- August 26, 2022
- Posted by: Ramkumar
- Category: Strategy
Estimating The Value Of Growth
What is growth, and why is it essential when valuing businesses? Does higher growth imply higher value? These are the few questions that an entrepreneur asked me a few days back. The below post provides my dialogue with a young company founder who started his entrepreneurship journey and is looking to raise capital to grow his startup.
For a young company burning cash, adding value implies a higher growth rate and the assumption that negative operating margins will turn positive over time. For such a firm, we estimate the firm’s growth rate with the sector-wide estimates. Thus a startup focusing on cryptocurrency will have a growth rate linked to the overall TAM (Total Addressable Market) of cryptocurrency and its growth forecast for the next few years. Thus, the higher the revenue growth generated by the entire sector followed by how much revenues the largest company in that sector made, the higher the estimate of the firm growth rate. For instance, an EV startup growth rate gets linked to the overall growth of the EV market and the revenues that Tesla (the most prominent company by revenues in EVs) generated in that particular year. The next step is to assess how much market share the firm will capture as it matures, which is a function of its ability to raise external capital and its survival potential. For instance, when valuing Nio/Rivian, are we assuming that over some time, it will become the top 5 EV global OEMs, or it will stagnate or even perish?
Our estimated firm growth rate assumes that the firm will grow with the existing service offerings. Still, there is an equal probability that the firm can expand its product/service offerings geographically. For instance, Amazon started as an online bookstore but grew to cloud and OTT over time. Thus, an analyst valuing Amazon as an online retail store cannot estimate that it would continue to grow by 20% CAGR for the last twenty years. We can extend this example to Coke and Apple. However, these companies are exceptions and thus difficult to estimate the growth rate to arrive at the intrinsic valuation. However, we can view these expansions as options and value them using Option pricing models. For instance, when Apple launched iPod, few realized they would succeed with iPhone and iPad, and the same customers using the iPod will use the iPhone. We can extend this optionality to Facebook and other platform companies where a new product launch on a platform will have a set of their existing customers, thus giving them a first-mover advantage. An option pricing model gives a premium to the discounted cash flow valuation.
Despite the conviction that the TAM of any new sector, like the social media industry, will grow, all the firms in the sector will not grow at the same rate. For instance, if i add up the revenues of all the firms in the social media sector, the combined revenues will exceed the forecasted revenues of the social media sector. We term this phenomenon Big Market Delusion. We can see this phenomenon in the dot com bubble, where the macro story of products/services shifting online was right. Still, we overestimated the growth of the dot com companies and underestimated the ease at which new firms can enter/exit and the effect of competition on profitability. Thus, the valuation of dot com companies was over the roof resulting in the exit of many dot com firms when the dot com bust happened.
As companies scale, it is difficult to sustain high growth because of the base effect and companies losing their competitive advantage over time. Of course, there are companies like Amazon, Google and Apple, but these are exceptions rather than the norm. As companies lose their competitive advantage, their growth rate approaches the nominal GDP.
As growth decelerates quickly at companies, delivering a 25% growth rate is far easier in year one than the same firm growing at a 25% growth rate in year nine. So when valuing a retail firm, a growth rate of 30% requires opening 20 new stores in year one but continuing to achieve a 30% growth rate in year nine, the firm has to open 200 new stores. Opening 200 new stores is challenging. Thus, we may need to revisit if a 30% growth rate in year nine is realistic when the overall sector is growing at 5%.
Value Of Growth
Does adding growth increase firm value? In my view, growth adds value only when the return of investing in new assets exceeds the cost of capital to fund investments in new assets.
For instance, assume that firm’s after-tax operating income = 10 million.
Invested capital =(BV of equity + BV of Debt – Cash) = 100 million
ROIC = 10%
To add value, a firm needs to generate more than 10 million without adding new investment by reducing costs or a firm can increase investment by another 50 million and generate 5% after-tax operating income. However, lowering costs to improve efficiencies has limitations, and firms cannot infinitely reduce costs to keep growing. Thus, for sustainable growth, making new investments is necessary, and the returns that the firm generates on the new investments determine if the growth adds value.
As companies scale, the marginal ROIC decreases, making it difficult for firms to sustain their competitive advantage.
Marginal ROIC = Change in revenues/Change in Invested capital.
Thus, we see companies like Facebook and Netflix struggling to grow as their marginal ROIC has recently declined.
Growth and Management Credibility
When we invest in any growing company or any Venture Capitalist invest in a startup, the bulk of value for the company comes from its growth assets, implying that the firm should not just grow at a high rate but generate excess returns (ROIC>WACC). Unfortunately, very few have achieved the above, indicating why achieving growth that adds value is so difficult.
For firms to achieve growth that adds value, management must be credible, competent and trustworthy. Thus, we see VC firms betting on the founders more than the product when investing their capital.
I define the firm’s management must have the following characteristics:
- The founders should have a vision grounded in reality. They cannot describe the potential market for its products as too narrow limiting its growth potential, or too broad, making their growth claims unrealistic.
- A product market fit is the first step; commercial success is elusive without setting up operations, sales and marketing. Founders may not have all these skill sets; thus, setting up the leadership team to take care of these functions is critical. Founders should identify the right people for the right jobs and delegate power to the people to run their functions.
- When thinking about growth, founders need to address potential risks that come with high growth. Thus, a founder discussing growth potential must manage the capital required to deliver this growth and how it will fund the capital. Further, the founder must address the competition risk and how its growth plans can get foiled with a better strategy from competitors and how it plans to counter with a risk mitigation strategy is crucial.
- If founders need external capital, they must listen to the investor’s opinion and willing to change the way they run their business, especially if their strategy does not work. Unfortunately, most startups’ voting power lies with founders when they issue dual-class stocks making it difficult for investors to replace the founder/incumbent management.
Estimating growth and then valuing growth is necessary but simultaneously challenging. For example, suppose founders grow to expand market share rather than improve profitability, or they set unrealistic growth rates to attract external capital. In that case, they use growth as a lever to destroy value.