Learning about valuing high growth companies seems almost like an oxymoron. The stock market clearly has two opposing camps, growth and value, and so the idea of putting a valuation on a growth stock can sound heretical to some.
But as Warren Buffett once said, “growth and value investing are joined at the hip”.
And if we are to think about growth stocks as compounding machines, many of the most successful ones will outgrow their current (high) valuations as their superior compounding of earnings and free cash flows outpaces the gradual reversion of the mean of valuations as growth slows.
In other words, the best growth stocks outgrow their valuations.
Their high valuations are either sustained, or reduce as the company grows.
This very real factor behind growth stocks working as compounding machines makes many traditional valuation metrics, particularly price-based ones like P/E, P/S, or P/FCF mostly irrelevant—as investors in these stocks aren’t investing for today’s results but rather for tomorrow’s compounding.
At the same time, investors valuing high growth companies can’t just throw caution to the wind when it comes to valuation, as some valuations can get so extreme that sustained growth at those levels become a simple business impossibility.
The 4 Main Features of the Most Attractive Growth Stocks
So let’s talk about a beautiful blend of valuation and growth, the profitable gray area between the polarized value and growth investors.
To understand both the pros and cons of growth stocks we need to understand the source of their greatest potentials, but also the limitations of that potential.
We’ll cover these 4 features of successful high growth companies:
- Ability to scale from great economics
- Impenetrable competitive moat
- High exposure to secular growth trends
- Inherent advantages in starting small
These are great buzz words in growth stock analysis, but they should not be blindly applied to each and every growth stock just because Wall Street does it.
You’ll find that each of the 4 big factors require both quantitative analysis and deep thought into whether the factor truly applies to the stock you are analyzing.
There’s also limitations to these factors in overcoming ridiculously optimistic valuations, which we can also quantify with some simple math.
#1: Ability to scale from great economics
The way I see great economics as a huge driver of growth for businesses becomes evident from a cursory peek into a company’s financials.
There’s 3 main categories in which investors commonly cite great economics as a main growth driver inside of this feature of successful growth companies:
- Operating leverage/ Operating margin
- Asset light business models/ High ROIC
- High gross margins/ High FCF Yield
I hope not to overwhelm you but to use basic definitions and presentations to spur deeper research and thinking on your part.
Operating Leverage/ Operating Margin
Don’t confuse operating leverage with financial leverage. Financial leverage refers to debt, which is generally bad the higher it becomes. Operating leverage refers to a company’s ability to scale and increase margins as it grows, which is generally good the higher it becomes.
A high operating leverage means a company that can grow revenues faster than increases in operating expenses to support that growth.
What high operating leverage looks like in a business is an increase in operating margin as a business grows its revenue.
Operating margin, quickly, is simply Operating Income as a percentage of Revenue.
You take revenue, subtract the cost to produce the goods or service, and subtract employment expenses such as selling and admins and R&D, to arrive at Operating Income. The higher the Operating Income compared to Revenue the higher operating margin, which usually flows down to higher profits.
Example of Operating Leverage: Facebook
For example, Facebook was able to grow operating margin from 10.6% in 2012 to as high as 49.7% in 2017, and it’s easy to understand how if you understand its business.
Facebook relies on network effects for its growth. This network effect means that they need a certain number of users to make up a community in order for the service to be worthwhile to use.
But once the network effect is in place, the company doesn’t need to spend much in order to increase potential revenue from the product.
Where in the beginning of a network effect a company could have to spend aggressively on marketing in order to build the network, once the network effect is in place the company can focus on monetizing the network—maybe spending on engineers to do this, but at rates that are much less expensive than building the network.
Looking at Facebook’s EPS in 2012, at $0.01 diluted, doesn’t fully capture their growth possibility since by 2017 they had a healthy diluted EPS of $5.39 from that much higher operating margin.
Limitations of Operating Leverage
Some businesses may sound like they have great operating leverage opportunities, but in reality the expenses scale just as high as revenues as a company grows.
Even a company in a business like SaaS, or Software as a Service, can have little to no operating leverage even though companies in this industry are highly sought after because they are implied to have the ability to scale from operating leverage.
It comes down to looking at the numbers, and details in the financials, in order to make a best estimate on whether the company truly has operating leverage potential or not.
An example could be a company with compensation for sales people tied to performance, in an aggressive way where the full benefit of higher revenue doesn’t accrue to higher operating margin.
One last ability to scale example: if a company is positioned to grow in revenues with its customers as they grow, they can have significant scalable abilities.
Perfect example of this are b2b (business-to-business) companies which serve solutions for critical aspects of a company’s business model, like Information Technology (IT).
If a SaaS company charges another company for usage, then as a business’s needs for usage of that software grow, then the SaaS provider sees revenues that grow in-line with their customer’s growth, with little added expenditures needed to grow sales from already established customers.
Companies which tend to benefit from this ability to scale with their customers include IaaS (information as a service) and PaaS (platform as a service), as well as a myriad of other types of b2b business models.
Limitation on scaling with customers: Like with operating leverage limitations, there could be increased expenses required with growing revenues from higher customer usage.
For example, if more sales personnel are needed to cross sell current customers and cancel out any operating leverage possibilities in growing with the customers, then the growth of profits and free cash flow are limited to just matching the growth in the customer’s spending.
Physical capacity limits can also work in the same way, such as for IaaS businesses, where increased expenses accompany the increase in sales and will slow growth potential due to these physical and capital limitations.
#2: Impenetrable Competitive Moat
One of the biggest downsides to investing in technology businesses is the effect of deflation with many of the products and services—which come about from the blazing fast speed of innovation.
In other words, prices for today’s technology go down as the tech gets better.
For a simple tangible example of the deflationary nature of technology, particularly in hardware, just think about how expensive big screen TVs used to be even 10 years ago. Today you can get the same sized TV with better resolution for 1/10th of the price of that size TV 10 years ago.
Prices of old products generally drop as products get better or provide more value to customers.
One of the best ways for a company to combat these deflationary effects is with an impenetrable competitive moat.
Coca Cola, while not considered a growth stock anymore, was a perfect example of a moat (aka competitive advantage) in the 90’s which allowed the company to increase prices as more alternatives hit the market.
Because the most popular Coca Cola drinks, like Coke and Diet Coke, brought such fierce brand loyalty that customers had to have Coke and only Coke, the company was able to consistently raise prices, and thus grow without having to spend aggressively to acquire new customers.
Coca Cola had dominant pricing power.
And that pricing power become one of the company’s big competitive advantages, which helped the stock return 49%+ annualized (with reinvested dividends) from 1987-1997.
The main products for Coca Cola had competitive advantages inherently due to their superiority, which lead to a competitive advantage for the company and dazzling growth to follow.
Again, don’t dismiss this example just because Coca Cola is an “old money” stock today.
For many decades Coca Cola was the #1 stock on the market, which is why it got its ticker symbol “KO”. The stock had consistently been a “knock out” stock, and Buffett rode perhaps its greatest wave through the 90’s.
Limitations of Competitive Advantages
The problem with a competitive advantage is that it often doesn’t last forever, especially when the economic results from such a moat bring intense competition.
A lesser source of competitive advantage such as scale or cost reduction can eventually be eroded over time, and make the best investments very subpar in the years to follow.
An example of this would be IBM, whose tyrannical competitive advantage in mainframe computers wasn’t enough to thwart the eventual innovations of the desktop and PC.
Unfortunately there’s no perfect measurement of the strength of a competitive advantage, which makes evaluating this factor so difficult.
That’s where concentrated, thoughtful analysis comes into play.
A key part of insightful thinking is in limiting the inherent biases you bring into an analysis, which is much easier said than done.
But by staying hungry for knowledge, and constantly testing your assumptions and biases, you can put yourself on a better track towards honestly evaluating a company’s perceived competitive advantage and the likelihood it can continue for serious growth.
#3: Exposure to Secular Growth Trends
This one is so straightforward that it almost doesn’t need discussion, but investors also need to be careful with it.
Some of the most common secular growth trends include the emergence of a new market or industry due to technological innovation or inventions. As an industry moves through a commonly established life cycle, there becomes a duality of opportunity as the market grows.
A company participating in a secular growth trend, in an industry that is growing, can simply participate in high growth by maintaining its market share.
As more customers or businesses demand the products or services that the industry provides, serious growth potential can accrue for all of the players in an industry—and many of the detrimental competitive strategies like price cutting and customer stealing doesn’t need to happen until the industry matures.
Combining a strong competitive advantage with a secular growth trend can be a spectacular source of compounding growth for a company and its shareholders, as a company swallows competitors and grows with a market.
Electric cars (EVs) are a perfect example of a secular growth trend that’s not likely to go away.
Tesla has been able to achieve extraordinary levels of growth due to both a competitive advantage and participation in a secular growth trend.
Just to illustrate just how fast growth can occur for a company when it’s part of a secular growth trend and is the leader in that trend (Tesla’s cars are hands down the coolest EVs in the market), here’s the revenue growth numbers over the last 8 years for the company:
- 2011: 74.9%
- 2012: 102.3%
- 2013: 387.2%
- 2014: 58.8%
- 2015: 26.5%
- 2016: 73.0%
- 2017: 68.0%
- 2018: 82.5%
- 2019: 14.5%
Along the way Tesla has had to make both serious investments in future growth (capital expenditures) which suppressed free cash flow in 2015-2017, and also take large depreciation expenses on these investments which suppressed earnings in 2018-2019.
But look at Tesla’s current cash from operations (2018, 2019, TTM) now that their past capital investments are starting to bear fruit:
- 2010: -$128 million
- 2013: $265 million
- 2018: $2,098 million
- 2019: $2,405 million
- TTM: $4,349 million
Being in a secular growth trend played a big part in Tesla’s success, since the company could barely keep up with customer demand for their EVs, which make their capital investments (capital expenditures) very efficient at providing growth and potential future growth.
Limitations of a Secular Growth Trend
However, at a certain point, investors can get so excited about a secular growth trend that they bid up company valuations to irrational values compared to even the company’s greatest potential.
Tesla makes for a perfect example of this again.
It should be widely understood that the future of the EV market is essentially as a replacement for traditional gas-powered vehicles, or ICE (internal combustion engines).
Consider that the following top ICE players have reported the following for recent sales:
- Toyota = $250B
- GM = $115B
- Honda = $125B
- Ford = $130B
- Tesla = $28B
That leaves Tesla with a possible addressable market of ~$700B, and if we assume that the growth for EVs will eventually slow due to that market eventually being saturated, then even with a (ridiculous) 50% share of that TAM, Tesla would have $350B in revenues.
Contrast that to Tesla’s valuation today, and the valuations for companies in the matured ICE industry (P/S around 1), and the growth valuation for Tesla ($610B today) looks like it could be stretched even as it benefits greatly from a secular trend.
In other words, it’d have to take almost all of the current market share, assuming a matured market after the cannibalization of ICE to EVs finishes.
Now of course Tesla could find profitability through other adjacent markets such as battery production or even auto insurance (link to rumors of that), but until those business models are proven it does provide an interesting case study between valuing high growth stocks on observable data vs speculative themes.
#4: Inherent Advantages in Starting Small
Companies with small revenues in small markets have a two-fold advantage in being small.
#1- A company with $100 million in revenue only needs $10 million in new sales in order to grow by 10%, while a company with $70 billion in revenue needs $7 billion to grow by that same 10%.
It’s simple math.
And so, a small company could serve a more smaller niche market for a while, and return fabulous compounding returns.
#2- This law of small vs big numbers applies to the types of competition that a smaller business is likely to run into as well.
If an industry has a TAM (total addressable market) of only $1B, then the risks of a big player like Amazon for example ($350 billion in sales) entering the field might be smaller since it’s small potatoes for the company.
This can particularly be significant if the returns on capital in the industry are temporarily suppressed, discouraging new capital looking for high ROIC projects from disrupting the industry and allowing the small company to build its own significant competitive advantage.
Limitations to the Small Size Advantage
If an industry does become extremely profitable, with high returns on capital and/or attractive margins, then that industry can attract all sorts of sharks no matter the size.
In that case, the smaller company better have a compelling competitive advantage in order to thwart the inevitable constant attacks from new and established competitors.
There are many variables when it comes to valuing high growth stocks, and I don’t want to imply that the key factors are limited to just these 4.
However, they are among the most popular reasons justifying stocks with the seemingly obnoxiously highest valuations—and sometimes those reasons are justified. I hope this framework brings you better understanding to why.
At the end of the day there’s no one size fits all answer to valuation for any investor.
We all have different goals, different time horizons, and a different circle of competence which helps us sleep at night with the investments we have researched and selected for the long term.
I hope this framework is a great starting point towards your journey to financial freedom as a stock market investor.
Hopefully I’ve inspired you to take a leap into the next rabbit hole so that you can compound your knowledge in the industries and companies you look into.
Whether you’re looking at growth stocks or sticking to value, always remember to invest with a margin of safety, emphasis on the safety.
Perhaps the greatest margin of safety for an investor, out of it all, is knowledge.