The global financial crisis prompted many companies to pull in their horns, hoard cash, trim costs, and take a wary view of large investments. Yet the same crisis ushered in a new age of capital superabundance. Bain & Company’s Macro Trends Group carefully analyzed the global balance sheet and found that the world is awash in money. Global capital balances more than doubled between 1990 and 2010 — from $220 trillion (about 6.5 times global GDP) to more than $600 trillion (9.5 times global GDP). And capital continues to expand. Our models suggest that by 2025 global financial capital could easily surpass a quadrillion dollars, more than 10 times global GDP.

Capital superabundance, combined with tepid economic growth, has produced historically low capital costs for most large companies. For much of the 1980s and 1990s, for instance, the average cost of equity capital for large U.S. corporations hovered between 10% and 15%. Today, the average cost of equity capital sits at close to half that: just 8% for the roughly 1600 companies comprising the Value Line Index. And the after-tax cost of debt for many large companies is close to the rate of inflation. So, in real terms, debt financing is essentially free.

The ready access to low-cost capital should change the way business leaders think about strategy, and in particular the relative value of improving profit margins versus accelerating growth. When capital costs are high, strategies that expand margins are almost always better than strategies that accelerate growth. When money is expensive, a dollar today is worth a lot more than a dollar tomorrow — or even the promise of many dollars tomorrow. But when capital costs are low, the time value of money is low. So the promise of more dollars tomorrow (through growth) exceeds the value of a few extra dollars next quarter. In these circumstances, strategies that generate faster growth create more value for most companies than those that improve profit margins.

To elaborate, a company’s intrinsic equity value reflects the long-term cash flows that shareholders expect to receive over time, discounted at the appropriate risk-adjusted cost of equity capital. Equity cash flows, in turn, are a function of a company’s long-term return on equity (ROE), growth, and the value of shareholders’ equity on its books. This relationship gives rise to three important heuristics:

• If a company’s long-term ROE is anticipated to be 400 basis points (bps) or more above its cost of equity capital, then the value created by accelerating growth will exceed the value created by improving pre-tax margins
• If a company’s long-term ROE is anticipated to be between 300 and 400 bps above its cost of equity capital, then the value created by accelerating growth will be roughly the same as the value created by improving pre-tax margins
• If a company’s long-term ROE is anticipated to be less than 300 bps above its cost of equity capital, then the value created by improving pre-tax margins will exceed the value created by accelerating growth. In fact, in cases where a company’s long-term ROE is anticipated to be below its cost of equity capital, accelerating growth will destroy value

Historically, when debt and equity costs were high, for most companies the trade-off between profitability and growth favored profitability. Accordingly, business leaders sought to improve efficiency by employing Six Sigma, process reengineering, spans and layers, and other tools.

But the scales have now tipped in favor of accelerating growth. For the average company, defined as the equity-weighted average of the roughly 1600 companies comprising the Value Line Index, the cost of equity capital is just 8%. And the average long-term ROE is more than 25%, reflecting improved efficiency combined with greater reliance on financial leverage at most companies. On average, then, the value created by accelerating growth by 1% far exceeds the value created by increasing pre-tax margins by 1% on a sustained basis. In fact, the multiple of value created by growth versus margins is more than four to one.

But a lot can get lost in the averages. Every company faces a different trade-off between growth and profitability. For example, in some industries — say, construction — long-term ROEs are very close to the cost of equity capital. For these companies, taking steps to improve margins will generate higher returns for investors than those designed to boost growth. But in most other sectors, ROEs are much greater than the cost of equity capital. In these settings, investors should value strategies that accelerate growth over those that improve margins (see the chart below).

Why is growth shortchanged at so many companies?

In our work with clients, we see three common reasons why companies continue to pursue margins over growth — but we also see how smart companies avoid those traps.