# Beyond margins *When cost focus is a mistake* Imagine you're running a business that's making £10m of operating profit on £62.5m of invested capital - a 16% return, up from 14% last year. The Board is happy - their investment hurdle rate is 10%. As you start next year's planning cycle, you've got two options on the table. Your COO wants to push harder on cost - there's more to go after and he sees a path to 18%. Your CCO wants to push into an adjacent market - underlying earnings grow at 5% but she thinks 8% is possible if the business expands. You don't think the exec team can successfully execute both at the same time. How do you work out which one to pick? --- We can use these numbers to do a very simple business valuation (called the Gordon Growth Model). You take the free cash flow and divide it by the difference between the required investor return and earnings growth rate. Let's work out the current valuation using this model and see the impact of the two options. To work out free cashflow, we need to reduce the operating profit by the amount of reinvestment needed for growth. $\text{Reinvestment rate} = \frac{\text{Growth rate}}{\text{Return on capital}}$ So in this instance the reinvestment rate is 5% / 16% = 31%. 31% x £10m = £3.1m operating profit going back into the business - the remaining £6.9m is free cash flow. We know that our investors want 10%, and our underlying growth rate is 5%, so we now have everything we need to do our simple valuation: $\frac{£6.9\text{m}}{10\% - 5\%} = £138\text{m}$ --- Let's model the valuation impact of the COO's cost programme that will push returns to 18%. Same capital base, so profit rises to £11.25m (62.5m * 18%) The underlying growth rate stays at 5%, the reinvestment rate drops to 28% (5 ÷ 18), or £3.125m. Free cash flow rises to £8.1m, and plugging these back into our valuation formula: $\frac{£8.1\text{m}}{10\% - 5\%} = £162\text{m}$ So the margin improvement work has created £24m of value, good news. --- Now let's look at the other option. Returns stay at 16%, but to grow at 8% instead of 5% the reinvestment rate rises to 50% (8 ÷ 16), or £5m. This means free cash flow drops to £5m, which doesn't sound promising. But hang on - plugging this back into our model: $\frac{£5\text{m}}{10\% - 8\%} = £250\text{m}$ Three more points of growth added £112m. Nearly five times as much as the cost programme. Focus on growth. --- In this stylised example - Growth only works so well because 16% is well above the 10% hurdle. - The reinvested capital earns six points more than investors require, and growth then multiplies that spread across a larger and larger base. - If returns were 10% - the same as the hurdle rate - the maths collapses and growth adds nothing. - The threshold is somewhere around 15%. - Below that, margin improvement is the priority because you need a wider spread before growth creates value. - But above it, another point of margin makes little difference and growth becomes disproportionately valuable. Every figure here is a single point standing in for a range - the returns, the growth rate, the hurdle. Reading a business case with that in mind is [[Confidence]]. --- This insight was most directly crystallised by Bergman and Beving in their application of the EBITA / WC metric, and the 'focus model' that emerged from it: - **Above 45%**: Focus on growth (organic and acquisitions) - **25-45%**: Improve margins and working capital turnover - **Below 25%**: Focus purely on margin improvement You can read more here: [[Bergman & Beving]] ---