When valuing a growth company, we confront many of the issues we faced with young idea companies, albeit on a lesser scale. Data on past operations provides a short, volatile, and not particularly useful basis for forecasting the future. Much of the company’s value comes from expectations about how high growth will be in the future, how long this growth can be sustained, and the quality of this growth, all of which are difficult to forecast. In particular, the rate at which growth rates will drop as the company becomes bigger will be a key factor determining its value. Estimating risk parameters from stock price data can yield strange values, and the firm’s risk profile will change as its growth rate changes.
Analysts, confronted with these challenges, often adopt shortcuts that might save them time but yield misleading values. They fail to adjust growth rates as the company gets bigger, allowing firms to grow for too long at high rates. They make assumptions about risk and reinvestment that are inconsistent with their own growth estimates. Finally, they are often cavalier about when they put their firms into stable growth and the assumptions they make to get terminal value. When doing relative valuation, they stick with the standard practices used to value mature companies. They use other firms in the industry as comparable companies and use revenue or forward earnings multiples. They don’t adjust for differences across firms, or they do so subjectively or in the most simplistic fashion.
Valuing growth companies well, in a discounted cash flow framework, has three key components. The first is to ensure that the assumptions we are making about growth and margins reflect not only market potential and competition, but also change to reflect the firm’s changing size over time. The second component is to reinvest enough into the business to sustain the forecast growth rates. The third component is to modify the firm’s risk profile to match its growth characteristics. The costs of equity, debt, and capital are all likely to decrease as the firm goes from high growth to stable growth. With relative valuation, controlling for differences in growth and risk when comparing companies is essential.