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  • CFO Magazine

Spend or Cut?

A new metric helps CFOs deal with an old dilemma: whether it makes sense to invest in growth or to cut costs.

Most companies, most of the time, think they know when to cut and when to spend. But this is a peculiar time for American business, as companies watch their cash continue to build up even as they keep cutting costs (and tiptoe back into M&A?).

Enter Nathaniel Mass, a senior fellow with the consultancy of Katzenbach Partners and managing director of N.J. Mass Associates, an investment-banking and advisory services firm in New York. Mass has devised a metric to help finance executives make more-informed spend-or-cut decisions. Known as the relative value of growth (or RVG), the metric compares the amount of shareholder value a company creates through revenue growth with that generated by margin improvement. In theory, this helps managers align their decisions more closely with investor expectations and create more shareholder value. “RVG measures the economic incentive for a company to grow versus reduce costs,” says Mass.

The apparent trade-offs between revenue growth and profit margin may lead managers to assume that additional amounts of either yield about the same gain in shareholder value. RVG reveals the difference, which is why Mass insists such a metric is needed. What’s more, the former McKinsey consultant argues, this measure shows that growth and margin are by no means incompatible, dispelling another misconception he says too many managers share. Mass goes so far as to suggest that RVG can enable financial managers to spot flaws in their strategies, target their investments, and cut costs more effectively, down to the level of specific products and services.

To compute RVG, it is necessary to estimate the average growth expectation of a company’s shareholders. Mass does that by establishing a discounted-cash-flow model, essentially an equation in which one side equals a company’s enterprise value (market capitalization plus the value of outstanding debt) and the other equals its sustainable cash flow divided by its weighted average cost of capital (WACC) minus investors’ growth expectations, where the only unknown is those expectations. Once Mass solves the equation and arrives at the company’s expected (or “embedded,” in Mass’s parlance) growth rate (EGR), he can apply that to the company’s revenue to calculate the enterprise value of one additional percentage point of cash-flow growth. Next, Mass calculates the enterprise value of a one-percentage-point improvement in margin by dividing the additional cash flow that improvement would produce by the difference between the company’s WACC and its EGR. Finally, he creates a ratio of the two values, dividing the amount that one percentage point of growth produces by the amount one percentage point of margin produces (see “Calculating RVG,” below). Generally speaking, the higher the ratio of the two, the more a company should emphasize growth, and the less it should seek cost savings — and vice versa. With an RVG over 2, you can think about growth strategies.

RVG, Meet P&G

Consider, for example, RVG’s application to Procter & Gamble’s 2004 results. Based on the company’s enterprise value of $157 billion, 8 percent WACC, and $5.6 billion in sustainable cash, Mass finds that P&G would gain $53 billion in shareholder value from a one- percentage-point increase in revenue, versus $7.35 billion in extra shareholder value produced by a one-point gain in margin. The former is 7.2 times more shareholder value, so P&G’s RVG is 7.2.

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