The Hidden Dangers of Triple Digit Growth

Some companies are able to achieve triple-digit revenue growth because they have identified a market need and have developed a product or service that effectively addresses that need. Triple-digit growth rates are generally seen in early-stage startups or companies in emerging markets with a significant untapped market opportunity. The rapid scaling of operations and subsequent revenue streams usually stems from innovative products or services and asset-light business models without physical constraints.

Triple-digit growth is often achieved by prioritizing growth through aggressive marketing and the development of new products or services, which can affect profitability. They can also be a function of rapidly changing but temporary market conditions, where even fast expansion of supply does not meet demand, and the underlying, long-term economics of the industry isn’t apparent until demand slows.

Triple-digit growth often comes at a significant cost. Companies need to invest heavily in marketing and advertising to achieve this, and may also need to hire additional staff to manage the increased demand. It has also become increasingly more common to attract talent through stock-based compensation in order to grow at high rates, which dilutes existing shareholders even if operating cash flows might look attractive. Thus, many fast-growing companies, especially in tech, often sacrifice short-term profit and cash flow or dilute shareholders to fund growth initiatives. It can be difficult to gauge whether or not the growth is sustainable or good for the long term, especially as an outside investor.

Sustaining triple digit growth over the long term is incredibly difficult. This is due to a number of factors, but the most pivotal one is the simple fact that it eventually becomes impossible to find investments, improvements, or new markets with the same potential to deliver the same growth percentage year after year. There are natural life cycles and maturations of markets that need to be taken into account as well.

It’s also very easy, and in some cases tempting, to overestimate the growth phase of a company. According to Aswath Damodoran, the legendary professor of corporate finance and also known as “The Dean of Valuation”, the median period of growth for companies classified as growth stocks was just 3.5 years. On the same note, research by McKinsey suggests that companies growing faster than 20 percent generally grew only 8 percent within 5 years and 5 percent within 10 years.

These are metrics that shouldn’t be viewed as a hard truth as every company is different, but as an investor, it’s something that’s well worth keeping in mind.

Growing revenue and even taking significant market share might seem like something that benefits every company and its shareholders. However, it might not always lead to increased shareholder value if the growth is so capital-intensive that the increased future sales and earnings do not compensate owners for the cash outflows during the growth phase. Also, it is often easier said than done to execute layoffs and to slim an organization if the growth were to diminish. In such cases, companies face the risk of being stuck with a cost base that is too high, which in many cases could be devastating and even impact its probability of default.

A company’s Return On Invested Capital (ROIC) and its revenue growth together determine how revenue is converted into cash flows. For example, a company with a 30% incremental ROIC on new projects can reinvest all of its earnings, and compound topline at 30% without burning through any cash, sometimes referred to as a reinvestment moat. Any reasonable market participant (equity and debtholder) requiring, for example, an average 8% return for the risk of an equivalent investment would love to see this company invest at these 30% for as long as they can.

The flowchart above illustrates the key drivers of value during the growth phase

High ROIC indicates a return on capital that has been invested prior, rather than the incremental invested capital. To exemplify, a 15% ROIC reported during one year is not worth as much to the investor if there are no more 15% ROIC opportunities where profits can be deployed the following year.

ROIIC (Return on Incremental Invested Capital) is also sometimes used in conjunction with ROIC when evaluating growth companies. It can be a practical method to grasp how effective a company is at capital allocation, and can also be helpful when trying to gauge what the growth could look like during the coming quarters or years.

The company has to earn revenue above its cost of capital to create value. The difference between a company’s ROIC and Weighted Average Cost of Capital (WACC), together with revenue growth, are key drivers of value. In the above example, that difference would be 22% and for every year the company accumulates in size, the capital on which it can earn this spread grows.

As previously discussed, increased revenues can destroy value when investments made to facilitate growth deliver below-cost-of-capital returns, and it's important that companies properly manages this balance. Projects that generate high ROIC in combination with high revenue growth are therefore the sweet spot for a company looking to generate value as they grow.

Not surprisingly, if a company’s ROIC is low, its share price usually increases more when its ROIC grows compared to when its revenue rises. On the other hand, the share price of a high-ROIC company increases more when revenues are increased than when ROIC is improved further. It’s much more important for a 50% ROIC company to increase its growth from say 5% to 10% than it is for its ROIC to go to 55%.

It might help to look at what the research says about what type of growth that (on average) does, and does not create value.

Valuable types of growth include creating new products, convincing an already existing customer base to buy more of a product, as well as attracting new customers. This can create above-average value for every dollar of revenue, due to all competitors benefiting from the development, or in some cases due to being alone with providing the specific product or service.

On the other hand, some growth is more likely to deliver below-average value in the long term. Gaining market share and growing one’s revenue through small incremental improvements or innovations, promotions, or lowered prices are all factors that come into play. This is due to the fact that competitors can replicate and/or retaliate, or the company in question simply has to pay more than it gets.

Growth can also deliver average value. This is normal in the case of small bolt-on acquisitions and gaining market share in fast-growing markets since the company in question can pay a reasonable price for what it gets, while still allowing competition to grow.

Value needs to be created through a combination of healthy ROIC-WACC Spread, Increasing Revenues, and Sustainable Growth in order to deliver long-term results.

Two examples of triple-digit growers are Zoom and Peloton. The video conferencing platform Zoom saw explosive growth during the COVID-19 pandemic as businesses and individuals shifted to remote work and virtual meetings while sheltering in place. As a result of the shifting landscape, Zoom's revenue grew by 355% in fiscal year 2021.

The home fitness company Peloton also experienced strong growth during the pandemic as consumers looked for ways to exercise at home. Peloton's revenue grew by 100% in fiscal year 2020. It is often extraordinary paradigm shifts like this that make it possible for large companies such as Zoom and Peloton to grow at triple-digit rates. Whether serving that market is value-creating for the shareholders, though, is another question.

Looking back at the period since 2020, though, it’s clear that the market's view on the value creation of the growth of these companies has changed. Taking Peloton, for example, the narrative that was told to (and clearly bought by) market participants was as follows:

A description of the business as a technology, media, software, product, experience, fitness, design, retail, and even a logistics company, all in one. Peloton also communicated they had a huge TAM in the US alone, with 65 million Americans that could pay at least 40 dollars a month. The company also placed an emphasis on the number of users (i.e. bikers) and the idea of becoming a platform with future pricing power, rather than the unit economics of individual users there and then. This narrative enabled the company to ultimately reach a $50 billion valuation. Moreover, it allowed significant value to be transferred from shareholders to option holders through share-based compensation, which was deep in the money at the time of the IPO.

Ultimately, Peloton went through three distinct phases

• Growth and profitability

• Negative growth with severe and increasing losses

• Negative growth with improving (yet still very negative) margins

Peloton perfectly exemplifies that even product innovation, favorable conditions (COVID), an enthusiastic user following, and a large potential market does not mean guaranteed, predictable, and valuable growth.

Companies that achieve triple-digit growth often do so by identifying a market need or by being pioneers in significant paradigm shifts. However, this growth can come at significant costs in terms of increased marketing, hiring, stock-based compensation, and large capital outlays. The task for companies’ management teams is always to weigh these opportunities and challenges effectively to maximize shareholder value over the long run. Whether this job is effectively done becomes clear to an outsider from a combination of high and increased ROIC, with predictably high revenue growth over time, driven by sustainable practices. If this is done, more often than not cashflow and share prices will follow.