It pays to keep your growth targets realistic

When Jeffrey Immelt became chairman and chief executive of General Electric, he set a new growth target: “We believe that GE can grow two to three times faster than world gross domestic product, which translates to about 8 per cent sustained sales growth.” Most chief executives feel the need to announce bold revenue growth targets. But how does top management arrive at these targets?

When we asked several chief executives and chief financial officers of Fortune Global 500 companies this question, the answers were remarkably similar: none had relied on a formal process. One chief executive of a leading European manufacturing company said: “We certainly listen to analysts and have a look at the targets the competition has announced, but in the end we rely on our expertise and gut feeling to set the right targets.”

Setting targets that are too low can have a dramatic impact on a company’s competitive strength and share price. Overambitious targets may drive companies too hard and too fast. But when does fast become too fast?

While traditional growth and investment metrics are useful, our analysis suggests that a new measure is needed. We call it the growth corridor – an indication of how much sustainable growth a company can bear before diminishing returns kick in. A company’s growth corridor can be calculated by following three easy steps.

First, determine the minimum growth threshold, which is based on the average sales growth of the company’s most relevant competitors. Companies need to grow at least as fast as the competition to avoid losing market share. Thereafter, estimate the company’s maximum growth threshold, which indicates the maximum sales growth a business can achieve without borrowing more money. This “sustainable growth rate” is calculated by multiplying the company’s return on equity by the proportion of the earnings that it retains. Companies that consistently exceed the given rate can face serious financial repercussions, such as bankruptcy. Finally, compare the two growth thresholds to the realised sales growth. Wal-Mart had an average competitive growth rate of 5.2 per cent and a sustainable growth rate of 21.4 per cent between 1997 and 2006. Its average sales growth for the decade was 12.7 per cent – within its growth corridor.

By calculating the growth corridors of all the Fortune Global 500 companies over the past decade, we found that companies that grew within their growth corridor limits outperformed their peers that did not. “Smart growers” delivered shareholders an average return of nearly double the rate of either the slower or faster growing companies. Smart growers included companies such as Citigroup, GE, Microsoft, Nestlé, Pfizer and Toyota.

Smart growers share three characteristics: they have cultures oriented to the long term; they set and communicate realistic growth targets; and they simultaneously pursue sales and profit growth.

Smart growers are the exception rather than the rule. More than 75 per cent of the Fortune Global 500 companies failed to operate within their corridor and paid a price – in rising debt and/or declining profit margins and/or falling share prices. Some, such as Coca-Cola, Eastman Kodak and Xerox, had the financial muscle to grow with the market but failed to realise new growth. In many cases, they saw continuous erosion of their market share. Other companies, such as AES, Vodafone and Tyco, managed to outgrow the market but they grew so rapidly that their financial means were stretched to the limit. In effect, they suffered sharply rising debt loads.

Smart growth is not about impressing financial markets with ambitious revenue targets. It is about finding the right corridor. A continued disparity between actual growth and the growth corridor should prompt managers to realign their targets. Chief executives need the courage to withstand pressure for ever-increasing, unrealistic growth rates.

The growth corridor shows outsiders that the company has set realistic targets and is fully utilising its resources to generate shareholder value. Long-term, value-oriented investors appreciate reliable growth prospects. In the long run, the best stocks are not the ones with the highest projected growth rates but those that consistently meet or exceed their targets.

Georg von Krogh is professor of strategic management and innovation at ETH Zurich. Sebastian Raisch is director of the Centre for Organisational Excellence at the University of St Gallen