Why investors should understand the company lifecycle

Looking back, one of the most useful concepts that I learned at Business School was that of the Company Lifecycle. Just as there is a Product Lifecycle so companies themselves, like all organic beings, are born, grow, mature and then decline. At last, they die – or they are taken over by other companies. True, the lifecycle of some companies is much longer than others, just as in nature oak trees live millions of times longer than moths. But in business, as in nature, nothing lasts forever.

As investors we need to know (roughly) where a company is in its lifecycle because the equities of young companies are very different investments from the equities of mature or declining companies. The financial theory behind all this is pretty simple.

A young dynamic company will grow very quickly. The finance required to fund its growth will overwhelmingly come from equity, as growth companies often take time to turn a profit. Such companies are often cash flow negative and are therefore very unlikely to pay a dividend. The value of the shares will (hopefully) grow rapidly as the share price reflects the market’s expectations about future earnings growth. So if you invest in a start-up, you won’t get any income but you get a potentially large capital gain over, say, a 2-5 year time horizon. (If everything works out, that is: there is a significant chance that you might lose everything that you invested.)

Once the growth company turns cash flow positive and starts to generate profits, it may still continue to reinvest all profits. Technically speaking, so long as the rate of return on invested capital is greater than the cost of capital (equity), it should reinvest like crazy so as to grow the business further and to make even more profit in the future. The share price continues to rise as the market licks its lips at the prospect of even more profit (Earnings per Share, EPS) yet to come.

In contrast, a mature company, which has achieved a high level of market penetration with a mature product portfolio, will find that there are diminishing marginal returns in reinvesting its profits in its own business. Of course, it might use its profits to diversify into other businesses – which is what Google is doing now. But there will come a point where the rate of growth falls and with that the prospective rate of increase in EPS. What happens at this point is that mature companies tend to finance an increasing portion of their balance sheet through debt, in preference to equity. (Remember that the cost of equity should always be higher than the cost of debt because equity is riskier than debt. One of the negative effects of super-low interest rates, as I have discussed elsewhere, is that the differential between the cost of equity and the cost of debt is artificially accentuated.)

Once growth slows to a point where the return on reinvested capital approaches the cost of capital, the company, theoretically, will best maximise shareholder value by paying out a dividend. The value of the dividend will compensate investors for the slow-down in the growth of EPS. Meanwhile, any profits after the dividend payout can be reinvested. Win-win: everybody happy.

Consider that Microsoft, incorporated in 1975, did not pay a dividend until 2003. Apple did not pay a dividend for nearly two decades between 1995 and 2012, by which time it had accumulated a US$100 billion cash pile. Apple continues to be incredibly cash generative, though this year its share price has stalled, despite a near 2% dividend.

There comes a point as the company matures where it ceases to grow at all. This is the “Steady State” company – it just happily chunters on doing what it always does, with sales and net income constant in real terms. (Actually most micro businesses – corner shops and high-street takeaways – are “Steady State” businesses, but I am focussing here on listed companies.) At this point, financial theory tells us, the company will reinvest the annual depreciation charge on fixed assets in the business so that it can continue to produce the same level of physical output, and pay out all remaining profit as dividends. So it will have a 100% dividend payout ratio. At this point the EPS and the dividend payout are equal and, all things being equal (i.e. no change in business risk), the share price will remain constant.

For those readers who enjoy theory, read on; otherwise skip to the next paragraph. If the discount rate applied to the future dividend stream to determine the “correct” share price is the market cost of equity (k), then it follows that the P/E ratio of a “Steady State” Company will be the reciprocal of the cost of equity. (Mathematically, the share price is the present value of the constant cash flows from dividends, discounted at rate k; and that share price equals EPS multiplied by P/E.) So, just assuming the cost of capital for a mature company were 12.5%, its P/E would be eight. Thus, if its EPS were £1, its share price should be £8. Simples (as meerkats say).

So, at risk of stating the bleeding obvious, the share price of start-ups is volatile (high-risk) and there is no prospect of income. For mature companies, the business risk is much lower, earnings volatility is much moderated, but growth is still in play: the share price is of low volatility and there is a decent income stream from dividends (low risk). For companies that have stopped growing and are coasting, the share price is (relative to the market) rock-solid, and all the return comes from dividends (zero-risk).

The lower the growth trajectory, the easier it is to price stocks, both in theory and in practise. But don’t knock low-to-zero growth stocks: they are dependable old friends, who, over time, become good company. Would you rather go for a drink with an old fellah who’s heard it all before, and doesn’t get excited or offended; or would you rather spend the evening with a neurasthenic young actor who might make it big one day, and who insults you after you have paid the drinks bill? The choice is yours.

When we describe companies (or countries for that matter) as “in decline” we usually mean that they have stopped growing, rather than that they have bombed. And many companies designated “in decline”, as with nations in the same boat, keep going, and can produce reliable income. Companies that are “in decline”, if they do not go bankrupt, will be taken over probably within a decade; whereas nations “in decline” will be repopulated or conquered by a more aggressive power after a century or two.

Sony Corporation is a wonderful business school case study on the corporate lifecycle. In its day it crossed the firmament like a comet; now it struggles to grow at all. Yet it still makes money and pays a dividend. Would you prefer to invest in Sony, or its Korean high-growth, innovating nemesis, Samsung? They are both decent, though very different investments.

If you want to invest in zero-risk Steady State investments, as a medium-term hold, try utilities, even telecoms, especially Internet Service Providers – their markets are all saturated. A zero-growth nation? What about Germany? At least they are countering their desperate demographics by importing citizens by the million from the Near East. I hope it all works out for them.

Corporate finance – unlike, say, macroeconomics – is pretty much a known quantity (though of course, there are contentions). So it’s amazing that many institutional investors don’t really understand this theory. When you invest in a stock, you should have a target return; and you should know how that return is going to be composed in terms of its capital gain and income components.

A parting thought: Google and Facebook might look like young companies; yet they are probably already mature. They should be paying dividends. My best guess is that Coca-Cola and Pepsi will outlive them. It’s moths versus oak trees. It’s all in the DNA.