'Organic
Growth'
Organic growth is the growth rate a company can
achieve by increasing output and enhancing sales internally. This does not
include profits
or growth acquired from takeovers,
acquisitions
or mergers. Takeovers, acquisitions and mergers
do not bring about profits generated within the company, and are therefore not
considered organic growth.
'Inorganic
Growth'
Inorganic growth arises from mergers
or takeovers
rather than an increase in the company's own business activity. Firms
that choose to grow inorganically can gain access to new markets through
successful mergers and acquisitions.
Inorganic growth is seen as a faster way for a company to grow when compared
with organic growth.
There
are two ways for human beings to keep our heads warm. We can grow hair, or we
can put on a hat. It takes a while to grow hair, but we create it ourselves. We
do not have to pay money for hair; the body grows hair naturally. The hair is
equivalent to organic growth, and a hat is equivalent to inorganic growth. Hair
doesn't cost anything, but it takes a while to grow. Those people that don't
grow hair fast may be better off buying a hat or a wig if it's cold outside.
Likewise, it may be easier for some companies to buy a fast-growing company.
Indeed, some companies use acquisitions as the foundation of their growth
strategy with the expectation that year-on-year growth is expected to decline.
In other words, some companies are losing their hair, and inorganic growth
vehicles help to manage the loss.
Not All
Growth Is Equal
Not All
Growth Is Equal
The best way to explain the importance of
differentiating between organic and inorganic growth
for investors is with an example.
If company A is growing at a rate of 5% and company
B is growing at a rate of 25%, most investors opt for company B. The assumption
is company A is growing at a slower rate than company B, and therefore has a
lower rate of return.
There is another scenario to consider, however. What if company B grew revenues
25% because it bought out its competitor for $12 billion. In fact, the reason
company B purchased its competitor is because company B’s sales were declining
by 5%.
Company B might be growing, but there appears to be
a lot of risk connected to this growth, while company A is growing by 5%
without an acquisition or the need to take on more debt. Perhaps company A is
the better investment even though it grew at a much slower pace than company B.
Some investors may be willing to take on the additional risk, but others opt
for the safer investment.
Organic vs.
Inorganic Growth
In this example, company A, the safer investment,
grew revenue by 5% through organic growth. The growth required no merger or
acquisition, and occurred due to an increase in demand for the company’s
current products. Company B grew revenue through acquisitions by borrowing
money. In fact, organic growth declined by negative 5%. Company B's growth is
completely reliant on acquisitions rather than its business model.
This is not a good development.
In some industries, particularly in retail, organic
growth is referred to as comparable growth or comps,
referring to sales based on a comparable base of stores or retail outlets.
Inorganic growth is not bad as long as it is being paid for with the company's
cash rather than debt or equity financing.
A combination of both organic and inorganic growth is ideal as it diversifies
the revenue base without relying solely on current operations to grow market share.
