- October 20, 2021
- Posted by: Ramkumar
- Category: Strategy
Valuing Growth Companies using Discounted Cash Flow Model
In 2008, Zomato was a young startup entering an untapped food delivery market funded by big investors. In the initial years, Zomato snowballed, generating a few million in revenue but was burning cash. Over the following decade, the company saw explosive growth, and in 2021, the company filed for an IPO, and as of today, the Price/BV is 14.3 (Zomato’s current share price is Rs.139). In this post, i provide my insights on how to value growth companies like Zomato.
How do you value Zomato? In my view, Zomato is still a growth company, but it is a much larger one today. Thus, two big questions in valuing it are:
- First, can Zomato sustain growth in the future?
- Second, what is Zomato’s risk profile? How has it changed, and how will it change in the future.
I call a company a Growth business when it gets more of its value from future investments and less from investments already made. Further, these reinvestments should earn excess returns (ROIC>WACC).
So what are the characteristics of a growth business?
- A growth company’s historical earnings and book value would be much less than its future because growth companies raise capital to fund their growth. For instance, Zomato’s book value is Rs.8100 crores, but its value was around Rs.5000 crores a year earlier.
- As the value of a growth company gets linked to their future performance, their market value would be very high compared to book value. As in Zomato, its P/BV is 14.2.
- Growth companies carry less or no debt in their balance sheet because they like flexibility.
- A growth company’s market history is short and unstable. For instance, Zomato’s history is less than a year, and its share price is already highly volatile.
DCF Valuation Issues
The above characteristics of the growth company – dynamic financials, disconnect between book value and market value with a short and volatile market history throws challenges in valuing them using DCF and relative valuation.
The intrinsic value comes from its cash flows, growth in the cash flows, and the underlying risks in the cash flows. The biggest challenge in valuing a company like Zomato is that the future growth rate would be much lower than the historical growth for two reasons.
- As the company grows in scale, maintaining a historical growth rate becomes challenging due to size.
- Growth attracts competition. In Zomato’s case, their worry should not only be Swiggy or Amazon but their restaurants themselves.
Thus, critical questions like how much growth will scale down in the future, how the risk changes as the growth changes become the center point when valuing a growth company.
DCF Valuation Solutions
The DCF models for valuing growth companies must be flexible to change growth rates and margins over time. For instance, when valuing Zomato, i make the following estimations:
- The food delivery market will continue to expand in India as internet penetration increases and more people access smartphones. Thus, I assume that the total addressable market for Zomato would grow by 20% annually in the next ten years, and Zomato’s market share would evolve from 42% in 2021 to 40% thus, indicating Zomato has strong network effects. Therefore, I assume Zomato will have less competition, and its high-quality management can maintain a 40% market share in the food delivery market.
- Zomato’s revenues as %of GMV would stay stagnant at 20-22% because, with scale and brand name, customers would be ready to pay a high delivery fee to Zomato.
- Zomato would continue to burn cash, but its operating margins would improve from -24% in 2021 to 35% in the next ten years. Thus, Zomato would continue to scale at the expense of margins in the initial years. Still, its focus would pivot to improvement in margins as it gets matured as Zomato reduces its SG&A expenses.
- Zomato’s Sales/Invested capital is 5 in 2021 and would remain the same or slightly decline to 4 in the next ten years. Thus, for every $1, Zomato reinvests in the business, earning $4 to $5.
- Zomato’s WACC is 10.25% at 2021 because its cost of equity should be high when its growth rate is high, but as it matures, the cost of equity should come down. Thus, i reduced Zomato’s WACC to a mature company of 9.5% after ten years.
- Zomato’s ROIC would improve to 12% in the next ten years and would remain the same.
After deriving the free cash flows for the next ten years, the biggest challenge is to arrive at a terminal value, especially for a growth company that comprises 90-100% of the firm’s current value. In the case of Zomato, after year 10, i assume its growth rate to be 4.19%- the estimated growth rate of the Indian economy. As Zomato becomes a mature business, i give Zomato the characteristics of a mature company: low cost of equity and debt and low reinvestment to sustain the low growth rate.
Stable reinvestment rate = Terminal Growth rate/ROIC.
For Zomato, the growth rate is 4.19% and target ROIC is 12%
Reinvestment rate = 4.19%/12% = 34.9%
I do not set Zomato’s target ROIC to be WACC because i feel that Zomato’s strong network effects and brand name will fetch higher ROIC than its competitors.
Thus when i discount cash flows over the next ten years with the cost of capital, i arrive at Zomato’s value of operations as Rs.3,51,670 million.
Once i get the value of operating assets, i add back the cash and subtract debt and management options to arrive at the equity value and the value per share.
In Zomato’s case,
Cash on hand = 6406 million
IPO proceeds = 90,000 million
debt = 6,869 million
Value of equity = 4,41,207 million
Value of options = 57,435 million
Shares oustanding = 7946.68 million
I get the value/share for Zomato as Rs.48.29, much lesser than the current price of Rs.132. Thus, i find Zomato to be highly overvalued.
For any growth company to be successful, it has to scale revenues and at the same time preserve margins. Thus, when valuing such companies, i take care of the following points:
- As firm scales, the growth rate declines. Thus, companies that diversify their product offerings and cater to a broader customer base will sustain their high growth rates. Thus, Zomato needs to diversify its offerings from food delivery to a last-mile logistics player to justify its current price. I assume that the market is factoring this when pricing Zomato.
- Growth attracts competition. Thus companies that have differentiated offerings will have a sustainable competitive advantage against the competitors. Moreover, successful firms do not grow at the expense of profit margins.
- Valuable companies can be disastrous investments when you buy them at a high price. Thus i always screen for cheap companies. In addition, I always advocate for patience and wait for a time when companies disappoint in their earnings calls. At this time, investors always overreact and dump shares, which will be the perfect moment to buy the stock.