market ratio, and the MV of common equity.
• In addition to these two variables, they also included a number of past return proxies to
control for the 1 month-reversal, 12-month momentum, and 3-year reversal effect, all
measured relative to the test month t of returns.
• They hypothesized that a high level of net operating assets is an indicator of strong past
earnings performance, but also of deteriorating future financial prospects. They also
hypothesized that investors with limited attention neglect this adverse indicator, leading
to stock return predictability.
• We first evaluate these hypotheses by presenting the time profile of accounting and
stock return performance in the periods surrounding the ranking year for NOA deciles.
We then test the ability of NOA to predict stock returns controlling for standard asset
pricing variables and accounting flow variables.
• Then test for abnormal returns by NOA deciles. Every month, stocks are ranked by NOA,
placed into deciles, and the equal-weighted and value-weighted monthly raw and
abnormal returns are computed.
• Then, by applying the Fama–MacBeth (1973) regressions, we evaluate the relation
between NOA and subsequent returns with an expanded set of controls.

What are the main conclusions?

In one sample, net operating assets do contain important information about the long-term
sustainability of the firm’s financial performance. Firms with high net operating assets
normalized by beginning total assets (NOA) have high and growing earnings prior to the
conditioning date, but declining earnings subsequent to that date.

NOA is a strong and highly robust negative predictor of abnormal stock returns for at least
three years after NOA is measured. These findings are both statistically and economically
significant. This evidence suggests that market prices do not fully reflect the information
contained in NOA for future financial performance. We call this phenomenon the
sustainability effect.

The predictive power of NOA remains strong after controlling for a wide range of known
return predictors and asset pricing controls. NOA has stronger and more persistent
predictive power than flow components of NOA such as operating accruals or the latest
change in NOA. This evidence suggests that there is a cumulative effect on investor
misperceptions of discrepancies between accounting and cash value added. Net operating
assets therefore provide a parsimonious balance sheet measure of the degree to which
investors overestimate the sustainability of accounting performance.

•
 Extra Theoretical
• Information is vast, and attention limited. People therefore simplify their judgments and decisions by
using rules of thumb, and by processing only subsets of available information.
• Several authors have argued that limited investor attention and processing power cause systematic errors
that affect market prices.
• A basic accounting identity states that a firm’s net operating assets are equal to the cumulation over time
of the difference between net operating income and free cash flow. Thus, net operating assets are a
cumulative measure of the deviation between accounting value added and cash value added—‘balance
sheet bloat’
• If investors have limited attention and fail to discount for the unsustainability of earnings growth, then
firms with high net operating assets will be overvalued relative to those with low net operating assets
• This implies that firms with high net operating assets will on average earn negative long-run abnormal
returns, and those with low net operating assets will earn positive long-run abnormal returns.
• A possible reason why high net operating assets may be followed by disappointment is that the high level
is a result of an extended pattern of earnings management that must soon be reversed