Profitable Growth is the combination of profitability and growth, more precisely the combination of Economic Profitability and Growth of Free cash flows. Profitable growth is aimed at seducing the financial community; it emerged in the early 80’s when shareholder value creation became firms’ main objective.
Profitable Growth stresses that Profitability and Growth should be jointly achieved. It is a break from previous firms’ development models which advocated growth at first to achieve economies of scale and then profitability (see BCG Growth-share matrix).
The Profitable Growth Paradox
Profitable Growth hides in fact a contradiction in terms, one often speaks of the Profitable Growth paradox. Most growth investment will at first reduce the profitability, cost reduction efforts to boost the bottom line usually have a negative impact on future growth. This is especially true with mature products or services. The only way out of the Profitable Growth paradox is through innovation. It concerns not only technical innovation but mainly business model innovation, a new product-market space where there is no competition (see Blue Ocean Strategy). An interesting piece of research by the BCG shows that no business model is able to achieve a sustainable competitive advantage for more than 10 years.
Economic Profit is the residual wealth calculated by deducting the cost of capital from the firm’s operating profit. It is defined as: Net Operating Profit After Taxes (NOPAT) - Cost of Capital Employed
- NOPAT (Net Operating Profit After Tax)
NOPAT = EBIT x (1 - Tax Rate)
NOPAT measures a company's potential cash earnings.
- Capital Employed Capital Employed is the amount of funds which has been used over the period by the company to generate the NOPAT.
There are 2 ways to measure Capital Employed (CE) :
- CE = Shareholders’ Equity + Net Financial Debt
Net Financial Debt is computed as: interest bearing Debt – Cash and Cash equivalents.
- CE = Fixed Assets + Net Working Capital
Net Working Capital is usually computed as: Account Receivables + Inventories – Account Payables.
Both definitions lead to the same measure of Capital Employed. One prefers the first one when computing Capital Employed at the firm level; the second one is more practical when focusing on a company’s business unit.
"Blue Ocean Strategy". Harvard Business Review (Boston: Harvard Business School Press): 76–85. October 2004
Michael C. Jensen, 'Value Maximization and the Corporate Objective Function,' Journal of Applied Corporate Finance, Fall 2001