3. How Much Should Companies Focus on Earnings vs. Long-Term Growth?

Is it even correct for large-company management to focus “over the horizon?”

What role do common performance metrics play in guiding company focus and activity?

A debate that rages in the academic literature is also a constant topic of conversation in the HBS classroom: Should managers, and companies, be investing for the long-term growth of the firm, conceiving of successive generations of new organic or inorganic growth, or should they rather exploit the current core business to its fullest and let investors diversify their bets?  Does it depend?  And if so, on what?

Further, what clues can you discern from reported performance metrics concerning the quality of a company’s growth planning efforts?  Are there any indicators you can spot that reassure you about a company’s long-term prospects?  Any that should raise concern?

3 thoughts on “3. How Much Should Companies Focus on Earnings vs. Long-Term Growth?

  1. While there are many different considerations as to whether a management team should focus on near-term versus long-term results, one that is commonly overlooked is the impact of the cost of capital. Assumed costs of capital should be adjusted in accordance with a number of factors, but significant among these factors is the level of investment returns available across markets at any particular time, most easily described by the general level of interest rates. Furthermore, there is a plethora of analysis on company valuation methods, but simply stated, the stock price of a company is roughly equal to the value of its assets, both tangible and intangible, and the earnings those assets can generate over time. During periods of very high interest rates (high costs of capital), the net present value of near term earnings contributes proportionately less to the total net present value of the company, and conversely, during periods of low interest rates – all else equal – near term earnings are less important to overall company valuation. Therefore, a management team should invest proportionately more in long-term projects, less certain innovation, etc during low interest rate periods, as long-term earnings comprise a far greater proportion of the company’s valuation. Interestingly though, during periods of low interest rates such as the environment that exists currently, shareholders become eager for more income because of the general lack of it in this low return environment. This leads management teams to feel pressured to provide more certainty with regard to increasing dividends and/or share buybacks, as opposed to reinvesting profits into the company’s long-term projects that can generate higher net present value long-term earnings. While this is a generalized description of the current behaviors of companies, it is important for both shareholders and management teams to appreciate that their costs of capital should influence their willingness to invest in long-term projects. It is clearly in the true interests of shareholders for management to focus on creating long-term profit streams that come from near-term investments in market-creating innovations, potentially far beyond their own tenure with the company, even if these investments dampen near-term earnings.

  2. The WSJ article on the dismissal of Klaus Kleinfeld from the CEO position of Arconic yesterday (https://www.wsj.com/articles/klaus-kleinfeld-steps-down-as-chair-and-ceo-of-arconic-1492435894) mentions a raging debate in Wall Street over “how to balance a company’s goals for the future with its returns in the present.” It certainly seems that there are just as many loud proponents of long-term growth as there are for quick gains.

  3. I observe SaaS companies focusing their capital on marketing and generating cash flow. The issue probably isn’t so much balancing growth or R&D. The smart companies such as Atlassian (who do not have a salesforce) are building value because every employee is accountable for a segment of the customer journey. The must collaborate to deliver shared outcomes. They must understand their customer’s pain points as a team, and they use their own product to develop solutions.

    At Stone & Chalk, our organisation is also a matrix of functions and products. As a not for profit, our success is dependent on our ability to articulate value for each “market”: Corporate Partners, Government, Startups and Industry groups. With little capital, mutually beneficial relationships underpin our reputation.

    Legacy companies with complex resource structures struggle to innovate, and rely heavily on partnerships to deliver solutions that would be difficult to execute internally. This is the trend we are discovering at Stone & Chalk.

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