LEVEL OF GROWTH AND ACCOUNTING PROFITABILITY



LEVEL OF GROWTH AND ACCOUNTING PROFITABILITY

IN CORPORATE VALUE CREATION STRATEGY

By

Erni Ekawati

ABSTRACT

This research examines associations between level of growth and accounting profitability drawn from corporate value creation strategy. Results demonstrate that although the accounting profitability measures generally rise with sales growth, an optimal point exists beyond which further growth contributes to value destruction and adversely affects profitability.

I. Introduction

Investment industry demands that managers have to maximize the company’s sales or earning growth over time. This presumption is based on the belief that growth can increase the accounting profitability, and is synonymous with shareholder value creation. Corporate strategies can then be assessed in term of their expected effect on accounting profitability and growth. As a consequence, traditional incentive schemes of compensation is often tied to the manager’s ability to beat budgeted increase in sales or earnings as measures of growth and in turn increasing accounting profitability ratios, such as return on equity, return on assets, and return on investment.

This view contrasts with perspectives that accounting profitability ratios alone cannot be used as an indicator of a profitable business. As Hax and Majluf (1984: 214) point out that it is economic, and not accounting profitability that determines the capability for wealth creation on the part of the firm. It is perfectly possible that the company is in the black, and yet its market value is way below its book value, which means that, from an economic perspective, its resources would be more profitable if deployed in an alternative investment of similar risk.

Based on the financial management perspective, the ultimate goal of the company is to maximize shareholders’ wealth by maximizing the firm value. The indicator of firm value is stock price. The higher the stock price the higher the value of the firm. Value must be created through company’s business over time in order to reach the maximum value of the firm above the book value.

Value creation strategy provides a conceptual and operational framework for evaluating corporate strategies (Albert and MacTaggart, 1979 and Fruhan, 1979). This strategy establishes firm value using two determinants of value, namely, growth and profitability. Interest in value creation strategy is increasing in practices. In fact the use of bonuses tied to market value of company stock, as opposed to the traditional incentive scheme using accounting profitability only, has made value creation a priority issues in many firms. In addition, academicians have considered value creation issues related to company sales and asset growth in order to maximize the value of the firm (Fruhan, 1984, Higgins and Kerin, 1983).

Ramezani, Soenen, and Jung (2002) found that maximizing the growth of sales or earnings is not identical to maximizing profitability and in turn maximizing the value of the firm. The ability of the company to determine the optimal growth of sales or earnings could drive the company through maximizing the value of the firm. Value creation could be obtained along the way up to reaching the optimal growth rate. The further growth rate would not contribute to the value creation. This finding was consistent with Fuller and Jensen (2002) warning about the dangers of conforming to market pressures of growth.

This research is concerned with three broad questions that are of considerable theoretical and practical interests. First, what is the effect of sales growth on measures of corporate profitability? Second, how are the combined sales growth and profitability influenced the company’s value creation strategy? Third, is the optimal growth rate to maximize profitability the same as that of to maximize the value of the firm? Understanding the nature of these effects will shed light on whether an optimal growth rate that maximizes profitability exists, and whether the optimal level of the growth rate is different from that of for maximizing firm value. If the level of growth is different within two conditions of profit and value maximization, managers should choose the level of growth that maximizes the value of the firm. Above the optimal level of growth the company will not generate value creation but value destruction.

Despite the apparent popularity of value creation strategy, its empirical validity has yet to be demonstrated for Indonesian companies. Without comprehensive empirical validation, managers may justifiably be skeptical of the viability of value creation strategy, as a framework for choosing among strategic alternatives. Empirical evidence related to the relationships between growth, profitability, and value creation of US companies are available (Varaiya, Kerin, and Weeks, 1987; Shin and Stulz, 2000; Ramezani, Soenen, and Jung , 2002; Fuller and Jensen, 2002). All the results are consistent that the level of optimal growth rate exists to maximize the value of the firm. However, evidence from companies in emerging market is hardly found. It is possible that under inefficient market condition, the measure of value derived from the capital asset pricing model may not reflect the fair value of the company. Therefore, should the same phenomena be empirically found from companies in emerging market, the study would indirectly provide the test of indication of emerging market following efficient market behavior. Using Ramezani, Soenen, and Jung (2002) methodology, this study would provide an additional empirical evidence from public companies listed in Jakarta Stock Exchanges, one of emerging markets in Asia, and demonstrate whether the similar phenomena applies.

II.Theoretical Background and Hypotheses Development

A. Growth and Profitability

Product life cycle concept is used to explain the relationship between growth and profitability. Products move through four identifiable phases-introduction, growth, maturity, and decline. During the introduction, a firm focuses on product development and market development. The objective is to gain market acceptance. During the growth phase, the focus move to enlarge capacity and increase market share. During maturity phase, as competition becomes more intense, the emphasis shifts into reducing costs through improve capacity utilization (economies of scale) and more efficient production process. During the decline phase, firms exit the industry as sales declines and profit opportunities diminish. In line with the product life cycle explanation, the sales growth will reach the optimal level on the third phase or maturity in which the growth of sales will maximize profit. Beyond the maturity phase, the further growth will diminish profit. However, due to the traditional incentive schemes of compensation that is tied with the growth of sales or earnings, managers tend to push the growth beyond the optimal point. Managers should have slowed down the growth when reaching the maturity stage. They should have started to plan some other alternative lines of business before it will be too late to quit from the existing business. Unfortunately, the growth tied incentive scheme inhibits managers to take preventive action to maintain the right level of profitability.

Selling and Stickney (1998) found that profitability measured as return on asset (ROA) differed across time and through time as product pass through different stages in their life cycles. Ramezani, Soenen, and Jung (2002) tested the effect of sales growth on company’s profitability. In their study, the sample of the companies are sorted into four quartiles based on their growth of sales and earnings. The results indicated that the companies’ profitability increased as the growth of sales increased. However, on the fourth quartile, declining on profitability occurred as sales continued to grow. This study shows that there is an optimal growth that should be reached before diminishing profitability occurred. The enforcement of further growth beyond the optimal level resulted in even more diminishing profitability. Accordingly, the following hypothesis is stated:

H1: Up to some certain level, increase in sales growth will increase corporate profitability, however, beyond the optimal level increase in sales growth will have a reversed effect.

B. Growth and Value Creation

Growth requires additional investment on operating assets and working capital. To ensure that the growth of sales results in value creation for the company, each additional investment project must have a positive net present value (NPV) of expected future net cash flows after initial investments. Project having a positive NPV would contribute to the stock price increase (Mc. Connel and Muscarella,1985). The increase of the stock price will increase stock return. The increase of stock return above the required rate of return will increase stockholders wealth beyond their expectation, termed as abnormal return. Thus, abnormal return can be used as a measured of company’s value creation which is the difference between actual return and expected return.

Further study by Mitra, Owers, and Biswas (1991) showed the relationship between NPV of expected net cash flows and stock price. Tobin’s q method was used to determine whether the company was a “value creator” or “over investor”. The “value creator” company with the Tobin’s q ratio greater than 1 experienced an increase in the stock price as the company invested in the new project. On the contrary, “over investor” company indicated by Tobin’s q ratio (less than 1) experienced a stock price decline as the company decided an additional investment, while divestiture could increase the stock price.

These findings show that the relation between growth and value creation follows a similar direction as the relation between growth and profitability. Accordingly, the following hypothesis is stated:

H2: Up to some certain level, increase in sales growth will increase corporate value creation, however, beyond the optimal level increase in sales growth will have a reversed effect.

C. Accounting Profitability and Value Creation

Literatures in financial management claimed that the goal of a company to maximize accounting profitability is not synonymous with that of to maximize the value of the firm.

This contention is based on some limitations exposed by the measures of accounting profitability such as return on equity (ROE), return on asset (ROA), and return on investment (ROI). The limitations are claimed due to the use of accounting profit which does not fully reflect cash flows, and the ignorance of cost of capital consideration required to create profit. However, based on the previous studies (Dodd and Johns, 1999; Garvey and Millbourn, 2000; Chen and Dodd, 2002), profitability ratios had a positive relationship with stock prices. Should profitability ratios have a positive relationship with stock prices, the level of growth maximizing the profitability should be the same as that of maximizing the value of the firm.

However, the weaknesses on the accounting measures of profitability ratios will direct into a conjecture that the level of growth that maximizes the value of the firm may not be the same as that of maximizing the company’s profitability. This notion is based on the consideration of ignoring the cost of capital in the computation of accounting profitability ratios. Varaiya, Kerin, and Weeks (1987) used the term spread to identify the ROE minus cost of equity capital, in which positive spread would contribute to the values creation, while negative spread to value destruction. Thus, increase in ROE alone would not guarantee to the increase in firm value. They empirically demonstrated the combination of expected growth and expected positive spread that are associated with higher firm value. This finding suggested that value creation clearly resulted from pursuing growth strategies that were not only profitable but also creating a positive spread. It is possible that the sales or earning growth still contributes to the increase in profitability but not to the increase in company’s value. This condition occurs because additional growth requires higher costs than the benefits created from it. Accordingly, the hypothesis is stated as follows:

H3: The level of sales growth that maximizes the value of the firm is lower than that of maximizing the company’s profitability.

D. Other Factors Influencing Profitability and Value Creation

Previous studies show that there are many factors that influence the company’s performance, whether the performance is measured by profitability ratios or value driven indicators such as economic value added and market value added. This study includes variables that have been cross-sectionally identified by the previous researches affecting the companies’ performance (Philips, 1999; Campbell and Shiller, 1998; Shin and Stultz, 2000; Opler, Pinkowitz, Stulz, and Williamson, 1999). The variables affecting company’s profitability are economic conditions, firm size, market-to-book ratios, price-earning ratios, dividend payments, and operational flexibility, and those affecting value creation are economic condition, firm size, and systematic risk. These variables are included in the analysis as control variables so the effects of growth levels on profitability and value creation can be identified without interfered by other factors that have been identified by the previous researches affecting the variables being studied.

III. Research Method

A. Data and Sample

The companies used as sample in this study are public companies listed in Jakarta Stock Exchange from the year of 1998 to the year of 2002. The periods being included in the sample are based on the availability of the capital market data from Accounting Development Center of Gadjah Mada University, and financial data from Indonesian Capital Market Directory. Following the standard practice, companies’ data from utilities and financial industry are excluded. The purposive sampling procedures are used to determine the companies being included in the sample. The criteria used are as follows:

- The company has to be listed until the year 2002.

- The companies’ financial statements and the data required to compute all the operational variables must be available.

There are 493 companies meeting the required criteria.

B. Data Analysis Procedures

For each year data in the sample, the companies are placed into quartiles based on their sales growth. The first quartile contains the companies with the lowest level of sales growth, the second quartile with the higher level and so forth. The sales growth on year t is measured by the average annual sales growth for the last three years (year t-3 to t). Some companies could move from one growth quartile to another from year to year. To ensure the persistence of the result, persistent sample is formed. Persistent sample contains only companies that belong to the same growth quartile for within at least three years in a row. There are 224 companies meeting this criteria.

Accounting profitability is measured by the following ratios:

- Return on equity (ROE) = Net Income/Total Equity

- Return on asset (ROANI) = Net Income/Total Assets

- Return on asset (ROAOP)= Operating Profit/Total Assets

ROAOP shows rate of return that come from the company’s business operation only. ROANI measures rate of return from core business activities and other activities such as investment in other companies and contribution of financial leverage. These ratios are computed in the end of each year.

Following Bacidore, Boquist, Milburn, and Thakor (1997), value creation is measured using the Jensen’s alpha derived from capital asset pricing model.

[pic]

[pic] is stock return of company i at period t, [pic] is market return at period t, and [pic] is risk free rate at period t. [pic]is an intercept used as a measure of abnormal return or value creation. One year estimation periods of stock daily return data are used to compute the abnormal return in the end of each year[1]. When alpha is positive, shareholders have received compensation above their risk-adjusted opportunity cost of capital. Conversely, when abnormal returns are negative, they have been inadequately compensated for risk.

Below is the list of variables influencing company’s profitability.

|Variables |Proxy |

|Economic conditions |Dummy variables for each year observation. |

|Firm size |Total sales. |

|Book-to-market |Book value per share /(Price per share x number of shares). |

|Earning-price ratio |Earnings per share/Price per share |

|Dividend payments |Cash dividend per share |

|Operational flexibility |Fixed assets/Total assets |

Expected signs for regression of firm size, dividend payment, and operating flexibility against profitability are positive, while negative signs are expected for book-to-market and earning price ratio.

Below is the list of variables influencing the abnormal return or value creation.

|Variables |Proxy |

|Economic conditions |Dummy variables for each year observation. |

|Profitability |ROAIN or ROAOP |

|Firm size |Total sales. |

|Sistematic risk |Sensitivity of company return to the market return, estimated by one year period |

| |daily return of the company’s stock return against market return. |

Expected signs for regression of firm size, profitability and systematic risk against abnormal return are positive.

C. Model

To investigate the relationship between level of sales growth and company’s profitability, the following multiple regression model is employed.

Model I:

[pic]

where,

ROA: a vector profitability measure in which element represents a company in a particular year (panel data). Two profitability measures are used, namely, ROAIN and ROAOP.

a: the regression intercept. It measures the conditional mean of the ROA for the first quartile in year 1998.

q: a quartile

bq: coefficient differentiating the quartiles. It measures difference in ROA across quartiles after other factors are controlled for. The null hypothesis was that companies in the second through the fourth quartiles are no different from companies in the first quartile; bq= 0 for q= 2, 3, 4.

Dq: 1 for companies in the qth quartile of sales growth and zero otherwise (q= 2, 3, 4).

cy: influence of each year on ROA.

Dy: a dummy variable for the year, Dy= 1 when y= 1999, 2000, 2001, and 2002, and 0 otherwise.

SIZE: firm size as a control variable having impact on ROA

BM: book-to-market ratio as a control variable having impact on ROA

DIV: dividend payments as a control variable having impact on ROA

FXA: operating flexibility as a control variable having impact on ROA

[pic]: regression error

Regression coefficients of Dq are used to test H1. As moved to the higher quartiles the coefficients of Dq should increase then decrease after reaching an optimal level.

To investigate the link between level of growth and value creation, the following multiple regression model is employed.

Model II:

[pic]

where,

[pic]: a vector with elements representing a company’s estimated alpha in a particular year (panel data).

k: estimate of the conditional mean of alpha; it measures difference in value creation across quartiles, after other factors have been controlled for.

[pic]: regression error; it is assumed to be independent identically distributed (i.i.d).

Regression coefficients of Dq are used to test H2. As moved to the higher quartiles the coefficients of Dq should increase then decrease after reaching an optimal level. H3 is tested by observing the difference of the optimal level obtained from Model I and Model II.

IV.Results and Discussions

A. Descriptive Statistics

Table 1 presents a comparison of performance measures, financial attributes, and asset pricing parameters for companies in the sample classified into four quartiles based on sales growth.

Insert Table 1 about here

Each company in the sample could move from one quartile of sales growth to another from year to year. Mean and median of sales growth rate rise across quartiles based on sales growth. The standard deviation sharply rises on the fourth quartile indicating high sales growth rates are accompanied by high volatility.

Performance measures reported are ROE, ROANI, ROAOP, net profit margin (NPM), and operating profit margin (OPM). As expected, the performance measures using ROE, ROANI, and NPM increases as the level of sales growth moves from the first quartile to the third one, however it decreases in the fourth quartile. ROAOP increases up to the second quartile and slowly decreases afterward. OPM increases all the way from the first to the fourth quartiles. Since the sample are driven from the condition of economic crises and recovery periods, there are many companies having negative book value during the sample periods. ROE may not have a real meaning in measuring profitability. Thus, the profitability measures used in the data analysis are ROANI and ROAOP. As hypothesized, the relationship between profitability and sales growth shows highly non linear relationship, on average, the companies in the inner quartiles perform better.

Variables of financial attributes provide broad pictures of firm size, operating flexibility, and future growth potential. High correlations are found between total assets and total sales. As shown in the Table 1, the firm size increases up to third quartile and decreases in the fourth quartile. It resembles an inverted U-shaped across the sales growth quartiles. Operating flexibility as measured by fixed assets/total assets is, on average, similar across quartiles. Book-to-market and earning-price ratios have, on average, negative values, due to many companies having negative book value and earning during the sample periods. This phenomena is attributed to the periods of Indonesian economic recession and recovery. The exclusion of the negative numbers would result in a very small sample size. Therefore, earning-price and book-market ratios rather than price-earning and market-to-book ratios are used to maintain the meaning of these ratios. The measures of these ratios follow Fama and French (1995) study in which they included negative book equity value companies in forming a market portfolio. Table 1 shows that book-to-market and earning-price ratios reach the highest value on the third quartile indicating that the highest growth potential occurs in the third quartile. Further growth beyond the third quartile will no longer be optimal.

Asset pricing parameters presented in Table 1 show measures of value creation attributed by annualized CAPM alpha. As expected, the alpha value increases from the first quartile to the third one and decreases on the fourth quartile. Inverted U-shaped phenomena is also found on the relation between abnormal return and level of sales growth. The systematic risk measured by CAPM beta are similar across companies in each quartile.

B. Results

To further investigate the relationship between level of growth and profitability, the formal test of regression of model I is employed. As shown in Table 2 the regression output lends support to the analysis from the descriptive statistics.

Insert Table 2 about here.

The regression of model I is estimated using ordinary least squares (OLS). Dependent variables used are ROANI and ROAOP. The majority of estimated coefficients are highly statistically significant. A number of diagnostic tests have been performed and the standard OLS assumptions cannot be rejected.

As shown in Table 2, intercept coefficient estimates are conditional mean of either ROANI or ROAOP for companies in the first growth quartile in year 1998 (used as a base value). The coefficients on the other quartile dummies represent the difference of average ROA of the corresponding quartile from the base value. Given this explanation, the coefficient of growth quartile dummies can be interpreted that ROANI increases from Q1 to Q2, reaches the maximum on Q3, and decreases on Q4. The coefficients of Q2, Q3, and Q4 are 4.68%, 8.22%, and 6.68%, respectively. This result supports H1 that profitability (ROANI) increases up to a certain level of growth, beyond that level the converse is true. In this case the optimal level of growth is on Q3. The result cannot clearly be seen from the regression of ROAOP, because the coefficients of growth quartile dummies are risen as moving through the higher quartiles. The coefficients of Q2, Q3, and Q4 are 5.31%, 7.63%, and 7.95% Yet, they still indicate diminishing marginal profitability[2]. Thus, an optimal level of growth exists even though it cannot be shown by the result. The optimal level occurs some where beyond Q4.

To test the persistence of the result due to the possibility of some companies moving from one quartile to another through the years, the regression of model I is also run using persistent sample. The results are robust for both measures of profitability.

All controlled variables have estimated coefficient signs as expected, except for earning-price ratio and book-to-market ratio. Earning-price (EP) and market-to-book (BM) ratios have a positive relationship with profitability. Companies having lower EP tend to have lower profitability. It is suspected that low (high) EP and MB may not reflect the companies’ potential growth but they may indicate market over (under) valuation.

Table 3 shows the results of the regression of abnormal return using ROANI and ROAOP as profitability measures.

Insert Table 3 about here.

Following the previous interpretations, the intercept coefficient estimate are conditional mean of abnormal return for companies in the first growth quartile in year 1998 (use as a base value). The coefficients on the other quartile dummies represent the difference of average abnormal return of the corresponding quartile from the base value. Using ROANI as a profitability measure, the abnormal return reaches the maximum value on Q3. The coefficients of Q2, Q3, and Q4 are 9.51%, 23.60%, and 23.10%, respectively. Using ROAOP as a profitability measure, the coefficients of Q2, Q3, and Q3 are 6.83%, 21.00%, and 19.70%, respectively. The decreasing abnormal return associated with the fourth quartile of growth is again a significant features of the results. Companies in the third quartile have the highest conditional abnormal return for both profitability measures. Moreover, the inverted U-shaped relationship between abnormal return and growth is similar to that of profitability and growth. The persistent sample also shows a similar pattern. This result supports H2 that value creation increases up to a certain level of growth, beyond that level the converse is true.

As expected profitability ratios and measure of systematic risk have a positive significant relationship with abnormal returns. However, firms size have no significant relationship with value creation. The amount of value creation also varies over times as reflected by the significant coefficients of year dummy variables. Thus, economic conditions do have affects on profitability and value creation.

Based on the results of the regression using ROANI as a profitability measure, it seems that the level of growth for maximizing firm value and profitability are the same, on Q3. However, further examinations on the profitability measured by ROAOP could shed light on the possibility of different level of growth that maximizes profitability and firm value. Of the regression of ROAOP, profitability still increases through Q4, and will reach a maximum point some where beyond Q4, but the abnormal return reaches a maximum value on Q3 (See: Table 3). The same result is also found in the persistent sample. This result demonstrates that maximizing accounting profitability does not necessarily enhance shareholders’ value. It is true that accounting profitability measures generally rise with sales growth, yet an optimal level of growth exists, beyond which further growths destroys shareholders’ value. Therefore, this study also provides a support to the H3 that the level of growth that maximizes firm value is lower than that of maximizing profitability.

V.Conclusions and Limitations

The empirical results of this study indicate that maximizing level of growth does not maximize accounting profitability and value creation. On the contrary the companies with moderate growth in sales have the highest profitability and value creation. This empirical findings also demonstrate that the level of growth that maximize the corporate profitability is higher that that of maximizing the value of the firm. Thus, managers should be cautious in planning the level of future growth. The optimal level of growth should maximize the firm value not maximizing the accounting profitability alone.

These results suggest that corporate managers need to abandon the habit of blindly increasing company size, and investors need to carefully consider the drawbacks of diseconomies of scales resulted from pushing level of growth beyond the optimal point. The incentive schemes of compensation should not merely rely on growth and accounting profitability measures. Value creation issues related to company sales and asset growth in order to maximize the value of the firm should be considered. These suggest that measures of value creation such as economic value added, market value added should be developed and become important alternative measures in value creation strategy.

The limitation of this study is the scheme of partitioning the data into quartiles and applying OLS to identify the non linearity of the relationship between growth and either profitability or value creation. An important question that deserves further investigation is what additional factors can be used to discriminate among the quartiles in an ex ante sense. Related to the OLS, another alternative such as nonlinear and non parametric procedures may be worth to examine in the future research.

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[1] The corrected alpha calculation is adopted from capital market database from Accounting Development Center of Gadjah Mada University. The market model is used to derive the alpha.

[2] Marginal profitability is an increase in profitability for each level increase in sales growth.

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