Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 418

Four tips to catch the next 10-bagger in early-stage growth

If investors cast their eyes back over the last two decades, it’s obvious the stock market’s massive winners and 10-baggers – the likes of Amazon, Google and Afterpay – have always looked overvalued and un-investable based on conventional valuation methods. Many investors wielding traditional valuation tools shunned these stocks and missed out on staggering returns.

When investors value established companies, it is a relatively straightforward exercise guided by market capitalisation and earnings multiples, as well as some subjective elements. But it is much more difficult to value early-stage growth companies. Investors often lack these foundations and are forced to follow a process that looks quite different.

Small cap equity investors, particularly, must frequently value less mature companies with short revenue histories, zero profit, and that require significant external capital for growth. Without years of financial data to rely on, early-stage companies and their investors must employ more creative ways to substitute these inputs.

We are in a period of unprecedented innovation and disruption globally. Exciting new companies are emerging every day. If investors can better understand how to value young, fast-growing companies, they will be much better placed to identify the next 10-bagger.

When DCF doesn’t work

For investors to grasp the challenges in valuing early-stage growth companies, they must first understand the mechanics of Discounted Cash Flow (DCF), a valuation method that all analysts are taught.

A DCF financial model projects the expected cash flows of a business into the future. Those future cash flows are then brought back to a value today by applying a discount rate to adjust for the level of risk and uncertainty faced in achieving those cash flows.

The DCF methodology is relatively easy to implement when investors value mature business that have years of consistent earnings and stable margins. But it is much harder to value a business using DCF when its earnings streams are less predictable, such as in an early-stage, fast-growing company. This can lead to potentially extreme mispricing of equities over time, as the likes of Amazon, Google and Afterpay all appeared overvalued but recorded spectacular growth.

Useless metrics

As with DCF, many of the stock standard valuation metrics such as P/E (price/earnings) or PEG (price/earnings to growth) can be completely useless when analysing immature companies.

Their P/E or PEG ratios can look astronomical, and change wildly, because their current earnings may only be a tiny sliver of their potential earnings when they mature. To achieve scale, these companies are often heavily reinvesting in themselves with high R&D costs. Revenues may grow rapidly, but it could take years to deliver profits.

Why is Afterpay’s ‘value’ so high?

A classic example is Afterpay. “How can it be valued so high when it doesn’t make a profit?” they ask. By ‘valued’ we assume they mean its market capitalisation.

Our answer is simple: Afterpay’s valuation, such as its P/E, is so high because it is deliberately keeping the ‘E’ low to non-existent by reinvesting for future growth. Given Afterpay’s superior offering, and the massive size of its potential markets, we would prefer that the company reinvest and realise that potential, rather than spit out profit today.

At the risk of oversimplifying, you can have revenue growth or you can have profits now, but you can’t have both.

Their Australian business is highly profitable but they are using that excess cash flow to grow and take market share in new geographies, meaning they have little to no profit at a group level. The moment they stop reinvesting for growth to prioritise generating profits, at least in the short to medium term, this would likely represent to us a signal for exiting the business.

The corporate lifecycle

The stylised example below paints a typical picture of a corporate’s lifecycle. Many early-stage growth companies simply don’t have free cash flows that are used to value the worth of a share. So, investors must make assumptions about what these will look like in the future.

Corporate Life and Death – a stylised lifecycle

Source: Aswath Damodaran

Turning to qualitative factors

But how do you make those assumptions?

To evaluate young, high-growth companies, analysts must dive into the underlying business, and judge how long it will take to mature. They will need to refer less to financial ratios and income statements, and more to qualitative factors such as:

  • Recurring revenue
  • Scalability
  • Competitive advantage
  • Size of addressable market
  • Best-in-class leadership
  • Organisational culture
  • Track-record of success
  • Ability to create new revenue streams

Few of these traits can be meaningfully reflected in spreadsheets.

For legendary investors, such as Peter Lynch, Warren Buffett and Howard Marks, it is the quality of a company’s growth that determines its value, not revenue or even earnings growth per se. When they analyse the broad range of factors outlined above, they can make informed judgements on which businesses are most likely to be long-term successes.

Focusing on four factors

The study of early-stage companies should focus heavily on four key factors:

1. Identifying assets

Usually, the first thing to consider when formulating a valuation for an early-stage company is the balance sheet. List the company’s assets which could include proprietary software, products, cash flow, patents, customers/users or partnerships. Although investors may not be able to precisely determine (outside cash flows) the true market value of most of these assets, this list provides a helpful guide through comparing valuations of other, similarly young businesses.

2. Defining revenue Key Progress Indicators

For many young companies, revenue is initially market validation of their product or service. Sales typically aren’t enough to sustain the company’s growth and allow it to capture its potential market share. Therefore, in addition to (or in place of) revenue, we look to identify the key progress indicators (KPIs) that will help justify the company’s valuation. Some common KPIs include user growth rate (monthly or weekly), customer success rate, referral rate, and daily usage statistics. This exercise can require creativity, especially in the start-up/tech space.

3. Reinvestment assumptions

Value-creating growth only happens when a firm generates a return on capital greater than its cost of capital on its investments. So a key element in determining the quality of growth is assessing how much the firm reinvests to generate its growth. For young companies, reinvestment assumptions are particularly critical, given they allow investors to better estimate future growth in revenues and operating margins.

4. Changing circumstances

Circumstances can move or change quickly for early-stage companies. When a young company achieves significant milestones, such as successfully launching a new product or securing a critical strategic partnership, it can reduce the risk of the business, which in turn can have a big impact on its value. Significant underperformance can also result when competitive or regulatory forces move against a company.

Landing the next 10-bagger

At Ophir, we believe that the market should reward the businesses with the greatest long-term potential premium valuations.

If you avoid early stage growth businesses simply because they have high valuation multiples compared to the market (such as P/Es), you will often miss the most exciting businesses and the next ‘10-bagger’.

That doesn’t mean you should ignore valuation measures, and they are a core part of our process. You can still overpay for high-growth companies.

But when you analyse high-growth early-stage companies, you need to accept that the long-term potential of a business ultimately matters more than its valuation at any given time.

 

Andrew Mitchell is Director and Senior Portfolio Manager at Ophir Asset Management, a sponsor of Firstlinks. This article is general information and does not consider the circumstances of any investor.

Read more articles and papers from Ophir here.

 

RELATED ARTICLES

Is your fund manager skilful or just lucky?

Where will investment returns come from in 2021?

A year like few others, but what's next?

banner

Most viewed in recent weeks

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Welcome to Firstlinks Edition 467

Fund manager reports for last financial year are drifting into client mailboxes, and many of the results are disappointing. With some funds giving back their 2021 gains, why did they not reduce their exposure to hot stocks when faced with rising inflation and rates?

  • 21 July 2022

Welcome to Firstlinks Edition 466 with weekend update

Heard the word, cakeism? As in, 'having your cake and eating it too'. The Reserve Bank wants to simultaneously fight inflation by taking away spending power, while not driving the economy into a recession. If you want to help, stop buying stuff.

  • 14 July 2022

Welcome to Firstlinks Edition 465 with weekend update

Many thanks for the thousands of revealing comments in our survey on retirement experiences. We discuss the full results. And with the ASX200 down 10%, the US S&P500 off 20% and bond prices tanking, each investor faces the new financial year deciding whether to sit, sell or invest more.

  • 7 July 2022

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.