Characteristics of growth companies
Growth
companies are diverse in size, growth prospects and can be spread
out over very different businesses but they share some common
characteristics that make an impact on how we value them. In this
section, we will look at some of these shared features:
- Dynamic
financials: Much of the information that we use to value
companies comes from their financial statements (income statements,
balance sheets and statements of cash flows). One feature shared by
growth companies is that the numbers in these statements are in a
state of flux. Not only can the numbers for the latest year be very
different from numbers in the prior year, but can change
dramatically even over shorter time periods. For many smaller, high
growth firms, for instance, the revenues and earnings from the most
recent four quarters can be dramatically different from the
revenues and earnings in the most recent fiscal year (which may
have ended only a few months ago).
- Private and Public
Equity: It is accepted as conventional wisdom that the
natural path for a young company that succeeds at the earliest
stages is to go public and tap capital markets for new funds. There
are three reasons why this transition is neither as orderly nor as
predictable in practice. The first is that the private to public
transition will vary across different economies, depending upon
both institutional considerations and the development of capital
markets. Historically, growth companies in the United States have
entered public markets earlier in the life cycle than growth
companies in Europe, partly because this is the preferred exit path
for many venture capitalists in the US. The second is that even
within any given market, access to capital markets for new
companies can vary across time, as markets ebb and flow. In the
United States, for instance, initial public offerings increase in
buoyant markets and drop in depressed markets; during the market
collapse in the last quarter of 2008, initial public offerings came
to a standstill. The third is that the pathway to going public
varies across sectors, with companies in some sectors like
technology and biotechnology getting access to public markets much
earlier in the life cycle than firms in other sectors such as
manufacturing or retailing. The net effect is that the growth
companies that we cover in chapter will draw on a mix of private
equity (venture capital) and public equity for their equity
capital. Put another way, some growth companies will be private
businesses and some will be publicly traded; many of the latter
group will still have venture capitalists and founders as large
holders of equity.
- Size
disconnect: The contrast we drew in chapter 1 between
accounting and financial balance sheets, with the former focused
primarily on existing investments and the latter incorporating
growth assets into the mix is stark in growth companies. The market
values of these companies, if they are publicly traded, are often
much higher than the accounting (or book) values, since the former
incorporate the value of growth assets and the latter often do not.
In addition, the market values can seem discordant with the
operating numbers for the firm – revenues and earnings. Many growth
firms that have market values in the hundreds of millions or even
in the billions can have small revenues and negative earnings.
Again, the reason lies in the fact that the operating numbers
reflect the existing investments of the firm and these investments
may represent a very small portion of the overall value of the
firm.
- Use of debt:
While the usage of debt can vary across sectors, the growth firms
in any business will tend to carry less debt, relative to their
value (intrinsic or market), than more stable firms in the same
business, simply because they do not have the cash flows from
existing assets to support more debt. In some sectors, such as
technology, even more mature growth firms with large positive
earnings and cash flows are reluctant to borrow money. In other
sectors, such as telecommunications, where debt is a preferred
financing mode, growth companies will generally have lower debt
ratios than mature companies.
- Market history is
short and shifting: We are dependent upon market price
inputs for several key components of valuation and especially so
for estimating risk parameters (such as betas). Even if growth
companies are publicly traded, they tend to have short and shifting
histories. For example, an analyst looking at Google in early 2009
would have been able to draw on about 4 years of market history (a
short period) but even those 4 years of data may not be
particularly useful or relevant because the company changed
dramatically over that period – from revenues in millions to
revenues in billions, operating losses to operating profits and
from a small market capitalization to a large one.
While the degree to which these factors affect growth firms can
vary across firms, they are prevalent in almost every growth
firm.
Some characteristics of a value stock
- The price-earnings ratio (P/E) should be in the bottom 10% of
all companies.
- A price to earnings growth ratio (PEG) should be less than 1,
which indicates the company is undervalued.
- There should be at least as much equity as debt.
- Current assets at twice current liabilities.
- Share price at tangible book value or less.