Valuation 202: Valuing Companies On The Grow

Last time in this series on valuation, we began the intermediate course on valuation with Valuation 201, where we discussed valuation strategies for young companies which were either just born or within the first few years of their existence.

Today in Valuation 202, we discuss valuation strategies for companies which have survived their tough initial years and are now in the high growth phase of their lifetime. So, your first question probably is, what defines a growth company?

Going back to Valuation 101, I had spoken about something known as a financial balance sheet, where assets are divided into assets in place (existing assets) and growth assets (investments expected to be made towards acquisition of assets in the future). Growth companies can be defined as those companies which derive most of their value from growth assets rather than assets in place. The company is given ample scope for future investment in assets because of the presence of strong long lasting tailwinds for the company.

Growth companies are often characterised by a typical set of traits as discussed below:

Fluctuating Earnings And Financials: The earnings and financials of growth companies are among the most unstable out there. They can gyrate this way and that over the years and even over a period of a few months.

Valuation Disconnect: Listed growth companies usually command very high valuations on the markets. There is invariably a great degree of disconnect between the book values and the market values of such companies, with the market values being way higher than the book values because markets usually tend to discount future growth prospects in advance. This is also part of the reason why these companies invariably trade at rich PE multiples.

Increased Debt Capacity: In comparison to young companies, growth companies have a greater debt capacity and a higher allocation to debt in their capital structure. They can afford this because they have managed to survive the crucial first few years of their existence and can now kick on to take their operations to the next level. This also allows them to take advantage of financial leverage to further magnify their profits and earnings.

Short And Unstable Market History: These companies usually have a very short history for which data points like profits, earnings and stock prices are available, and whatever little data is available is also usually pretty unstable.

There are a few common issues an investor may face when valuing a growth company, both intrinsically and relatively. The issues that intrinsic valuation of growth companies present stem from the facts that growth companies face constant changes in scale. Growth companies keep growing year on year, but after a point, it is invariably impossible for a growth company to keep growing at the same rate as it had in the past. Moreover, businesses which have strong growth potential, inevitably attracts competition, which in turn sees growth get attenuated. Estimating how quickly growth will slow down and estimating how growth will change the fundamental characteristics of the company, present the biggest problems in valuation of growth companies.

Coming to relative valuation, as with young companies, the question of which firms are your comparable firms remains, because no two growth companies can sustain similar growth rates over a substantial period of time. Moreover, growth companies are inherently risky, no two growth companies are as risky as the other, and there is no clear method or procedure to relatively value the varying degree of risk between two growth companies.

But, as always, where there are problems there are also solutions. Let us first look at solutions for intrinsic valuation of growth companies.

When valuing a growth company intrinsically, it is important to value the operating assets of the company and estimate future revenue growth for the company. Companies with quality goods and services, headed by managers with a high level of integrity and incompetent competitors will be able to grow faster for longer periods of time.

Next, it is important to see how long a growth company will take to transition from high growth companies to stable growth, mature companies. Estimating the time period required for the transition is a function of the quality of the business in question. What we are looking for here is, quality growth companies with sustainable underlying businesses, backed by durable and widening competitive advantages. Growth companies with these characteristics will be able to sustain the high growth phase for longer than other growth companies.

Coming to solutions for relative valuation, first, instead of using the traditional PE ratios for comparison, look to try and base your valuation on the PEG ratio. PEG Ratio = PE Ratio/Annual Earnings Growth Rate. So, for example, if you are analysing a stock with a PE multiple of 16 and an expected annual earnings growth rate of 15, PEG Ratio = 16/15 = 1.07. Look for companies which have a PEG Ratio of less than one, because that usually shows that the markets have not yet realised the growth potential of the company and therefore the growth potential is yet to be fully discounted.

Secondly, instead of using standard valuation multiple, those of you with a statistical bent of mind can make use of regression equations. A multiple regression equation with the valuation multiple as the dependent variable and growth and risk as the independent variables will help us control for risk across a large number of growth companies.

So much for intrinsic and relative valuation solutions for growth companies. Now lets look at the three key factors that drive value for growth companies :

Scalable Growth: The logic here is two pronged and simple. Firstly, the faster your company grows, the larger it inevitably becomes. Secondly, as the years go by, the growth base becomes larger, and because of the high base effect, it becomes that much more difficult to sustain high rates of growth. Look for growth companies which can sustain reasonable growth over long periods of time, in spite of high growth bases.

Teflon Coated Against Competition: As companies begin to grow, they attract competition, which inevitably eats away at the profit margins and market share. Look for companies which have strong, durable and widening competitive advantages which helps protect the profit margins and market share.

Quality Growth: Look for companies which not only grow, but also create incremental value for investors as a result of its growth. As Warren Buffett famously said, “We look for companies which earn a dollar’s worth of growth and pay out more than a dollar’s worth in value.”

As an example of a growth company in India, consider the case of Himadri Speciality Chemicals Limited (HSCL). One of the company’s main products is Coal Tar Pitch (CTP) which is a raw material for graphite electrodes and aluminum smelting. The recent tailwinds which have been created in the graphite electrode and aluminum industries, have in turn created tailwinds for HSCL as well, which are likely to last for at least the next 2-4 years. Moreover the management has recently announced that plans have been put in place to increase production capacity, which would mean that the total manufacturing capacity of the company would be 60000 metric tons per annum. This represents an investment in growth assets which would add value to the company going forward. All these are tell tale signs of a growth company.

So in summary, look for companies which have the ability to offer a wide array of offerings to a larger section of the available market, combined with the presence of strong long lasting competitive advantages and availability of the stock at a reasonable price.

So, that’s all there is in this piece on valuation of growth companies. See you next week for Valuation 203, where we will discuss valuation strategies for stable growth mature companies.


Himadri Speciality chemicals main product is CTP( coal tar pitch) not CPC and recent Tailwind is due to supply constrain of CTP and its ideal example of Capital Cycle in commodity business and If all similar companies go for capacity expansion then in future they may erode there own margins
personally on this topic probably Himadri is not a perfect example

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@ashit Sorry for mentioning the wrong product (was typing that part while watching the Under 19 World Cup final which India won earlier today, honest mistake :P). Have made the correction in the original post. As far as the tailwinds are concerned I feel they will be long lasting for the following reasons:

  1. HSCL is India’s largest CTP producer. Being the leading producer in an industry is undoubtedly a durable competitive advantage because it may give HSCL a certain degree of pricing power.

  2. The graphite shortage is expected to last for the next three to five years. Leading graphite electrode companies in India like Graphite India Limited and HEG have already negotiated supply contracts for the next five years in the range of $9000 - $10000 per tonne. And when production of graphite electrodes increases, demand for CTP, which is a raw material in the production of graphite electrodes, may also increase.

  3. Even after the supply shortage situation surrounding CTP and graphite electrodes sorts itself out, the next set of tailwinds will come from the government’s plan to implement the EV drive in India from 2020. Graphite electrodes are used to produce Lithium ion batteries which are used in electric vehicles. So when that happens, the increased requirement for graphite electrodes is likely to stimulate demand for CTP all over again.
    Of course a BJP victory in 2019 is a major caveat in this regard.

  4. CTP is also used for aluminum smelting. Most metals are going through a strong cycle right now. And aluminum is expected to play a major role during the impending infrastructure boom which is likely to come around in the next few years. So demand for CTP may receive another fillip.

Hope you find this explanation helpful.