Sep 18, 2010

THE GROWTH CORRIDOR: FINANCIAL THRESHOLDS TO OPTIMUM FIRM EXPANSION


Abstract: One of the most controversial issues in the growth literature is whether there is an optimal growth rate that maximizes firm performance. Contrary to prior research, we argue that optimum growth rates are firm-specific and, as such, cannot be established across whole populations of firms. Drawing on financial theories, we develop a model of optimum firm growth. Our research suggests that there are firm-specific corridors of optimum growth and that  they  may  have  a  significant  effect  on  firms'  long  term-performance.  Our  research  shows  that  a  company’s minimum  growth  requirement  results  from  shareholder’s  earnings  expectations  and  that  the  upper  boundary  of growth is defined by the firm’s sustainable growth rate.

THEORY DEVELOPMENT AND HYPOTHESES

Introduction
Managerial practice as well as academic research has linked firm growth to various benefits. Growth is regarded
as essential if companies are to remain vital and competitive (Drucker, 1973; Robins & Wiersema, 1995). At the same time, firm growth has been related to increasing complexity and various managerial problems. Studies have shown  that  excessive  growth  can  destroy  shareholder  value  and  adversely  affects  profitability  (Baumol,  1962;
Hedberg,  Nystrom,  &  Starbuck,  1976;  Richardson,  1964;  Whetten,  1987).  There  is,  nevertheless,  inconclusive
empirical  evidence  regarding  the  relationship  between  growth  and  performance.  While  some  studies  have  found support for a curvilinear relationship (e.g. Ramezani, Soenen, & Jung, 2002), others revealed a positive and linear effect (e.g. Miedich & Melicher, 1985), or no significant linkage at all (e.g. Markman & Gartner 2002). From these inconsistencies, the questions arise as to whether there is an optimum pace of growth, and if so, how this optimum rate can be determined.

Growth and Firm Performance
The most relevant explanation for previous inconclusive findings may be traced back to the practice of classifying growth  rates  across  companies  and  industries  into  normal,  high,  and  hyper  growth  (e.g.  Markman  and  Gartner, 2002). However, various researchers have argued that firms ability to growth is contingent on their unique resource base and market conditions (i.e., Penrose, 1959; Porter, 1980; Slater, 1980). It is thus more likely that the relativdegree of growth is contingent upon firm-specific characteristics, rather than being valid and applicable to firms in general. Consequently, we assume that the level of optimum growth varies from company to company and cannot be established across whole populations of firms.

Determinants of Firm Growth
Researchers  in  the  field  of  management  generally  accept  that  a  firm's  resource  endowment  is  one  of  the  main determinants of its ability to grow (Mishina, Pollock, & Porac, 2004). Two broad types of resource categories have been  discussed:  financial  and  human  resources  (e.g.  Bamford  et  al,  1999;  Cooper  et  al.,  1994).  Studies  from the finance literature emphasize the role played by financial resources in enabling and curtailing growth (Clark et al, 1989; Higgins, 1977; Kyd, 1981).
Financial growth requirements. From a financial market perspective, firms’ growth requirements are determined by the shareholders long-term earnings growth expectations, which are inherent in the firm’s current market value Koller et al, 2005: 74). Empirical findings suggest that there is a reward for meeting or beating expectations and a penalty for failing to do so (Kasznik & McNichols, 2002; Skinner & Sloan, 2002). While the premium is relatively small  in  the  short  term,  there  is  a  significantly  greater  return  for  firms  that  consistently  meet  expectations  over several years (Kasznik & McNichols, 2002). A firm's minimum growth requirement may thus be determined by the rate of expected sales growth (ESG): the annual percentage increase in sales required (after considering the firm’s growth with regard to its net income) to meet market expectations. Growth consistently below ESG will negatively affect firm returns.

Hypothesis 1: Firms that achieve long-term sales growth greater than their rate of expected sales growth outperform firms growing below this rate.

Financial  growth  limits.  Over  the  years,  the  finance  literature  has  presented  numerous  models  with  which  to measure the growth that a firm, given its operating and financial constraints, can sustain (i.e., Babcock, 1970; Clark et al, 1989; Higgins, 1977, 1981; Kyd, 1981; Varadarajan, 1983). Sustainable growth refers to the maximum annual increase in sales that can be achieved based on target operating, debt, and dividend payout ratios (Van Horne, 1997: 743). If a firm grows at a faster rate than its sustainable growth rate (SGR), it will be forced to increase its debt ratio, decrease dividends, or issue new equity. Research has shown that all three options are limited, usually to the detriment of financial soundness. Excessive growth, defined as growth above the firm’s financial means, is thus regarded as a main reason for insolvencies (Probst & Raisch, 2005). While growth above the SGR may be detrimental, sales growth that remains below the SGR allows the firm to increase its dividends, reduce its leverage, and build liquid assets (Higgins, 1977; Varadarajan, 1983).

Hypothesis 2: Firms that restrict their long-term sales growth to the limits set by their sustainable growth rate outperform firms growing above this rate.

The optimum growth corridor. Research has also indicated that firms’ expected sales growth (ESG) and sustain- able growth (SGR) rates are closely interrelated. Studies from behavioural finance suggest that market overreaction and underreaction may lead to irrational price deviations (Abarbanell & Bernard, 1992; De Bondt & Thaler, 1985).
If the SGR slips below the ESG, firms have to choose between two suboptimal growth strategies: First, the firm may limit its actual growth to the SGR, which is likely to disappoint shareholders and to cause declining stock prices (i.e., Kasznik & McNichols, 2002). Secondly, the firm may continue to grow above its ESG, preserving its short- term valuation  at  the  cost of increasing  its  long-term risk.  Both growth  strategies  are  thus  likely  to  contribute  to declining market performance. Firms are clearly better off when the SGR exceeds the ESG, providing the potential
for sustainable growth at or above the shareholders’ expectations.

Hypothesis 3: Firms with a long-term SGR above the ESG outperform firms that lack this corridor of growth.

If there is a growth corridor, firms should pursue sales growth above the ESG, but within the limits set by the SGR. As discussed above, growth below the ESG has been related to declining return to shareholders, while growth above the SGR has been linked to increasing debt and the risk of bankruptcy.

Hypothesis 4: Long-term sales growth exceeding the ESG but remaining within the limits set by the SGR, is linked to superior performance.

RESULTS
To test our hypothesis, we employed a quantitative empirical research design. We drew our sample from the firms listed in the Fortune 500 index for 2005. Our reference timeframe comprises the ten years between 1995 and 2004.

Analysis.  To  test  our  first  three  hypotheses,  we  examined  the  difference  in  the  mean  of  the  total  return  to shareholders with regard to firms growing above and below ESG and SGR as well as the mean of those company's whose SGR exceeds ESG and those that lack this corridor of growth. To test the fourth hypothesis, we compared the differences in the mean of firms whose sales growth exceeds the ESG, but remains within the limits set by the SGR with that of firms that fail to meet these conditions.

Results. Our results clearly indicated that the long-term performance of firms growing above ESG is significantly higher than the performance of those firms that grow below ESG. By testing hypothesis 2, we verified that firms growing above the SGR yield significantly lower long-term performance than firms growing below the SGR. The results for Hypothesis 3 showed that the first group’s performance is significantly higher than that of the second group. Finally, we found a significant difference in the long-term performance of firms growing within the corridor of sustainable growth and those who don't. In sum, our preliminary results provide support for all four hypotheses.

CONCLUSION
Besides having provided a tool for managerial practice, the findings of this study have important implications for corporate growth and organizational change theories. Prior research on corporate growth has mainly focused on the directions and modes of corporate growth. In this study, we suggest a third dimension: the pace of growth. Prior research has largely neglected this aspect of firms’ growth strategies. However, some recent studies have indicated that  pace  may  indeed  matter,  and  found  pace  to  be  an  important  moderator  of  the  relationship  between  growth directions or modes and performance (e.g. Chang, 1995; Hayward, 2002; Pettus, 2001; Vermeulen and Barkema,
2002; Wagner, 2004). In a more general context, our study contributes to recent studies on the pace of organizational change. Traditionally, such studies support fast change as being beneficial in overcoming unproductive inertia in firms’ mental maps and routines (Barkema & Vermeulen, 1998). Firms that develop too slowly are expected to fall behind as their rivals race ahead. However, since a firm’s capacity to expand and absorb new experiences is limited,
the pace of change may also become too high (Cohen & Levinthal, 1990; Perlow, Okhuyson, & Repenning, 2002). Our study contributes to this research by providing concrete limits to firm expansion’s optimum pace.

http://sandiego.strategicmanagement.net/handouts/b5dac82f70ef0cd0008dfb93b81fe07fThe%20Growth%20Corridor%20Handout.pdf

Reactions:

0 comments:

Post a Comment