Revenue Growth and ROIC Are All That Matter

And they both matter about equally

In discussions I’ve had, there has been disagreement about the right goals to set for companies; therefore, there’s been disagreement about the role that strategy should play.

Two of the most common mentalities I’ve come across are “let’s skip any real innovation investments—we need to improve the bottom line this quarter” or, “let’s grow revenue at all costs.” Both are wrong and both represent a loss of focus on the right long-term goal.

The goal of companies = long-term value creation driven by solid strategy.

Long-term value creation is a function of two pillars working together: revenue growth and return on invested capital (ROIC). ROIC = annual net profits / total invested capital.

If you don’t like those two terms, P&G has a corporate measure that they call operating TRS (total return to shareholders). It is a mix of revenue growth, profit margin improvement, and an increase in capital efficiency. It appears to include the same core components.

Revenue growth
Only revenue growth that preserves ROIC leads to long-term value creation. The authors of the McKinsey classic finance book, Value, rank the unique types of revenue growth in terms of their ability to generate long-term value creation.

The most valuable forms of revenue growth come from creating new products and new markets (e.g., Blue Ocean Strategy) and attracting new customers to a market. In the middle are bolt-on acquisitions. The least valuable forms of revenue growth come from large acquisitions and market share battles based on marketing, pricing, and incremental product updates.

Building wholly new products and developing new markets are the fundamental building blocks of long-term value creation. Business development, marketing, and product management are important, but they support—and not overtake (as often happens in large companies)—the company’s strategy, innovation, and R&D engines.

What is ROIC? Annual profits divided by the capital (e.g., all shareholder’s equity that is not sitting in a bank) invested in the business. ROIC increases through lasting improvements in profit margin and/or reducing the capital locked up, such as through a reduction in servers or physical plant footprint.

What drives ROIC? Your competitive advantage—i.e., the things you do uniquely well.

If you’re an established company, knowing where and why you are profitable will tell you where your sources of competitive advantage are—and thus be a significant starting point for building a future strategy.

For startups, your initial competitive advantage often comprises your unique customer insights, your own development skills, and your ability to build something others can’t copy. Once you build an integrated set of systems serving your customers, such as through learning loops, that complete set of unique processes becomes harder to mimic.

Improving ROIC matters a bit more than growing revenue… but the magic happens when you can do both
In 2018, McKinsey’s strategy practice determined the relative impact of these two levers on economic profit.

In short, the general odds are 8% for a company to move from being in the middle to being a top performer. But the odds of doing so are 19% if you outperform in both ROIC and revenue growth.

Outperforming on ROIC alone (e.g., becoming more cost efficient without growing) keeps you at 8%. Outperforming on growth but underperforming on ROIC (e.g., scaling your business when you are not ready to do so efficiently), has just a 4% chance of upward mobility—and it comes with a 25% chance of slipping into being a bottom performer.

Venture Capitalists say the same thing in a different way
When we were raising money for, and then selling, our last company, we talked with many investors about what creates higher valuations. The summary of those discussions was that there are four primary factors and two additional ones. In order of importance:

  1. High revenue growth. If you are growing at 40% or more annually, you’re in a “hypergrowth” category which will command a premium. This is aligned with the “Revenue Growth” category above.
  2. Quality of revenue. High renewal rates are important. If you are B2B and are able to sign two-to-three-year term contracts, that is highly valued. SaaS platform revenue as a concept is highly valued as sustainable revenue (as opposed to, say, consulting, where every year all of the revenue has to be created anew). This is aligned with the “Revenue Growth” category by adding the additional detail that companies that are well situated to prove future revenue growth is inevitable will be valued higher.
  3. Is there a clear moat around the business? Barriers to others disrupting or replicating your business are investigated. This is aligned with both “Revenue Growth” and “ROIC” stability: what are the chances that a competitor or supplier can force the company to lower prices, lose customers, or accept higher costs and therefore lower margins?
  4. Is there a continued path to scalable growth? Low per-unit cost implies the company will become more profitable as volume grows. This is directly aligned with the “ROIC” category. In other words, investors give revenue growth precedence over ROIC, but both comprise all the major areas that they care about.
  5. Next in line, but much lower on the list of importance, is the strength of EBITDA and cash flow. In other words, was a major fixed cost investment made that the company is now paying off with annual cash flow? High invested capital of course lowers ROIC and so this one is aligned with that category.
  6. And finally, is there a larger market this company can go after as part of a future growth story? In other words, is revenue growth limited or could it realistically keep growing and growing?

Focus on the long-term profitable growth, not one or the other in the short-term
Make smart decisions and fight hard for the most profitable (but perhaps lower revenue) pockets of the market. Over time, you will become stronger and more able to serve your customers; the pure revenue-chasing competitors will fall. The goal of strategy is not to squeeze out a few more dollars or a few points of market share this year. It is about finding the large new profitable growth opportunities over the coming years.

Returning to the perennial favorite strategy case study, Southwest Airlines. Their founder and CEO Herb Kelleher pointed out that other airlines would allow their costs to increase by 25% to gain an incremental 5% of market share. Why do that? Focus on the customers you’ve chosen to serve and focus on profitability; don’t torque your business away from your core value proposition, he argued.

Michael Porter addresses this issue head-on as well: “The desire to grow has perhaps the most perverse effect on strategy… inconsistencies in the pursuit of growth will erode the competitive advantage a company had with its original varieties or target customers. Attempts to compete in several ways at once create confusion and undermine organizational motivation and focus. Profits fall, but more revenue is seen as the answer… the growth imperative is hazardous to strategy.”

And this: “Gaining ten percent share in another segment where you have no advantage will often damage your profitability.”

You can set financial targets if you like. But a target cannot define a strategy. Strategy is about how you are going to fulfill a customer’s need in a unique way. You can then determine if executing the strategy will get you to your target or not.

Don’t allow yourself to chase revenue growth at the expense of lowering ROIC.

Chet Richards, a disciple of military strategist Col. John Boyd agrees: “The simplest business strategy is to grow: A competitor makes an acquisition, so we make a larger one… The idea is that once a company achieves sufficient market share, it can dictate the terms of the competition… Players using this strategy included such famous names as SwissAir, Enron, WorldCom, and AOL.”

Why is this important to emphasize? Because the early goal of startups is to get revenue. Until you have paying customers, you really have nothing at all. Startups need time to get to that point and, later, to profitability.

The moral is: go after the revenue when you have to. But whenever there’s a choice between mindlessly growing revenue versus protecting or growing profitable revenue, the latter must be your north star.

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All books and other resources referenced in this article