There are lots of different ways to work out the intrinsic value of a business. Most of these use some sort of growth rate, i.e. estimating a company's growth potential over the next few years. Even very straightforward valuation methods such as the price-earnings ratio use some growth calculation, whether it be backwards-looking or a prediction for the future.
Coming up with a valuation for a company seems easy if you know the correct growth figures. However, this is actually the hard part. It is impossible to tell the future, and those who say they can are either lying or misguided. All we can do is guess. What's more, the further out one tries to predict a company's future earnings, the more unreliable these forecasts will become.
Long-term growth projections
These kinds of excessive long-term growth projections become more prevalent in growth markets. One of the most widely-studied growth projections of recent years is Ark's Tesla (TSLA, Financial) valuation model. Catherine Wood (Trades, Portfolio)'s Ark Investment Management predicts the stock could be worth as much as $4,000 in the bull case by 2025. To arrive at this forecast, the group used a "Monte Carlo model with 34 inputs, the high and low forecasts incorporating 40,000 possible simulations."
I have no particular insight into Tesla, so I cannot say if this projection is accurate. But what I do know is that the more inputs one has for an equation, the less likely it is the equation will be accurate, especially when the majority of these inputs rely on projections over the next five years. Using 40,000 different simulations means there are 40,000 things that could go wrong.
A value of infinity
Projecting high growth rates can lead to another issue. If a company's projected growth rate exceeds the discount rate, the valuation becomes infinity. Warren Buffett (Trades, Portfolio) explained this principle at Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) 2004 annual shareholder meeting:
"It gets very dangerous to project out high growth rates because you get into this paradox. If you say the growth rate of a company is going to be 9% between now and judgment day and you use a 7% discount rate, it goes off, you know, you get into infinity. And that's where people get in a lot of trouble. The idea of projecting out extremely high growth rates for very long periods of time has caused investors to lose, you know, very, very large sums of money."
He went on to add:
"There's a real danger in projecting out high growth rates. And Charlie and I will very seldom — virtually never — get up into high digits. You can lose a lot of money doing that."
I am not saying that Ark or other investment managers who use complex growth projections are destined to lose big time. Whether their investments are successful or not doesn't change the fact that it is challenging to project future growth. Companies can and do successfully grow at double-digit rates year after year, but finding these organizations in the first place is incredibly difficult.
That is what Buffett was trying to get across in 2004. More often than not, companies cannot grow at high growth rates for an indefinite period. If they could, they would be worth an infinite amount of money. If a company can grow at a high growth rate year after year, it will attract competitors, which will eat into its market share and hold back the growth rate. This is the natural cycle of capitalism and has been going on for hundreds of years. Some companies have managed to break out of this cycle, but even the world's biggest technology businesses today may find themselves struggling in 10 or 20 years' time.
That is why it is so dangerous to predict high growth rates indefinitely. The nature of capitalism means growth will not last forever, and the easiest way to avoid these disasters is not to set your expectations to infinity in the first place.
Also check out:
