Wharton@Work

May 2011 | Finance

Mastering Organic Growth

"The truth is that organic growth is hard," says Wharton adjunct finance professor John Percival. "Frankly, that's the reason a lot of companies do acquisitions. If you can come up with the capital, you can pay — often too much — to grow. But organic growth is much more difficult. You need to assess opportunities, make a wise choice, and then pursue it better than the competition."

To be good at organic growth, Percival stresses, you need to know the strengths and weaknesses of your organization well. Whatever growth opportunity you're considering, you must weigh your capabilities and limitations, and ask tough questions about why it's worth pursuing. "So few companies do this," he says. "If something looks good, they jump, without acknowledging whether they have what it takes to make it work. If you can't create a competitive advantage over everyone else who chooses that opportunity, you need to consider another option.

"In the program Integrating Finance and Strategy for Value Creation, we talk about growth using financial terminology: go after growth opportunities only when you have a very good chance of earning more than cost of capital [the rate of return needed to make a project worthwhile]. That must be your benchmark, your deciding factor. If you're not pretty certain that whatever the opportunity costs, you're going to be able to make more, you don't make a move."

Creating a Cost of Capital Culture

Cost of capital isn't just a concern for the CFO, though. Percival notes that to improve organic growth, everyone in an organization needs to understand what it is, and why it's so important. He explains, "If the only person who understands this idea is the CFO, you're not going to have a strong chance of selecting the right opportunity. He or she is not the one who's going to be deciding what to pursue and with which strategies to pursue it. The CFO should be the champion of the Cost of Capital mindset, but it must also be embedded more widely. You need to create a Cost of Capital culture."

When that culture is in place, you assess opportunities differently. Instead of choosing things because they are related to what you're doing now, or because they look like they have huge opportunities for growth, you think as carefully as you can about which opportunity is the right one for you. "That means," says Percival, "that you have the skills and capability. You have a believable story that you have a good chance of earning more than cost of capital. Without that process, your chances of selecting the wrong opportunity are great.

"There are companies who decide to move out of their domestic market and go into China. Do they know what that opportunity means, and are they equipped to have an advantage there? Just because you're successful in your domestic market doesn't mean you have the skills to be successful in China. It could be a good opportunity for someone, but the question is, is it you? You also have to ask, since everyone else is seeing the same opportunity, what is your competitive advantage? If you don't have a Cost of Capital culture, these questions often don't get asked, and companies not only don't achieve organic growth, but they make some very costly mistakes."

Execution Is Key

Percival notes that even with a Cost of Capital culture, growth for some organizations is more difficult than for others. In Integrating Finance and Strategy for Value Creation, he works with participants with a wide range of responsibilities, including CFOs, owners of small companies, consultants, and others who represent many industries. "They bring real challenges to the discussion. When your business is mature or competitive, or you've got excess capacity, growth is more difficult. But the same truths apply: you need to know your skills and capabilities, you need to assess the opportunities out there, and only pursue those that make sense for you."

He continues, "What I hear often is, 'what about market share or strategy?' When your goal is to have the best strategy, or gain the greatest market share, you can lose your focus. Neither is as important as execution."

According to Percival, one company that gets it right is Emerson Electric. The multinational manufacturing and technology company, based in Ferguson, Missouri, has earned more than cost of capital for 54 of the last 55 years. "That's not luck. It's remarkable execution. When they choose an opportunity, they choose carefully, and then they execute it better than anyone else. Creating real value through organic growth isn't easy. But it's worth pursuing because the alternative isn't an option anyone really wants."