Valuing Growth companies
An exploration of growth and valuation
A couple of weeks weeks ago we did a valuation on Intel, and unlike previous companies which were evaluated based on their existing cash flows, their debt and book value, we tried branching out into a more growth based valuation.
Back then we saw some of the issues involved with that type of valuations, and today we’re going to explore a few “homemade” ways and factors that we should take into account when making a growth valuation.
The Issues with Growth Valuations
The core problem with growth valuation methods is the same as any other valuation method, that is, we simply cannot look into the future to know which companies will do well, and which companies will fail.
That’s not to mean we can’t make educated guesses, or that those guesses won’t be fairly and consistently close to what will happen, but it does mean that those guesses have to have some margin for error in them in order to account for the likely possibility that we are wrong.
Additionally, growth valuations suffer from issues that other types of valuations do not, and have other issues amplified by the inherent questions regarding both the amount and the quality of the growth expected.
While it is usually fairly simple to determine the exact dollar value of a company at a given time, after all you need only to take the Net Current Asset Value of its equity on the balance sheet and discount it by the expected costs involved in winding down the company, such valuations and often counter productive to our purposes.
I say this, not because the Net Current Asset Value method is wrong, or worthless, but because for small retail investors like myself it is generally infeasible to purchase the entire company, which is more often than not a pre-requisite for its dissolution and subsequent return of shareholder wealth.
Additionally, when we buy companies we generally don’t want to wind them down, after all, the purposes of companies is to generate cash for their owners, and they cannot do that if they cease to be.
That is where the Margin to PE, the Discounted Cash flow Model, and other methods of valuation that we discussed in previous post come in.
The purpose of those valuation methods is primarily to determine a companies earnings capacity. Unfortunately when we try to estimate a companies earnings capacity we leave aside the exact and known facts, and become embroiled in unknowable futures.
Sometimes this isn’t too bad, after all, certain companies like AFLAC or 3M have fairly large and stable businesses, with regular and consistent incomes which can be reliably expected to carry on for the near future.
But what of growth companies?
These are companies that have low (or even non-existent!) earnings, but ones which are expected to increased in the future. For these sorts of companies and valuations, we need to add an additional uncertainty factor, that is, we need to account for not only the companies expected earnings, but also for the growth in those earnings.
This additional uncertainty increases the risk of any valuation, and must therefore increase the margin of safety required before any investment can be considered.
Additionally we need to consider what factors we should take into account when examining the idea of growth. Are we considering only earnings, which can be distorted by tax engineering? Or perhaps revenue, which can be “bought” by deficit spending to no effect? Or are we perhaps talking about operational margins, which don’t take into account debt related leverage?
The Factors that must be taken into account
Like we discussed before when we talked about why valuations matter earnings matter, as do dividends.
Historically speaking earnings increases and dividends account for all, or substantially all long term returns of the stock market, and so it makes sense to account for both when making a growth valuation model.
All the same, we can’t just make a wild guess as to the earnings growth and take that guess as gospel, we might be wrong after all, or too optimistic.
There are other factors that we can use to check whether that level of growth can be relied upon, though all have their flaws.
That being said, I believe the following factors are likely the most important when estimating both current value, and future growth:
3 Year Average Revenue Growth
3 Year Average Gross Margin Growth
3 Year Earnings per Share Growth
3 Year Pre-Tax Income Growth
Each of these are relevant data points that can and should be taken into account in any estimation regarding earnings growth. The reason for this is because both the amount and quality of growth matters for a company.
A company may well increase their Revenue, thereby increasing the universe from which earnings can be harvested from, but if those new sales are done at a price that is below cost, then the company is on its way to bankruptcy.
In the same manner, gross margin growth can be increased tremendously in certain types of business with low incremental operational costs, but if they have done so at the expense of large capital expenditures and their subsequent depreciation, earnings will suffer.
The same happens with pre-tax income, which may be achieved in spite of individual shareholders being left holding the bag, as a result of high amounts of dilution.
Earnings per share too can be manipulated by management and the board to suit their individual purposes, at the detriment to shareholders.
That being said, manipulation of one such variable, almost inevitably results in the negative effects showing up in another, and so by combining all of these, as well as a few others, we might be able to come up with an adequate formula.
In addition to those points we also need to account for the Dividend, unfortunately like we saw in our discussion for Intel we don’t really have a good way of generating the return for that, since the yield is dependent on the price paid for the stock… which is what we want to find!
That said, I would say the following factors are relevant:
Dividend Payout Ratio
The problem with the Yield
Let’s get this out of the way, to put it simply we cannot derive the dividend yield from the companies financial data.
The reason for this is because the Yield is always a function of price paid for the stock.
To resolve this issue we have a few options:
We can calculate the Yield based on its current price
We can calculate the Yield based on a standard valuation model (like Margin to PE)
We do not calculate the Yield, and instead add the dividend to the earnings
Points 1 and 2 are fairly simple to comprehend, in this case we simply check whether the company is worthwhile at either the current price, or at a otherwise fair price for the company.
Option 3 on the other hand, rubs me the wrong way at first, after all, by adding the dividend to the earnings, we are effectively double counting the same earnings.
At the same time however any accounting for the dividends (or yield) will suffer from the same problem.
And yet, both earnings growth and Dividends explain all stock market returns…
The Formula Proposed
In order to get a general valuation of a company, I would propose the following formula:
In essence, we add up the earnings with the dividend, and multiply that value by the sum of the expected Earnings Per Share Growth, the pre-tax Margin and a “Advantage Modifier”.
We may switch the EPS growth, with one of the other growth factors, at our judgement. In general they should move together.
The advantage modifier is intended to ensure that only the companies competitive advantage (as represented by their margin) is added to the EPS growth, as opposed to the entire expected margin.
In general I would set the advantage modifier as the same as the general industry margin, so long as that margin is not lower than 10. Industries with margins below 10 are highly competitive, and so we must account for that by ensuring the modifier is no less than 10.
This way, we can ensure that only companies with high quality business models will benefit from the margin, while still allowing high growth companies to be valued accordingly.
The accounting for the dividend, also provides a “bonus” to companies which make it a priority to repay shareholders through them, while the fact that we use EPS growth, rather than the plain earnings growth also accounts for share buybacks.
Overall, this formula should account for all factors we discussed before, and should make it difficult for management to optimize for it, giving us a clearer view of the company.
Additionally, we can adjust the times from which we get these averages, though I would recommend keeping them between the last 3 to 5 years of business, rather than the full 10 year valuation we’ve done before. The reason for this is because a companies growth path can change quite a lot in 10 years.
It’s not perfect, and I don’t doubt that I will be modifying it over time, however I think it is a fair start, and gives additional color to our other valuation methods.
What do you think? Is this a good formula?
Do you have a better suggestion?
Let me know in the comments down below!
And as always, if you have any questions or comments, shoot them on Twitter @TiagoDias_VC or down below!
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