My absence from the writing stage is a great example of life disagreeing with your priorities. In case you did not know it, I started a new business in February, Active Investment Management (AIM) Consulting, LLC. Those of you starting your own business know just what this entails. Ironically this plays into this article’s theme. Apologies for my long absence. Time and space are clearing, and I am returning to my bi-weekly missives on investing.

Before all things in my life got intense, I started a series on what I feel are The Most Misunderstood Investing Concepts. Ground I covered included:

• Fair value and its evil twin, target price;
• Time horizon and its subterranean influence on investors’ thinking; and,
• PEG ratios and the ignorance of the math underlying them.

The Lonely Income Statement

In this edition I discuss one of the hidden sources of investment losses. Namely, many investors treat growth as free in their valuation models. This oversight is especially true for the sell side. I won’t name names, but many an analyst over the years has presented a valuation model that is simply a projected 3-5 years income statement for a company.

Typically, revenues are assumed to grow at a much faster rate than the economy. After all, this business is in a growing market, gaining market share, and is going to benefit from returns to scale. Pedal to the metal! Expenses are assumed to flatten, and in most cases decline; either on a relative basis (there’s that scale), or even more aggressively on an absolute basis. Interest expense is easy to calculate based on current debt levels. Tax rate assumptions and stock buy back assumptions are generously provided by investor relations.

And so earnings for some future period are determined. A multiple, usually a higher one than the market currently ascribes is applied to the earnings per share calculation – multiple expansion and all that, don’t you know – and voila we have a valuation. And a ‘strong buy’ case. Fantastic! That was easy. Too easy. Do you see the problem here? You guessed it: growth is not free.

Growth is Not Free

In the preceding analysts’ legerdemain them conducting the arithmetic of n * (1 + g) was about as expensive as growth cost the business under their scrutiny. Yet, in reality to grow a business is very difficult. First, it is very hard to move the needle on revenues. Fierce competition ensures that pricing pressures materialize rapidly in many industries. Volumes are tough to grow for the same reason in many businesses. To move the needle on revenues requires big and ongoing outlays in research and development to create new killer products. Either that or firms must advertise like mad to attract those new customers and to keep the old ones. True, some businesses are first to market and have a crazily in-demand product. Woohoo! But again, growth is…you guessed it, not free.

In the case of any growth, but especially true of the firm that has the amazing, new, must-have product growth is hard. For starters, is the 43^rd managerial vice-president hired to manage another part of operations as effective and dedicated as the 3^rd? Probably not. Next, new salespeople need to be hired. Is the 300^th salesperson of the same quality as the 30^th? Probably not. Is it as easy to find that 300^th salesperson as it was the 30^th? Probably not. Does compensation have to increase to reward the salespeople for the growth they are generating. Yup. What about the office space and equipment needed to support these new employees? And the training? And possibly the benefits to attract them in the first place? What about the inventories that need to be built up? Is the 1,000^th customer as creditworthy as the 50^th? Probably not. Were volume discounts used to induce more and more and more sales? What about the expansion of manufacturing capacity and concurrent increase in property, plant, and equipment? You might argue that a company can outsource manufacturing. Great, but that may cause production or supply chain bottlenecks, manufacturing defects, and there may also be capacity constraints from suppliers, too. What about the IT infrastructure needed to properly manage this growing and likely increasingly far flung operation? Is it possible that there are net working capital timing problems that cause short-term financing pressures? Yup. And, last, and definitely not least: how is all of this growth paid for?? After all, most of the preceding changes/expenses need to be in place just slightly in advance of receipt of their additional benefits received. By no means is this exhaustive list exhaustive. There are many additional costs of growing.

The Forgotten Financial Statement

Put another way, and as simply as I can…in valuing a business:

Where is the balance sheet?!?!

How are the effects of growth measured on the balance sheet? If an analyst has a projected balance sheet at all (and it is rare) the closest interlinkages are with numbers like “days sales outstanding,” “days inventory outstanding,” and “days payable outstanding.” But in what other ways are the feedback effects between the balance sheet and income statement, and balance sheet and income statement measured? A company must first raise capital, a new liability. With that cash it buys something to help sales. Then a firm must sell product. This generates new expenses that need to be paid for in some manner. That may lead to a growth in operating profit, or not. That, in turn leads to more debt and more interest expense. Then there are more taxes that need to be paid with some source of capital. All this activity ideally leads to more profits. That may lead to cash. And for a growing business, the cash generated is usually less than is needed in order to become self-financing. So, receivables must be collected faster, inventories turned faster, suppliers more patient, short-term debt financiers placated, long-term debt financiers placated, interest rates must remain stable, and shareholders happy to again open their wallets. Whew!

In a perfect world, the company earns enough from its activities to professionalize itself, eventually pay off its debtors, satisfy its shareholders, and its profits become the support underneath growth. None of this is free, and consequently: growth is not free!