Growth companies, especially those that have spectacular, fast starts, demand our attention, even if we never buy them. We can’t help but ask ourselves, “Wouldn’t it have been nice to have bought one of the FAANG stocks—Facebook (FB, Financial), Amazon (AMZN, Financial), Apple (AAPL, Financial), Netflix (NFLX, Financial) or Google (GOOG, Financial)(GOOGL, Financial) when they first went public?”
And the questions continue: Will this growth stock continue to grow? To address this question, it would be quite helpful to be able to do a valuation, despite the uncertainty that comes with growth stocks.
Aswath Damodaran has addressed that issue in chapter 6 "The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit." Once again, he helps investors rely less on stories and more on quantitative evidence. First, though, he wanted to clarify the term “growth company:"
- Some analysts use sectors to distinguish between growth and mature companies. For example, technology companies are thought to be growth companies, while steel companies are considered mature companies. Damodaran dismisses this definition because it does not account for growth potential among companies in the same industry.
- Other analysts turn to price-earnings ratios, treating those with high price-earnings ratios as growth companies and those with low price-earnings ratios as mature firms. The author also rejected this definition.
What he proposes instead is the following definition: “Growth firms get more of their value from investments that they expect to make in the future and less from investments already made.” Damodaran argues that this definition takes in both the amount of growth anticipated and the quality of that growth. The quality of growth is to be measured according to excess returns.
Continuing on, Damodaran wrote that growth companies come in various sizes and with varying growth potential, but they all share several characteristics:
- Dynamic financials: Earnings can vary dramatically from year to year, and even quarter to quarter.
- Size disconnect: Market values of publicly traded growth companies are often much higher than book values.
- Use of debt: Growth companies generally take on less debt because they do not have cash flows that would support debt.
- Market history: A short and unstable price history.
These characteristics have “consequences” for both intrinsic and relative valuations:
- Scaling becomes an issue: A company that grows by 80% over five years becomes larger — by a factor of 18. That means a growth company faces a bigger challenge every year, in that the dollar amount of growth gets exponentially larger.
- Competition becomes an issue as companies grow quickly because their success signals that a large and profitable market exists.
Despite these issues, Damodaran continued to believe it was possible to “navigate our way through these problems to arrive at values for these firms that are less likely to be contaminated by internal inconsistencies.”
Looking specifically at intrinsic valuations, he pointed out that discounted cash flow (DCF) models require adjustments as the amount of growth changes and as margins change. To help illustrate his valuations, he used the example of Under Armour (UA, Financial), which went public in 2006. The firm’s revenues had tripled, from $205 million in 2004 to $607 million in 2007. That represented a compounded growth rate of 44% per year.
Moving on from there, Damodaran set out to develop forecasts, based on three “value drivers:”
- Scalable growth: Damodaran began by estimating future revenues, a process made more difficult by scaling. In other words, how fast will revenues decline as the company grows? He wrote that revenues will depend on some company specifics: market size, competitiveness, quality of products and quality of management. He concluded that Under Armour would grow at 35% in the first year, 25% in the second year and then taper off. The compounded annual growth rate over 10 years was expected to be 12.51%.
- Sustainable margins: To transition from revenues to operating income, Damodaran noted he needed operating margins over time. He wrote that many growth companies experience a negative or very low operating margins in their early years because of up-front fixed costs for infrastructure. Margins typically will grow as revenues increase. On the other hand, there are companies that start with very high margins because they have niche products in small markets, too small to attract competitors. In his assessment, Under Armour’s current margin of 12.25% will grow to 12.72% in year 10.
- Quality of growth: Reinvestments are essential if growth companies are to fulfill their promise, and according to Damodaran there are three paths to estimating reinvestment. The first, most commonly used and the one he applies is to estimate it, uses changes in revenue and a sales-to-capital ratio (from historical data for company and industry averages). For Under Armour, he used the industry average of 1.83. He wrote, “Growth has value, only if accompanied by excess returns. Do you see your firm generating returns significantly higher than its cost of funding?”
To this set of considerations, Damodaran added a risk factor, since the risk profiles of growth companies will shift as they age and mature. Generally, growth firms start out paying a premium for both equity and debt capital, but that should go down as revenue begins to slow and margins improve. At the same time, cash flows will increase to the point where they can support debt repayment, so companies begin taking on more debt. For Under Armour, he expected the cost of capital to decline from 9.27% to 7.28% over the 10-year forecast.
There is also the issue of reaching a stable state, when growth companies become mature companies. In turn, this will affect terminal value assessments. Damodaran recommended putting a firm into stable growth earlier rather than later because, “Both scale and competition conspire to lower growth rates quickly at even the most promising growth companies.”
Thus, discounting cash flows for the next decade, using time-varying costs of capital and adding the present value of the terminal value, leads Damodaran to value Under Armour’s operating assets at $1.384 billion.
Moving from operating asset value to equity value per share involves adding back the cash balance, subtracting outstanding debt, and subtracting management options. That amount is then divided by the number of shares outstanding, 49.3 million, to arrive at a value per share of $25.73. At the time of the valuation exercise, Under Armour stock was trading at about $19 per share, so the stock was undervalued.
Relative valuations also are possible on young growth companies, using one of two approaches: revenue multiples or forward-earnings multiples. However, each approach has its problems because there are likely to be major differences across companies. “No matter how careful you are about constructing a set of comparable firms and picking the right multiple, there will be significant differences across the firms on both the level and the quality of expected growth,” he wrote. To compensate, Damodaran recommended the same techniques used for relative valuations of all companies (chapter 4):
- The growth story.
- Adjusted multiples.
- Statistical approaches.
He finished chapter 6 with this advice:
“Time can be your ally. Even the most worthy growth company will disappoint investors at some point, delivering earnings that do not match up to lofty expectations. When that happens, there will be investors who overreact, dumping their shares, and embarking on their search for the next great growth story. The drop in price will offer you an opportunity to pick up the company at the right price.”
The author: Aswath Damodaran is the author of three books on valuation and is a professor of finance and the David Margolis teaching fellow at the Stern School of Business at New York University. There, he teaches corporate finance and equity valuation courses in the MBA program. His research interests lie in valuation, portfolio management and applied corporate finance.
This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
