Tuesday, April 26, 2016

5 Ways Companies Can Grow


As dividend growth investors the most exciting part is the growth.  Dividend growth streaks aren't built by happenstance.  Companies that can amass decades long streaks have one thing in common: they grow.  Companies must constantly figure out ways to grow earnings, cash flow and most importantly revenue in order to grow their dividend.

How do they grow?

It's pretty simple actually, but not all growth is created equally.  Whenever you're analyzing potential investments it's important to make sure the companies are actually growing.  That means looking at the nominal numbers rather than the per share values to determine if the growth is real or manufactured.

Real Growth

Real growth is the best kind of growth for a company.  The organic expansion process is the purest growth you'll find for a company.  There's 4 types of real growth for a company.
  1. Price Increases
  2. Volume Growth
  3. Market Share
  4. New Products
Price increases are one of the most recognizable ways for a company to grow its top line.  1% increase here, 2% increase there and don't forget about passing on the rise of the input costs for your products too.  Price increases are immediate boosts to your revenue and profit since all you're doing is charging customers more for the same product.

Volume growth is the other easily recognizable ways for a company to grow.  If you sell more widgets all of your financials go up.  Your revenue obviously goes up, so does your profit, as well as your cash flow.  

Increasing a company's market share is a vital element to consistent growth although it's much harder to obtain.  If a given market can only support 5,000 widgets sold each year then it's very important to you to have your company sell as many of those widgets as possible.  If you sell 2,000 of the 5,000 sold each year you have a strong 40% market share.  That's great but market share increases are hard to come by and typically require aggressive pricing which tightens profit margins and usually high advertising and marketing expenses.

When the first 3 levers of real growth are done right that allows companies to maximize their profit margins and profits are the life blood of a company.  When profits are high and the business is running full steam ahead that allows companies to develop new products which are the last source of organic growth for a company.  New products allow companies to generate a new revenue stream.

Manufactured Growth

Manufactured growth is growth through acquisition.  Manufactured growth is easier to get than organic growth, but much harder to get right.  There's a long history of acquisitions gone wrong that either don't provide the promised cost savings through synergies or end up disappointing because of the high acquisition costs.

However, acquisitions do provide many benefits.  The acquisition of companies gives the buyer options.  They can look to buy up a competitor which will increase their market share.  After all, if you're competitor's products are now your products you benefit through higher sales.

Another benefit to growth through acquisition is that the buyer can more easily move into new markets or products.  Once a company identifies a new market or product that it wants to expand into it has 2 options.  It can either spend the upfront research, development, design and marketing costs, and of course the lead time to do all of that, to build its way into the market or it can acquire its way there.

Buying your way to growth will reduce the very important time factor that goes into developing a new product; however, that comes at a price.  Acquisitions aren't cheap and buying an established company will typically come at a premium to the costs they've already put into building their company.  And of course a nice premium to those costs as well.

Conclusion

In order for a company to reward its shareholders over time they have to find ways to grow their revenue.  The history books are filled with companies that stopped growing and eventually went out of business.  That's why checking in on the growth in sales of the companies you own is a vital step in analyzing the business.

However, not all growth is created equal which means as investors we have to be vigilant on tracking how the companies are obtaining their growth.  Real growth is my preferred way of seeing my investments grow.  Real growth shows companies that are working well.  Seek out companies that generate the majority of their growth year to year from price or volume increases, increasing their market share or developing new products.

One of my first stops when analyzing companies is to see where their growth is coming from because a growing top line will lead to growing profits.

Do you take stagnant sales as a warning about the companies you invest in?

Image provided by Sujin Jetkasettakorn via FreeDigitalPhotos

5 comments:

  1. Hi,

    Nice article. I would like to add some more ways to grow:
    1. Sell more products
    2. Sell more products per purchase (increase average order value)
    3. Decrease time between new purchases

    Hope this adds.

    Take care!

    Asset Blogger

    ReplyDelete
    Replies
    1. Asset Blogger,

      Thanks for stopping by and commenting.

      All of the things you mentioned fall under one of the categories I listed but it's important to look at the specific ways so thanks for adding that.

      Hope you keep coming back. All the best!

      Delete
    2. Hi,

      Thanks for your reply. Indeed they are basically all the same. Nice site you got here
      and i'll come back for sure to read and add some value!

      Regards,
      Asset Blogger

      Delete
  2. This is so helpful -- thanks. It's also a good reminder of why we aren't ideally suited for dividend investing! I can't see myself paying close attention to sales and growth figures for all the companies we are thinking about investing in or have already bought shares in, so I see this as an important cautionary tale.

    ReplyDelete
    Replies
    1. Our Next Life,

      To be fair this is something that everyone that invests in individual companies needs to monitor, not just dividend investors. But for index/mutual fund/ETF investors it's not quite as important. Investing in individual companies is a much bigger time commitment, but for now it's one that I enjoy since I have ample time on my hands.

      Thanks for stopping by!

      Delete