If you buy a growth company, the bulk of the value that you attach to the company comes from its growth assets. For these growth assets to be valuable, though, not only do you need high growth potential, but the company has to be able to scale up its growth while ensuring that it generates returns that exceed its cost of capital, while delivering this growth. That is tough to do, and it should come as no surprise that most young, growth companies do not make it through these tests. Investors who are able to look at a large group of young, growth companies, and separate those that will survive...
Growth (Part 3): The Value of Growth
Consider a firm that has $ 100 million invested in capital that generated $ 10 million in after-tax income in the most recent year. For this firm to generate more income next year, it has to do one of two things:Manage its existing capital (assets) more efficiently: Thus, if the firm can cut its operating expenses and increase its income to $12 million next period, it will have a growth rate of 20% for the next period. Let's call this efficiency growth.Add to its capital base: If the firm can add another $ 10 million to its capital base and maintain its current return on capital (10%), its income...
Growth (Part 2): Scaling up Growth
As companies get larger, it becomes more difficult to sustain high percentage growth rates in revenues for two reasons. The first is that the same percentage growth rate will require larger and larger absolute changes in revenues each period and thus will be more difficult to deliver. The second is that a company's success will attract the attention of other firms; the resulting competition will act as a damper on growth.I know! I know! You have your counter examples ready: Apple and Google come to mind. First, note that even these exemplars of success have seen growth rates decline over...
Growth (Part 1): The Limits of Growth
When valuing young, growth companies, a key input into the valuation is the expected growth rate in revenues. For these companies to become valuable, small revenues have to become big revenues (and negative operating margins have to become positive ones...) and revenue growth is the driver of value. It is a tough number to estimate and it is easy to get carried away, especially in hot sectors. In this post, I will look at the information that can be used to put limits on this estimate, reasons why some companies may be able to blow through these limits and the disconnect that often emerges between...
Growth and Value: Thoughts on Google, Groupon and Green Mountain
In the last week, I noticed three stories that at first sight seem to be unrelated but I think share a common theme:The first was on Google, with the focus being on how much Google is spending to impressive growth numbers.The second and continuing story is on Groupon and it’s imminent or not so imminent IPO, with the emphasis being on the accounting shenanigans and market whiplash.The third story is on Green Mountain Coffee, an incredible success story over the last five years, and the skepticism that some investors are showing about whether it can sustain its growth.While the stories are on different...
