The right kind of growth

Companies are rewarded for growth with higher share prices. However, this creates an incentive for managers to “fake” growth by loading up on additional debt or raising additional equity that creates capital that cannot be employed with sufficiently high returns. Professional investors and analysts have learned to be sceptical of asset growth, particularly if it is fuelled by debt. And indeed there is plenty of evidence that companies with stronger growth in total assets or total equity have lower returns in the future.

But a new paper has managed to come up with a way to strip out unhealthy growth from companies’ balance sheets. What the authors do is to start with the growth in total assets of a company and peel away all the layers from financing activities and other accounting measures to end up with something they call operational growth. In particular, they start with total asset growth and subtract growth in debt and growth in total equity. Then they also remove growth in taxes payable and deferred taxes since this has nothing to do with the operational performance of the company. Finally, they subtract any changes in accounts payable since these are dominated by small routine purchases that have little information content about long-term trends. What is left, is what they call operational growth and it is in effect the growth in tangible and intangible assets finance by vendors, customers, and contractors.

And now comes the fun part. Because this growth is due to the operational activities of a company, it is highly predictive of next year’s earnings growth of a company and its share price return. The chart below shows both the raw share price return in the year after a company publishes its annual report and the abnormal return corrected for valuation, size, momentum, and other systematic effects. And while the effect is stronger for smaller companies, the research shows that it is still economically large in medium-sized and large-cap companies. So, this measure of operational growth is something professional investors should pay more attention to.

Share price return as a function of operational growth

Source: Cao et al. (2021)