Wednesday, October 26, 2011

Growth (Part 1): The Limits of Growth

When valuing young, growth companies, a key input into the valuation is the expected growth rate in revenues. For these companies to become valuable, small revenues have to become big revenues (and negative operating margins have to become positive ones...) and revenue growth is the driver of value. It is a tough number to estimate and it is easy to get carried away, especially in hot sectors. In this post, I will look at the information that can be used to put limits on this estimate, reasons why some companies may be able to blow through these limits and the disconnect that often emerges between company level estimates (made by analysts) and sector-wide estimates.

The Limits on Growth
Let's start with the fundamental question. When valuing an individual company with potential for growth, how high can the revenue growth rate be? Put differently, how big can dollar revenues become at a company, assuming that it is successful? As I noted in the Green Mountain Coffee discussion in my last post, there are at least two numbers that need to be used as sanity checks.
  • The first is the overall size of the market for the product(s)/services that the company offers. Clearly, the expected revenues for Whole Foods, a company operating in a huge market (groceries) can become much larger than the expected revenues for Green Mountain Coffee, operating in a narrower market. (Whether it will or not remains a judgment call you have to make when valuing the company...)
  • The second are the revenues of the largest players in that market. In effect, you are looking for the point at which revenues will plateau in a particular business. Thus, the fact that Folgers, the largest company in the coffee market, made only $2 billion in revenues in 2010 operated as a cautionary note in how much revenues you could project for Green Mountain Coffee. In contrast, Safeway,one of the largest grocery store companies, had revenues of $42 billion in 2010.
If you are valuing a company in a sector that you are unfamiliar with, you should get a sense of the revenues generated by the entire sector and how much revenues the largest company or companies in the sector had. To help, I have put together a spreadsheet that lists aggregate revenues, by business, for companies in the US, as well as the highest revenue company in each one. While my business categorization may be too broad for some of you, it should help provide some perspective on what comprises large revenues. In making these estimates, though, you will have to exercise judgment, which can cause your "limits" to be different from mine (and your valuation to be higher or lower than mine). The first judgment is the potential market for the product or service provided by the company. While that may be easy for Green Mountain, what is the potential market it for Groupon or Google? In the case of Groupon, is it a slice of the retail business (which would be huge) or it is a smaller subset? In the case of Google, is it the online advertising market or the entire advertising market or is its something else altogether? The second is the market share that you see your company gaining, if it makes it through to mature firm status. In other words,  do you see your company becoming one of the largest companies in the business or remaining a smaller player?

The Exceptions
Now, for the follow up. Over history, a few companies have surprised us be growing beyond even the most optimistic assumptions. How did these legendary growth companies bust through the limits? I see three possible sources for these "positive" surprises:
  1. Expand product/service offerings: A company can increase its potential market, by altering its product/service mix. Amazon.com, in its early days in the 1990s, was primarily an online book retailer. If it had stayed in that business, the potential market would have been small and Amazon's value would have been constrained. By remaking itself as an online retailer (of pretty much any product), Amazon expanded its potential market (and with it, its value).
  2. Expand geographically: While most companies initially target domestic or local markets, the potential market can be increased by expanding geographically. The list of big name companies that have rediscovered growth by going global is long - Coca Cola, McDonald's and Procter and Gamble come to mind.
  3. Expand product reach: In perhaps the most interesting scenario, a company can expand the potential market for a product or service through innovations. The secret for Apple's success in the last decade has not only been a stream of winning products - iPod, iPhone and iPad, but each product has expanded what were small markets (music players, smart phones, computer pads) into much larger ones.
Can these surprises be incorporated into conventional valuation? By their very nature, I don't think they can, since they are unexpected at the point of initial analysis. (If you invested in Apple at the time of the iPod introduction, foreseeing the iPhone and iPad, you have a far better crystal ball than I do...) However, these "market expansion possibilities" can be viewed as options, where companies use existing platforms to generate new products and enter new markets, and can be valued as such. Even if you choose not go down the road of using option pricing models, these options will translate into a premium on conventional valuations, albeit one that cannot be easily quantified. You would expect this premium to be greatest in companies that have a proprietary edge (Apple, with its ownership of its operating system, is a perfect example...) and smallest when products can be imitated at low cost. As an investor, I tend not to include these "options to expand" premium in my initial valuations. If I can find a stock that is cheap relative to intrinsic value, the option premium is just icing on the cake.

From micro to macro... It has to add up.. 
One final note on growth limits. I believe that investors (and markets) generally get the macro story right but are not always consistent on the micro story. Put in revenue growth terms, optimistic investors are right that the social media businesses collectively will generate high revenues in the future. However, here is where I think that they make their mistake. First, if you add up the expected revenue numbers (that are implicit in the valuations you see for these companies) of the individual companies that comprise the social media space, the collective revenues will significantly exceed the forecasted revenues for the entire  market. In other words, your collective market share across companies will be well in excess of 100%. Second, I think that investors are under estimating the ease with which new companies can enter these businesses, under cutting margins and profitability. You can have a growing market where companies have trouble making money.
In fact, the dot com boom provides an interesting historical perspective. In hindsight, investors clearly got the macro story right: that consumers would get more and more of their products/services online. It was in the valuation of the individual companies that they made their mistakes, over estimating growth at these companies and under estimating both the ease of entry/exit into the business and the effect of competition on profitability.


Blog post series on growth

9 comments:

Pacioli said...

Aswath, this is one of the best posts you've done in a long time. Thank you!

Nishant Kashyap said...

Question - Somewhere shouldn't we also price in promoter/management capability to actually execute the plans? If so, how should one do that?

Gopal said...

Prof.Damodaran said -- ...In other words, your collective market share across companies will be well in excess of 100%....

It is important to keep in mind that there are different set of investors betting on different companies in the same sector. So, unless you are planning to invest in the entire sector via an ETF etc, it is not necessary to tally up sum of future revenues to the sector revenue projection. When someone invests in early stage growth companies, inherently they are betting that their horse is going to win and many others in the sector will go out of business/will not grow as projected.

So, the framework is different, more like venture style investing than traditional mature sectors (e.g., staples -- P&G, CP) where sum of the future revenues should add up to the projected revenue of the sector.

Aswath Damodaran said...

Gopal,
That may behaviorally explain what is going on but if the valuations are based on individual company forecasts, you are also saying that sectors composed on young, growth companies are collectively over valued. So, if you can bet against the entire sector (sell short on all of the companies or sell an ETF), you would make money, right?

JR said...

Hi Professor - I would argue that comparing Green Mountain's revenue potential by using Folgers revenues is not an apples to apples comparison.

Green Mountain is very much a convenience-driven product where a consumer pops a coffee packet into the machine and can brew a single serving quickly, no muss, no fuss. Folger's is used typically for brewing multiple cups and the coffee has to be measured into the brewer, the used coffee grounds have to be dealt with, etc. etc.

It's a little bit like saying McDonald's hamburger market size potential should be measured against the sales of ground beef purchased in the grocery store.

Thank you for doing this blog series - it's really great.

Gopal said...

...you are also saying that sectors composed on young, growth companies are collectively over valued. So, if you can bet against the entire sector (sell short on all of the companies or sell an ETF), you would make money, right?

Though personally I am a long-only, buy-to-hold-longterm investor, I would say it may be possible to make money by shorting such ETFs (assuming that those ETFs truly represent the entire sector). Using the dotcom bubble example, if we use Nasdaq as a proxy, probably a investor shorting an Nasdaq ETF would have made money in 2000-01. However, few caveats -

1. In young, growing sectors, the accuracy of sector projections are likely to be less than that in case of mature sectors such as consumer staples. So, shorting based on such erroneous estimates can prove to be risky.

2. Shorting is partially a bet on timing. Especially, in case of young, in-the-news sectors; the market can value irrationally longer than investors can stay solvent. (a recent such example is Whitney Tilson's public short of Netflix and than subsequent rewind of the short with a loss because the stock price kept going up and up... though now his short thesis played out, he lost money in his investment based on that thesis)

Aswath Damodaran said...

JR,
Comparing it to Folger's may be unfair to Green Mountain. Perhaps, it is reinventing this business. But what will this reinvention generate as revenues? That is the open question. As an intellectual exercise, ask yourself the following question. What if everyone who drinks coffee in the US drinks Green Mountain Coffee? What revenues would they have?

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Thiago said...

Hi Prof. Damodaran,
I have a question about the micro adding up to the macro and I hope you can still read this comment even if I put it at a so old post...

Is there any empirical research done on these grounds? For instance, looking if the micro forecasts are adding up to the macro ones? If so, could you maybe send me one reference?

All the best,
Thiago