Does growth always translate into good returns ?

With multi-billion dollar valuations of recent technology deals, there is a renewed focus and interest in understanding whether these valuations are justified.  Growth and user adoption have  become the 2 prominent  metrics for rationalizing investments off late. It is true that these are important data points  and need to be factored in in valuing firms. But growth and size alone do not  translate into value and it is critical that we remember this nuance. Even big companies often mistake growth for returns resulting in sub par performance.

Prof. Damodharan  from NYU makes an excellent argument on this in his blogpost  where he argues that there is no glory in growth for the sake of growth and that less than 50% of companies post returns in excess of their cost of capital. He uses Google as an example to demonstrate declining marginal pre-tax return on capital. His analysis only covers through 2010. I extended this through 2013 to understand the type of investments ( organic and inorganic ) that Google has been making off late and how efficient it has been in managing its investments.

 

Not surprisingly, the return on capital continued to decline and so are the marginal returns on pre-tax operating income. Some might argue, that the type of investments that Google is making will materialize 3 to 5 years down the line. I am not sure if that argument holds good as it is clear from the above analysis that returns have been consistently declining ever since Google went public .More importantly their marginal returns on pre-tax operating income have been particularly bad for the past 2 years. It is clear that Google’s recent investments haven’t been as lucrative as they were a few years back. Though some of this might be a natural progression of becoming a mature company, it might also be a result of sub-optimal investments and operational inefficiencies. As you are probably aware, some of Google’s recent acquisitions (e.g. Motorola ) haven’t performed to expectations and might have contributed to the declining returns.

It is worth pointing out that despite declining returns, Google still commands a very respectable return on investment of > 17% that is well above its cost of capital. Also, given its market dominance and resource talent, there is no question that Google is a great company and would continue to outperform the market. The interesting point to note here is that Google despite being a stellar company cannot sustain the quality of its returns over time, and that its growth is not as profitable as it used to be. If so, how can we assume that a startup with negligible revenue and high user adoption  can translate its growth into value. This is not the first time where growth has been rewarded despite the underlying risks in monetizing that metric. Not long ago, internet companies were valued based on metrics such as unique visitors and eyeballs. We all know the end of that story : a number of companies went bust when investors started demanding revenues and profits.

I remember reading a comment on one of the blog posts which clearly summarizes my thoughts : “Growth for the sake of growth is cancer”.