How to Value Growth Companies
Climbs the life cycle ladder to look at young growth companies, whose products and services have found a market and where revenues are growing fast. This chapter also examines the valuation implications of going public as opposed to staying private and the sustainability of growth.
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In the preceding chapter, we looked at the estimation challenges associated with valuing young companies. One of the issues we confronted was the question of survival, because many young companies fail early in their lives. But what about firms that make it through the test of competition and become successful businesses? This chapter looks at a subset of these firms that become growth companies. A few of these firms stay private, but many of them enter public markets, partly because of their need for capital and partly to allow owners to cash in on their success.
This chapter examines the issues we face when valuing growth companies. Many of the concerns we saw with young companies—short and volatile operating histories, uncertainty about future growth, and changing risk profiles—remain problems when we value growth companies, especially in their initial phases. However, the data and tools we use to deal with them do become better. The existing concerns are joined by new concerns about how growth rates might change as companies get larger and how access and exposure to public capital markets will change financing and investment decisions at the firm.
Companies at every stage of the life cycle aspire to be growth companies. The young businesses in the preceding chapter hope to make it through the rigors of the marketplace to become growth companies, and mature firms keep trying to reinvent themselves as growth companies. This section looks at why growth companies are appealing and the role that growth companies play in the economy and in public markets.
A Life Cycle View of Growth Companies
While investors and managers often talk about growth and mature companies as distinct groups, the differences are hazier in the real world. So, what is a growth company? Many definitions for growth companies are used in practice, but they all tend to be subjective and have significant flaws:
Sector-based measures: Many analysts categorize companies as growth companies or mature companies based on the sector they operate in. Thus, technology companies in the U.S. are treated as growth companies, whereas steel companies are considered mature. This definition clearly misses the vast differences in growth prospects across companies within any given sector. Technology companies like Intel and Microsoft are more mature businesses than growth businesses at this stage of their corporate evolution.
Analyst growth estimates/growth history: A second categorization of companies into growth and mature companies is based on expected growth in future earnings, usually based on forecasts by equity research analysts. In the absence of forecast growth, some services use past growth in earnings as the growth measure. In both cases, firms that have high growth rates are considered growth companies; how high is a matter of both judgment and overall market growth. For instance, if earnings for the entire market are growing at 10% a year, companies might need to deliver 25% growth to be considered growth companies. With market earnings growth of only 5%, a 15% growth rate in earnings might qualify a company as a growth company. The limits of this approach are that it is circumscribed by its focus on earnings, as opposed to revenues or units sold. After all, many young high-growth companies might have exponential growth in revenues while losing money. Similarly, mature companies can post healthy earnings increases with improved efficiency and relatively little operating unit growth.
Market-based measures: Morningstar, as part of its mutual fund tracking service, categorizes mutual funds into those investing in growth stocks and those investing in mature companies. Morningstar bases its categorization on the market multiples that companies trade at. It argues that companies that are perceived to be growth companies will trade at higher multiples of earnings, revenues, and book value than mature companies. Given that our focus in valuation is to decide whether markets are pricing stocks correctly, this process seems to work backwards by implicitly assuming that the market is right.
All three definitions—industry groupings, earnings growth, and market multiples—lead to miscategorization. Although we cannot offer a perfect alternative, we suggest using the financial balance sheet we introduced in Chapter 1 to make this judgment. Figure 10.1 focuses on the asset side of the financial balance sheet, where assets are broken into existing investments and growth assets.
Figure 10.1 The Asset Side of the Financial Balance Sheet
Growth firms get a significant portion of their value from growth assets—investments they expect to make in the future. While this might seem like a restatement of the growth categorization described earlier, where firms with high growth rates are treated as growth companies, an important difference exists. As we noted in Chapter 2, the value of growth assets is a function of not only how much growth is anticipated but also the excess returns that accompany that growth. Specifically, growth investments have no value if the firm earns a return on capital equal to the cost of capital on these investments. The problem with this categorization is that it can be made only after you value a company, because you need to assess a company’s fundamentals (prospective returns on new investments and cost of capital) to make the judgment.
No matter how we decide to categorize companies into growth and mature businesses, we still think about growth in terms of a firm’s life cycle. Chapter 9 was our attempt to value firms in their infancy, at the earliest stages of the life cycle. The firms in this chapter have made it through perhaps the most difficult part of the life cycle and are reaping some of the benefits of surviving the early phase. Because the growth phase can extend over many years, the companies we will consider in this chapter are diverse. Some are small and risky and bear a resemblance to the young firms we analyzed in Chapter 9. Others are further along in the growth cycle and have more in common with the mature firms we will value in Chapter 11 than young firms.
Growth companies play a key role in any economy, with an impact that is often larger than their economic output. Growth companies collectively might account for a smaller portion of the real economy (output and employment) than mature companies. But they are the engines of economic growth because they account for a much larger proportion of changes in the real economy over time. In the U.S., for instance, where traditional manufacturing has retreated from its central role, much of the growth in employment and economic output the last two decades has come from technology and health care businesses, many of which would be categorized as growth companies.
Finally, if we look at publicly traded companies, the proportion of overall market value that accounts for growth companies will be much higher than the proportion of the real economy they account for. The disparity between market value and current operating assets depends on a number of factors, including the level of interest rates, risk premiums, and optimism about future economic growth. In early 2000, at the peak of the technology boom, technology companies represented almost 35% of the overall market capitalization of the S&P 500. One year later, after the collapse in the sector, technology stocks accounted for only 17% of the overall index.