Investors often fantasise about buying shares in the next Google – now Alphabet (US:GOOG) – or Facebook (US:FB) before the business hits the big time. Backing the biotech that develops the next blockbuster drug, unearthing the explorer that strikes gold – black or otherwise – or discovering a market disrupter like Uber or Airbnb almost guarantees outsized returns. But potential superstars tend to be risky, unpredictable propositions: they can remain unprofitable for years and many go bust. So how do we minimise the chance of a slip-up when trying to pick growth shares?
Investors seeking to double or triple their money in a few years tend to flock to small, fast-growing companies. They often look for businesses that are ‘first movers’ in their industry or have some proprietary product or technology that gives them a leg-up on the competition. Those companies may have greater pricing power and be able to negotiate superior terms with suppliers and distributors. They may also realise greater economies of scale than their rivals and foster deep loyalty and brand recognition among their customers. And a reputation for being disruptive and ambitious can entice talented employees, attract external funding and help management to secure partnerships and win big clients.
However, rapid growth has its risks and drawbacks. A company that scales up too quickly may see costs spiral and quality suffer as it splurges on workers, equipment and premises, strains its infrastructure and juggles new and existing customers. A flood of new employees can also reduce productivity, upend workplace dynamics and alter a company’s culture, threatening the ‘je ne sais quoi’ that made it prosper. Managers may also grow overconfident or complacent, leading them to alienate stakeholders, or buckle under the intense pressure to perform.
Research has shown that rapid top-line growth is no guarantee of profits. In a study of 500 high-growth companies in 2002, two business professors – Gideon Markman and William Gartner – found that revenue growth of more than 500 per cent over a five-year period was not correlated with consistent profits. In a similar study of more than 45,000 companies in 2000, a trio of US business experts (Sexton, Pricer and Nenide) found that companies able to finance growth through cash generation were more profitable than those that grew uncontrollably and couldn’t finance that growth internally.
The relentless pursuit of growth can ultimately lead to a company’s demise. In his book The Innovator’s Dilemma, Harvard business professor Clayton Christensen warns that corporate practices that lead to success, such as focusing investments to maximise profitability and catering to key customers, can be harmful in the long run. Indeed, shareholders may eventually balk at the innovations and investments required to deliver the growth rates they expect. Mr Christensen highlights the case of AT&T (US:T), which squandered about $50bn (£34.6bn) on acquisitions and eroded even more in shareholder value as it battled to meet Wall Street’s growth expectations. That example points to the inevitable fate of fast-growing companies: they will eventually fall short of the market’s ever-rising expectations. Indeed, their shares often price in the perceived value of future lines of business that don’t yet exist: more than three-quarters of Dell's (US:DELL) market cap in August 2002 represented the value that investors placed on future, highly cash-generative assets in which they expected management to invest.
More simply, fast revenue growth is often hard to achieve. In a study of 172 of the largest US companies between 1955 and 1995, fewer than 10 managed real sales growth of more than 6 per cent. Moreover, among the companies where growth had already stalled, only 4 per cent recorded growth of even 1 per cent above the nation’s economic growth rate. Therefore, argues Mr Christensen, investors should demand companies attain profitability as soon as possible: “Ventures that are allowed to defer profitability typically never get there.” He adds that in bad times profits can provide a safety net, stave off cutbacks and may help company executives to retain the support and enthusiasm of the board and shareholders.
Several experts have developed ways to value fast-growing, unpredictable, heavily loss-making businesses. In a paper published in 2000, McKinsey management consultants extolled the virtues of discounted cash-flow models: negative earnings and a lack of historical data don’t matter, they don’t distinguish between expensed and capital investment, and their reliance on performance forecasts allows them to capture the value of unprofitable businesses. They attempted to value Amazon (US:AMZN) on that basis, but also considered several other factors. For instance, they envisioned what the e-commerce giant and the retail industry would look like in 10 to 15 years’ time when the business matured and began to grow at a sustainable rate.
They accounted for Amazon’s business model, assuming the group would require less working capital and fewer fixed assets than traditional retailers. They also estimated average revenue per user, gross margins and ‘total penetration rate’, or the proportion of the population using the group’s services. And they considered Amazon’s track record of entering and quickly dominating new product categories: it became the largest US seller of consumer electronics in just 10 days.
The authors combined those measures to draw up four estimates of Amazon’s future market share, margins and capital requirements. For instance, in a “fairly optimistic” scenario, they saw the group becoming the largest online retailer in the US and the leading overall retailer in several markets. In that case, they pegged turnover at $60bn and operating profits at $7bn in 2010, and valued the company at $37bn. With hindsight, their estimates were a little off.
Industry analysts ranked Amazon as the nation’s 26th biggest retailer in 2010, while the group earned operating profits of $1.4bn on turnover of $34bn in 2010. On the other hand, the company’s working capital requirements and fixed costs as a proportion of turnover were significantly lower than they predicted. But they came closer on customer numbers: they predicted Amazon would grow from 9m customers in 1999 to 120m worldwide in 2010; the real number was 130m. Perhaps the most useful takeaway from their analysis is their use of four scenarios that are added up and weighed by probability to arrive at a fair value for the company.
