Breaking out of the no-growth trap

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Many management teams these days find themselves in intense debates over a pressing question. There’s a lot of cash on the company’s balance sheet right now. Should we buy back some of our shares—or should we invest in growth?

Share buybacks have an obvious appeal and an obvious limitation. They give a quick shot in the arm to earnings per share and (usually) the stock price. They pacify activist investors clamoring for the company to return cash to shareholders. But while buybacks may be viewed as a sign of a company’s confidence in its future, they are pure financial engineering. They do nothing to stimulate growth.

Growth investments encounter obstacles of their own. Presented with investment proposals, chief financial officers (CFOs) often report back that the proposals don’t make economic sense—the anticipated return doesn’t exceed the company’s hurdle rate for the assumed level of risk. Mergers and acquisitions are particularly prone to this type of reasoning. Given the unusually high prices in today’s M&A environment, how can available deals possibly pass a company’s hurdle rates?

The result can be a kind of no-growth trap: Cautious companies wind up holding on to their cash, returning it to shareholders or trying to boost margins through cost reductions. Procter & Gamble is a case in point. P&G has spent heavily on dividends and share buybacks over the past five years, but both its revenues and earnings (in real terms) have been essentially flat. Overall, companies on the S&P 500 increased their revenue an average of 7% a year from 2003 to 2008, but only 1.7% a year from 2008 through 2013. While EBITDA margins grew faster in the latter period, most of the increase came from margin expansion rather than from top-line growth.

But there is a path out of this trap—a path based on a different way of analyzing and assessing growth opportunities. It has five key steps.

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