38  Fundamental Principles of Value Creation Growth strategies based on organic new-product development frequently have the highest returns because they don’t require much new capital; com- panies can add new products to their existing factory lines and distribution systems. Furthermore, the investments to produce new products are not all required at once. If preliminary results are not promising, future investments can be scaled back or canceled. Acquisitions, by contrast, require that the entire investment be made up front. The amount of up-front payment reflects the expected cash flows from the target plus a premium to stave off other bidders. So even if the buyer can improve the target enough to generate an attractive ROIC, the rate of return is typically only a small amount higher than its cost of capital. To be fair, this analysis doesn’t reflect the risk of failure. Most product ideas fail before reaching the market, and the cost of failed ideas is not reflected in the numbers. By contrast, acquisitions typically bring existing revenues and cash flows that limit the downside risk to the acquirer. But including the risk of failure would not change the pecking order of investments from a value- creation viewpoint. The interaction between growth and ROIC is a key factor to consider when assessing the likely impact of a particular investment on a company’s overall ROIC. For example, we’ve found that some very successful, high-ROIC com- panies in the United States are reluctant to invest in growth if it will reduce their returns on capital. One technology company had a 30 percent operating margin and ROIC of more than 50 percent, so it didn’t want to invest in projects that might earn only 25 percent returns, fearing this would dilute its average returns. But as the first principle of value creation would lead you to expect, even an opportunity with a 25 percent return would still create value as long as the cost of capital was lower, despite the resulting decline in average ROIC. The evidence backs this up. We examined the performance of 157 companies with high (greater than 20 percent) ROIC over two time periods: 1996–2005 EXHIBIT 3.8  Value Creation by Type of Growth Shareholder value created for incremental $1.00 of revenue, $1 Introduce new products Expand an existing business Increase share of a growing market Compete for share in a stable market Acquire businesses –0.5 0 0.5 1 1.5 2 2.5 1 Value for a typical consumer packaged goods company. Implications for Managers  39 and 2010–2017.7 Not surprisingly, the companies that created the most value, measured by total shareholder returns, were those that grew fastest and main- tained their high ROICs (see Exhibit 3.9). But the second-highest value creators within this group were those that grew fastest even though they experienced moderate declines in their ROICs. They created more value than companies that increased their ROICs but grew slowly. We’ve also seen companies with low returns pursue growth on the as- sumption that this will also improve their profit margins and returns, rea- soning that growth will increase ROIC by spreading fixed costs across more revenues. As mentioned earlier in this chapter, however, except at small start- up companies, faster growth rarely fixes a company’s ROIC problem. Low re- turns usually indicate a poor industry structure (as is the case with airlines in Europe and Asia),8 a flawed business model, or weak execution. If a company has a problem with ROIC, the company shouldn’t grow until the problem is fixed. The evidence backs this up as well. We examined the performance of 110 low-ROIC companies (the right column in Exhibit 3.9). The companies that 7 B. Jiang and T. Koller, “How to Choose between Growth and ROIC,” McKinsey on Finance, no. 25 (Au- tumn 2007): 19–22. Updated to include 2010–2017 data by the authors of this book. EXHIBIT 3.9  Impact of Growth and ROIC on High- and Low-ROIC Companies Median annualized TSR vs. S&P 500, 1996–2005 and 2010–2017, % –3 0 2 6 Increased Decreased Increased Decreased –7 –2 4 3 Above average Above average Below average Below average Change in ROIC Companies with ROIC over 20% Companies with ROIC of 6%–9% Growth Performance, by high vs. low ROIC Drivers of performance Source: B. Jiang and T. Koller, “How to Choose between Growth and ROIC,” McKinsey on Finance, no. 25 (Autumn 2007): 19–22. Updated to include 2010–2017 data by the authors of this book. 8 Airlines have traditionally suffered from overcapacity and lack of differentiation, leading to price competition and low returns. Recently, U.S. airlines, after a wave of consolidation, have been disci- plined about adding capacity and creating ways to charge for services, like checking bags, with the result that returns on capital are higher than in the past.