The
Little Book of Valuation
Growth companies- Value Drivers
Scalable growth
The
question of how quickly revenue growth rates will decline at a given company
can generally be addressed by looking at the companyÕs specifics – the
size of the overall market for its products and services, the strength of the
competition and quality of both its products and management. Companies in larger markets with less
aggressive competition (or protection from competition) and better management
can maintain high revenue growth rates for longer periods.[1]
There
are a few tools that we can use to assess whether the assumptions we are making
about revenue growth rates in the future, for an individual company, are
reasonable:
1.
Absolute revenue changes: One simple test
is to compute the absolute change in revenues each period, rather than to trust
the percentage growth rate. Even experienced analysts often under estimate the
compounding effect of growth and how much revenues can balloon out over time
with high growth rates. Computing the absolute change in revenues, given a
growth rate in revenues, can be a sobering antidote to irrational exuberance
when it comes to growth.
2.
Past history: Looking at past revenue
growth rates for the firm in question should give us a sense of how growth
rates have changed as the company size changed in the past. To those who are
mathematically inclined, there are clues in the relationship that can be used
for forecasting future growth.
3.
Sector data: The final tool is to look at
revenue growth rates of more mature firms in the business, to get a sense of
what a reasonable growth rate will be as the firm becomes larger.
In summary, expected revenue growth rates will tend to drop
over time for all growth companies but the pace of the drop off will vary
across companies.
Sustainable margins
To get from revenues to operating income, we need operating
margins over time. The easiest and most convenient scenario is the one where
the current margins of the firm being valued are sustainable and can be used as
the expected margins over time. In fact, if this is the case, we can dispense
with forecasting revenue growth and instead focus on operating income growth,
since the two will be the equivalent. In most growth firms, though, it is more
likely that the current margin is likely to change over time.
Let
us start with the most likely case first, which is that the current margin is
either negative or too low, relative to the sustainable long-term margin. There
are three reasons why this can happen. One is that the firm has up-front fixed
costs that have to be incurred in the initial phases of growth, with the payoff
in terms of revenue and growth in later periods. This is often the case with
infrastructure companies such as energy, telecommunications and cable firms.
The second is the mingling of expenses incurred to generate growth with
operating expenses; we noted earlier that selling expenses at growth firms are
often directed towards future growth rather than current sales but are included
with other operating expenses. As the firm matures, this problem will get
smaller, leading to higher margins and profits. The third is that there might
be a lag between expenses being incurred and revenues being generated; if the
expenses incurred this year are directed towards much higher revenues in 3
years, earnings and margins will be low today.
The
other possibility, where the current margin is too high and will decrease over
time, is less likely but can occur, especially with growth companies that have
a niche product in a small market. In fact, the market may be too small to
attract the attention of larger, better-capitalized competitors, thus allowing
the firms to operate under the radar for the moment, charging high prices to a
captive market. As the firm grows, this will change and margins will decrease.
In other cases, the high margins may come from owning a patent or other legal
protection against competitors, and as this protection lapses, margins will
decrease.
In both of the latter two scenarios – low margins converging to a higher value or high margins dropping back to more sustainable levels – we have to make judgment calls on what the target margin should be and how the current margin will change over time towards this target. The answer to the first question can be usually be found by looking at both the average operating margin for the industry in which the firm operates and the margins commanded by larger, more stable firms in that industry. The answer to the second will depend upon the reason for the divergence between the current and the target margin. With infrastructure companies, for instance, it will reflect how long it will take for the investment to be operational and capacity to be fully utilized.
Quality Growth
A constant theme in valuation is the insistence that growth
is not free and that firms will have to reinvest to growth.To estimate reinvestment for a growth firm, we
will follow one of three paths, depending largely upon the characteristics of
the firm in question:
1.
For growth firms earlier in the life cycle,
we will adopt the same roadmap we used for young growth companies, where we
estimated reinvestment based upon the change in revenues and the sales to
capital ratio.
Reinvestmentt
= Change in revenuest/ (Sales/Capital)
The
sales to capital ratio can be estimated using the companyÕs data (and it will be
more stable than the net capital expenditure or working capital numbers) and
the sector averages. Thus, assuming a sales to capital
ratio of 2.5, in conjunction with a revenue increase of $ 250 million will
result in reinvestment of $ 100 million.
We can build in lags between the reinvestment and revenue change into
the computation, by using revenues in a future period to estimate reinvestment
in the current one.
2.
With a growth firm that has a more
established track record of earnings and reinvestment, we can use the
relationship between fundamentals and growth rates that we laid out in chapter
2:
Expected growth rate in operating income =
Return on Capital * Reinvestment Rate + Efficiency growth (as a result of
changing return on capital)
In the unusual case where margins and
returns and capital have settled into sustainable levels, the second term will
drop out of the equation.
3.
Growth firms that have already invested in
capacity for future years are in the unusual position of being able to grow
with little or no reinvestment for the near term. For these firms, we can
forecast capacity usage to determine how long the investment holiday will last
and when the firm will have to reinvest again. During the investment holiday,
reinvestment can be minimal or even zero, accompanied by healthy growth in
revenues and operating income.
With all three classes of firms, though, the leeway that we
have in estimating reinvestment needs during the high growth phase should
disappear, once the firm has reached its mature phase. The reinvestment in the
mature phase should hew strictly to fundamentals:
Reinvestment rate in mature phase = 
In fact, even in cases where reinvestment is estimated independently of the operating income during the growth period, and without recourse to the return on capital, we should keep track of the imputed return on capital (based on our forecasts of operating income and capital invested) to ensure that it stays within reasonable bounds.