Valuation and Growth

Valuation and Growth


 Its okay to buy growth, just don't pay for it.

  Marty Whitman

This ties in closely to the idea of “Margin of Safety” and is more of a dynamic concept than most investors realize. Valuing a stock of a company depends on where the company is in its life cycle. It could be emerging growth (Micro Cap), growth (Small to Mid Cap and even Large Cap in some cases) or Value (Large Cap that has saturated its market and stopped growing). It could be a cyclical stock closely tied to vagaries of the business cycle. In my own investing my focus is on growth and  the small to mid cap area so that is what I’ll be discussing here. 

I've talked before about "buying cheap", which means buying a stock for less than its intrinsic value. The intrinsic value of a business is equal to all the cash it will generate in the future discounted back to the present time. The way I approach this problem is to focus on companies that have high rates of ROE and/ or ROIC that are currently trading at a low to reasonable P/E ratio and if they pay a dividend I want to see a low payout ratio. The pros deal with things like discounted cash flow analysis and the like but since I steal most of my ideas from the pros I don't bother with that. And I don't really believe that projecting cash flows out to 10 years in the future is a wise policy. Three years makes more sense to me. Just stick with the profitability ratios and a low P/E. I also look at Price to Operating Cash Flow as that metric has more Wager Value than the overused P/E. Operating Cash flow is also a much more difficult metric to manipulate, but use both of them when you can. Where do you see the profits of the company in the next three years? If things take off be prepared for an expanding P/E to compensate for the growth of the company. Another thing to remember is to try to use the forward P/E (based on next year's estimates) since we're dealing with growth companies.

There is more risk when investing in a emerging growth Micro Cap (under 100 million) but if you hit one that survives and prospers the rewards can be enormous. The key drivers to focus on in this area are the size of the potential market. It has to be huge to fuel the growth in revenues. As you move down the food chain in market cap, management becomes a more critical factor in the investment process. They have to manage the expenses of the growing enterprise as well as work on improving the profit margins of the company. If things grow too fast they can spin out of control very easily.  Access to capital is another key area and it helps a lot if the company has some key institutional investors behind it. and of course its needs above all a sustainable advantage over the competition in the form of patents, technology, growing network affects, distribution routes etc...

For larger growth firms (100 million to 2 or 3 billion) scalable growth with sustainable margins will come into play. you want companies that can diversify their product lines and cater to a wider customer base as they grow. Keep an eye on their profit margins. At this stage of the growth cycle revenue will begin to decelerate. The rate of deceleration will depend upon the size of the overall market for its products and services as well as the strength of the competition. The better growth companies will have their revenue growth decelerate at a slower rate. Management as always must steer the ship.

Remember focus on the profitability ratios and growing revenue streams. Are the companies adding value to their enterprise over time? When they stumble and miss their quarterly numbers, Mr Market will provide you an opportunity to make a good long term investment at a reasonable price.

A good little book covering this area of investing is The Little Book of Valuation by Aswath Damodaran.