Look Beyond Growth

In this week’s blog we are going to cover an important aspect of fundamental analysis.

When researching a stock, many of us look for revenue and profit growth as some of the most important indicators right? Growth may look impressive on paper, but here's the catch: not all growth creates value. Two companies can show identical 20% profit growth, yet one enriches shareholders while the other silently dilutes them. The difference lies in the underlying quality: the efficiency of capital deployment, the quality of earnings, the sustainability of competitive advantages, and whether growth is being built on a solid foundation.

Let us take an example, where two companies are good stocks and the other two are deceptively good stocks but fail to create value. The time period considered is from 2014 to 2025. 

 Important metrics: 2014-2025

Figure 1

Even though all stocks have great revenue growths, only two of them actually create shareholder value. The key factor? Quality of execution. Strong underwriting standards and operational excellence lead to consistent asset quality, which translates into superior ROA and efficient book value creation.

To understand why quality matters, let’s look at how banks and NBFC’s, also called lending companies, grow. A lending company primarily makes money by lending and earning interest. Part of this profit is retained inside the business and becomes its shareholder’s equity (capital).

Regulations require lending companies to maintain a minimum amount of capital for every loan they give. Because of this rule, the company cannot grow its loan book freely. Its growth is limited by how much capital it has.

As a result, if a company funds its growth solely through internal accruals, its growth is limited to the growth of its capital which is measured by return on equity (ROE). 

If the company wants to grow faster than its ROE, it needs more capital. To get that, it must raise fresh capital from the market. While this provides funds for growth, it also increases the number of shares, meaning existing shareholders get diluted.

To understand this more intuitively, let us look at an example.

Example of how capital limits growth

Figure 2

The table shows how loan growth in a lending business is constrained by minimum capital requirement. In year 1, the maximum loan book allowed is constrained to 100 with a capital of 15.

To grow faster, the bank had to raise 9% fresh equity in Year 2, increasing capital to 18 which allowed the lending company to meet the target. This faster growth, however, comes at the risk of dilution.

However, the market rewards quality companies with higher P/B multiples, and this creates a powerful compounding effect. When a high-quality company raises equity at 5-6x book value, it creates disproportionate shareholder value as not only does it dilute less, but every rupee raised is valued at a premium multiple again. 

How Quality Drives Long-Term Growth

Figure 3

The above table clearly explains the impact a higher multiple has on value creation. Bajaj finance, for example, saw a higher growth in its BVPS compared to RBL from raising fresh capital. This can lead to a stock valuation growth of 33.65% given it can maintain its P/B multiple, which is ultimately achieved through sustained quality execution.

A key takeaway from this is that even though revenue and profit growth are important indicators to look at, the underlying quality of the engines driving the growth are more important to consider. Growth supported by quality and consistency leads to long term value creation.

While we've used banking to illustrate this principle, the lesson applies universally. Whether analyzing a capital-light SaaS company or a capital-intensive manufacturer, ask: Is this business earning returns above its cost of capital? Is growth requiring continuous dilution? What metrics denote quality in this sector? For banks it's ROE and asset quality. For tech companies it might be unit economics and customer acquisition costs. For manufacturers, asset turnover and ROIC. The specifics change, but the principle holds: quality determines whether growth creates or destroys value.

Stay tuned for more such insightful content!

References:

• Bajaj Finance Ltd: company reports (2014 - 2025)

• RBL Bank Ltd: company reports (2014 - 2025)

• Kotak Mahindra Bank Ltd: company reports (2014 - 2025)

• Indusind Bank ltd: company reports (2014 - 2025)

Glossary

• Lending company:  Financial institutions such as banks and NBFCs whose main activity is offering credit such as personal, business, or secured loans and generating returns through interest, fees, and repayment of principal.

  
  

• ROA (Return on Assets):  A financial ratio that measures the profit a company earns for every unit of assets it owns. It is used to assess operational efficiency and to compare profitability across companies with different asset sizes. Disclaimer-This article is for educational and informational purposes only and should not be considered as investment advice or a recommendation to buy or sell any securities or adopt any investment strategy.