Characteristics of Growth Companies
Growth companies are diverse in size and growth prospects and can be spread out over very different businesses. But they share some common characteristics that make an impact on how we value them. This section looks at some of these shared features:
Dynamic financials: Much of the information we use to value companies comes from their financial statements (income statements, balance sheets, and statements of cash flows). One feature shared by growth companies is that the numbers in these statements are in a state of flux. Not only can the numbers for the latest year be very different from numbers in the prior year, but they can change dramatically, even over shorter time periods. For many smaller, high-growth firms, for instance, the revenues and earnings from the most recent four quarters can be significantly different from the revenues and earnings in the most recent fiscal year (which might have ended only a few months ago).
Private and public equity: It is accepted as conventional wisdom that the natural path for a young company that succeeds at the earliest stages is to go public and tap capital markets for new funds. There are four reasons why this transition is neither as orderly nor as predictable in practice. The first is that the private-to-public transition varies across different economies, depending on both institutional considerations and the development of capital markets. Historically, growth companies in the U.S. have entered public markets earlier in the life cycle than growth companies in Europe, partly because this is the preferred exit path for many venture capitalists in the U.S. The second reason is that even within any given market, access to capital markets for new companies can vary across time as markets ebb and flow. In the U.S., for instance, initial public offerings increase in buoyant markets and drop in depressed markets. During the market collapse in the last quarter of 2008, initial public offerings came to a standstill. The third reason is that the pathway to going public varies across sectors. Companies in some sectors, such as technology and biotechnology, get access to public markets much earlier in the life cycle than firms in other sectors, such as manufacturing and retailing. The net effect is that the growth companies we cover in this chapter draw on a mix of private equity (venture capital) and public equity for their equity capital. Put another way, some growth companies are private businesses, and some are publicly traded. Many of the latter group will still have venture capitalists and founders as large holders of equity. Finally, improvements in liquidity in the private share market and the increased willingness of public market investors to invest in private businesses have allowed some young companies to stay private for longer periods than they would have been able to a few years ago.
Size disconnect: The contrast we drew in Chapter 1 between accounting and financial balance sheets, with the former focused primarily on existing investments and the latter incorporating growth assets into the mix, is stark in growth companies. The market values of these companies, if they are publicly traded, are often much higher than the accounting (or book) values because the former incorporate the value of growth assets and the latter often do not. In addition, the market values can seem discordant with the firm’s operating numbers—revenues and earnings. Many growth firms that have market values in the hundreds of millions or even billions can have small revenues and negative earnings. Again, the reason lies in the fact that the operating numbers reflect the firm’s existing investments, and these investments might represent a very small portion of the firm’s overall value.
Use of debt: While the usage of debt can vary across sectors, the growth firms in any business tend to carry less debt, relative to their value (intrinsic or market), than more stable firms in the same business. This is simply because they do not have the cash flows from existing assets to support more debt. In some sectors, such as technology, even more mature growth firms with large positive earnings and cash flows are reluctant to borrow money. In other sectors, such as telecommunications, where debt is a preferred financing mode, growth companies generally have lower debt ratios than mature companies.
Market history is short and shifting: We are dependent on market price inputs for several key components of valuation—especially for estimating risk parameters (such as betas). Even if growth companies are publicly traded, they tend to have short and shifting histories. For example, an analyst looking at Google in early 2009 would have been able to draw on about four years of market history (a short period). But even those four years of data might not be particularly useful or relevant, because the company changed dramatically over that period. It went from revenues in the millions to revenues in the billions, from small operating profits to large operating profits, and from a small market capitalization to a large one.
Although the degree to which these factors affect growth firms can vary across firms, they are prevalent in almost every growth firm.