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,
And if we are to think about growth stocks as compounding machines, the most successful ones should outgrow their high valuations… Which makes the returns attractive, even after a gradual reversion of the mean.
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 makes many traditional valuation metrics, mostly irrelevant. Investors in these high growth 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. Some valuations can get so extreme that sustained returns are simply an 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 are 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 are 3 main categories within the “great economics” category:
- 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 can grow revenues faster than 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 operating expenses like SG&A and R&D, to arrive at Operating Income. The higher the Operating Margin, the more revenue 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.
In the initial stages of building a network effect, a company might have to spend aggressively on marketing. Once the network effect is in place, the company can focus on monetizing the network.
Facebook’s EPS in 2012 at $0.01 diluted doesn’t fully capture their growth possibility. You can see that 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 actually don’t. These might have expenses that scale just as high as revenues as a company grows.
An example could be a company with compensation for sales people tied to performance. If sales people are paid on commission which scales as total company revenues scale, margins will stay the same.
#2: Impenetrable competitive moat
One of the best ways for a company to combat competitive forces is with an impenetrable moat.
Coca Cola, while not considered a growth stock anymore, was a perfect example of a moat (aka competitive advantage) in the 1990’s. Their moat allowed the company to increase prices even as more alternatives hit the market.
The company’s most popular drinks, like Coke and Diet Coke, have brought fierce brand loyalty. So much so that customers had to have Coke and only Coke, which let the company continue to raise its prices. This allowed the company to 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. It helped the stock return 49%+ annualized (with reinvested dividends) from 1987-1997.
The main products for Coca Cola had competitive advantages due to their superiority, which led to dazzling growth.
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. This can be especially accentuated from new entrants bringing intense competition.
A lesser source of competitive advantage can eventually be eroded over time. It can make even 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. Try to honestly evaluate a company’s perceived competitive advantage and its staying power, without bringing biases.
#3: High exposure to secular growth trends
This one is straightforward but also potentially dangerous.
Common secular growth trends include new markets or industries borne from technological innovation. 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 maintain its market share and grow very fast.
As more customers demand the products or services that an industry provides, serious growth can accrue for all players in an industry. Many of the detrimental competitive strategies, like price cutting and customer stealing, doesn’t need to happen until the industry matures.
A strong moat and a secular growth trend can be a spectacular source of compounding. A company can get exponential growth as it swallows competitors and grows with its 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 secular growth trend.
To illustrate just how fast growth can occur in a situation like this, here are 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%
- 2020: 28.3%
- 2021: 70.7%
Along the way, Tesla has had to make serious investments in future growth (through capex). This suppressed free cash flow in 2015-2017. It also created 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
- 2020: $5,943 million
- 2021: $11,497 million
- TTM: $14,078 million
Being in a secular growth trend played a big part in Tesla’s success. Since the company could barely keep up with customer demand for their EVs, their capital investments were very efficient. High growth was easily achieved.
Limitations of a Secular Growth Trend
However, at a certain point, investors can get so excited about a secular growth trend that they bid up company valuations to irrational values.
It can take even the greatest growth stocks years to recover from irrationally high valuations. Take Qualcomm ($QCOM) and Cisco ($CSCO) during the 1999/2000 Dot Com Crash. Fast forward 20 years; neither of the stocks have recovered from their impossible highs.
#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 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 entering the field might be smaller.
This can particularly be significant if the returns on capital in the industry are also smaller. It discourages new capital looking for high ROIC projects from disrupting the industry. This allows a 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 the most expensive stocks. Sometimes those reasons are justified. I hope this framework brings you better understanding as 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.
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.