Stock in Focus: The cost of growth

In this week’s webinar with screening expert Algy Hall, one of the members of our audience asked an interesting question: “Aside from long term EPS growth, is any other measure a key factor for share price appreciation?”

The answer, in brief, is yes. In addition to reliable earnings growth, company shares can be driven upwards if their valuation multiple (for example, the price to earnings ratio) rises. Investors on the hunt for growth stocks should therefore seek companies whose valuation has room for expansion. This is something we have written about in depth in the past and you can watch Algy’s full answer in the replay of the webinar, available here.

Seeking growth companies with a sensible valuation multiple may seem counter-intuitive to what many of us think we know about growth stocks (that companies on a high growth trajectory justify higher valuations). But this leads onto to the other important part of the conversation about the quest for growth: never overpay.

Most investors know that overpaying for growth can be very costly: jumping on the bandwagon of a stock on a rapid trajectory can be very painful if that stock can’t live up to expectations. But investors should also be mindful of companies that overpay for their own growth. Strong sales are all well and good, but what if those sales are coming at too high a cost? And how can you identify stocks that are overpaying?

In analyst circles, there is a golden rule which answers that question. The cost of growth is too high if a company’s weighted average cost of capital (WACC) is consistently higher than its return on invested capital (ROIC). Put simply, this means that the average cost of financing a company’s assets assets is higher than the returns that company makes from those assets. Importantly this distinguishes companies which are paying too much upfront for growth than those that are simply reinvesting their profits.

But for many investors, that golden rule is difficult to check owing to the need for relatively complex financial modelling. ROIC is calculated by dividing a company’s after tax profits by its average invested capital (certainly doable, but not simple). WACC is calculated by multiplying the cost of each source of capital (debt or equity) by its relative weight in the company’s market capitalisation (doable if the company in question provides a fair and detailed breakdown of the cost of each source of capital, or the investor has a working knowledge of the dividend capitalisation model which allows them to calculate the cost of equity).

The good news is there are a handful of simpler (and far less mathematically intense) solutions to sense checking whether a company is overpaying for growth.

For starters it is important to check where the company is spending its money. Reinvesting in the business is crucial for long term growth, but investors should always ensure that companies are redeploying their capital into areas which can actually deliver increased sales. For example, you would expect to see tech and healthcare companies investing a high proportion of their expenses in research and development. Companies in the hospitality market might do well for investing in their staff. Infrastructure and property companies should spend on their real estate.

Darktrace - a long-time disappointment for British tech investors - provides a good example of misaligned spending. This tech company (which was reportedly at the cutting edge of cyber security) has spent far more on sales and marketing than product development. Why would a company which claims novel and exciting tech need to spend so much on sales people?

Robotics processing company Blue Prism provides another stark lesson from history. Between 2016 (at the IPO) and 2020 the company’s staff numbers rose 10-fold sending workforce costs up at a compound annual rate of 92% - a faster pace than the rise in revenue. Significantly, the company was also paying massive upfront commission to many of its staff - thus booking an upfront cost for sales which might never come to fruition. The company’s share price stumbled from its searing highs before being rescued by a takeover offer in 2021.

And overpaying on staff is an affliction which has befallen several companies in the tech sector in recent years. Strong demand for products and services during the pandemic lead to overambitious expansion, and a surge in the number of expensive staff. Many of them are now culling staff or paying the price. Elon Musk lead the way at Twitter, trimming its staff numbers down to 20% (with plans to rebuild once costs are in order). A friend of mine has recently take redundancy from Trainline after the company cut all of their business analysts (the new CTO who has come from Google has decided the developers can absorb the work).

So look out for companies overspending in the wrong places. When the good times end, the cost of that growth can suddenly seem like too high a price to pay.