What do investors seek when they purchase shares in a public company? In a word, growth.
They want to see growth in sales and revenue, growth in profits, growth in market share and, as a result, growth in share price.
Companies employ many different strategies in order to grow, but they are primarily broken into two categories: organic and inorganic.
When companies report organic growth, this means they have boosted their size, revenue or market penetration by growing their own businesses and developing new ones. Inorganic growth, meanwhile, comes through the acquisition of other companies. Most companies seek to grow using a mixture of both approaches.
Organic Growth and Its Pros and Cons
When people refer to organic growth, they are essentially referring to growth stemming from a company’s own operations. For example, if a company is in the business of making and selling soft drinks and sees sales of those beverages grow by 10%, that’s considered organic growth.
When companies report earnings figures, they will often break out pieces of information to show the growth of internal sales and revenue. It’s common for a retailer such as Walmart, for instance, to report same-store sales from one quarter or one year to the next, and point to revenue from the opening of new stores.
If you see a company with consistently strong organic growth, it’s generally a sign that the firm has a solid business plan and is executing it well. However, it is often hard for a company to achieve rapid overall growth through internal operations alone. It’s also difficult for companies to quickly respond to changes in market conditions and consumer preferences.
Consider the example of the soft drink company. As long as people continue to buy and enjoy soft drinks, organic sales may continue to grow. But what if customers start to prefer flavored iced tea instead of soda? Then the company is faced with a choice. The company could develop and launch a line of iced tea products, but this could take time and involve a great deal of expense. That’s why companies will turn to acquisitions—inorganic growth—to maintain their competitive edge and keep shareholders happy.
Inorganic Growth and Its Pros and Cons
Let’s say the soft drink company above is losing its market share in the beverage sector because customers are gravitating to flavored iced teas. The CEO of the soft drink company could decide to launch a new product line but instead directs the company to spend $1 billion to acquire the world’s largest iced tea manufacturer. Almost overnight, the company’s market share is restored.
This happens all of the time in corporate America, as companies look to acquire other companies in order to move into different product lines and respond to market conditions.
But acquisitions are not without risk. It takes a lot of work and expense to integrate one firm into another, and the companies are often not a perfect fit. Stories abound of high-profile acquisitions that result in the purchased company being spun off or shuttered entirely.
In the case of the soft drink company, what happens if consumer tastes shift again, from iced tea to energy drinks? Suddenly, the soft drink company may find that its iced tea revenues are lower than expected, and they may end up reporting a massive loss from the acquisition.
The Investor’s View
An investor could argue that growth is growth. Why should you care if growth comes organically or inorganically, as long as the company is growing shareholder value?
This is a defensible view, but investors should still take time to understand the risks and potential rewards of each approach and pay attention to broader trends on the company’s balance sheet.
By way of illustration, imagine you are an investor in the soft drink company above, and you see that its last annual report shows a 25% increase in revenue. That’s great, right? It certainly could be. But what if all of that revenue growth came from because the company acquired the ice tea company? What if the company’s core business of soft drinks saw a 15% decline in sales, with no apparent hope of rebounding?
Inorganic growth and acquisitions are not necessarily bad things, but they can mask problems with the company’s internal growth.
Investors should also take note of the type of acquisitions that a company may be making. It certainly makes sense for a soft drink company to buy a maker of iced tea. But what if the company buys a large brewery? Can investors be confident that the company is prepared to enter the alcoholic beverage space? And what if the company acquires another firm that is not in the beverage space at all?
Business consulting firm McKinsey & Co. recommends that companies seek a healthy combination of organic and inorganic growth, and that investors should see the logic behind the decision making.
Ideally, an investor should seek companies that are succeeding in all areas, generating strong growth from their core businesses and boosting revenue and expanding through smart acquisitions that complement organic growth.
“Our conclusion is that acquisition programs should be robust, and they must build on the core business,” McKinsey said. “It’s the combination of organic and inorganic growth that allows companies to survive and delivers excess total return to shareholders.”