Musings on Markets

Growth and Value: Thoughts on Google, Groupon and Green Mountain

Growth (Part 3): The Value of Growth

2011-10-27T13:26:00.000-07:00

Consider a firm that has $ 100 million invested in capital that generated $ 10 million in after-tax income in the most recent year. For this firm to generate more income next year, it has to do one of two things:

Manage its existing capital (assets) more efficiently: Thus, if the firm can cut its operating expenses and increase its income to $12 million next period, it will have a growth rate of 20% for the next period. Let's call this efficiency growth.
Add to its capital base: If the firm can add another $ 10 million to its capital base and maintain its current return on capital (10%), its income next period will be $ 11 million, with a growth rate of 10% over the prior year. Let's call this "new investment" growth.

While both components feed into observed growth, they are not equal in their effect on value on two dimensions:

Time: A firm can cut costs and make itself more efficient over time but only to the extent that these inefficiencies exist. Thus, a firm that is badly managed may be able to generate efficiency growth for 3, 4 or maybe even 5 years, but not forever. New investment growth is called sustainable growth because it can be continued for as long as the firm can maintain its policy on reinvestment and the return it generates on its investment.
Value: Efficiency growth always creates value, since no investments are needed and earnings and cash flows will go up. Whether new investment growth creates value revolves around whether the higher earnings created are justified by the additional investment that is required to generate them. Since it costs companies to raise capital (the cost of equity for equity and the cost of debt for borrowed money), the return generated on that capital has to exceed the cost of capital for growth to add value. In the example above, introducing a cost of capital of 10% into the analysis will make the new investment growth "worthless", since what is added in value through the higher growth will be exactly offset by the higher reinvestment (and lower cash flows) needed to generate that growth. As an exercise, you can try entering different combinations of growth, return on capital and reinvestment and measure the value effect in this spreadsheet.

Looking at any company's past, you can draw conclusions about whether the growth registered in the past was valuable, neutral or value destroying, by comparing the return on capital generated on the growth investments to the cost of capital. The return on capital itself is computed based on operating income and the book value of capital invested:
Return on capital = Operating income (1- tax rate)/ (Book value of equity + Book value of debt - Cash)
This calculation is also in the spreadsheet referenced in the last paragraph. It is the only place in valuation/corporate finance, where we use book value and we do so because we are looking at the profits generated on what was originally invested in existing assets (rather than their updated market values). There are a host of dangers associated with trusting accounting numbers and I have written about them and what to do to compensate in a paper on measuring returns.

So, how well do publicly traded companies do in terms of delivering returns? Which sectors do the best? To answer the first question, I computed the return on capital and cost of capital for all publicly traded companies listed globally in 2007 and 2008 and found the following:

While the crisis in 2008 took at toll on returns, even in 2007, a good year for most companies globally, about a third of all companies in the US and a higher proportion elsewhere generated returns on capital that were less than the cost of capital. While you may quibble with the year and have issues with how I computed cost of capital and return on capital, I think you will agree that value destruction is far more common at companies than we would like to believe and that quality growth (that increases value) is rare. To answer the second question, I compute returns on capital and cost of capital, by sector, for US companies and report them on my website at the start of every year. You can get the most recent update (from the start of 2011) by clicking here.

For those of you who do not want to go through the process of computing return on capital and cost of capital, I have a simpler proxy for measuring the quality of growth. Start by computing the capital invested thus:
Capital invested = Book value of equity + Book value of debt - Cash
Divide the change in operating income over the period by the change in capital invested over the period; the ratio is a measure of the the quality of the growth, with higher ratios representing higher quality. In the table below, I have computed the number for Google going back to 2003:

In the last column, I computed the marginal return on capital in that year by dividing the change in operating income that year by the change in capital. Based on this measure, in 2009 and 2010, Google saw a drop off in its quality of growth, a drop off I would attribute to acquisitions made by the company to keep its growth rate high. Its pre-tax marginal return has dropped to about 20%; in after-tax terms that would be closer to 13 or 14%, a good return on capital, but not a great one. Investors have had wake up calls in Amazon and Netflix as well in recent days, as the costs of delivering growth have come to the surface. In most growth companies that disappoint, the clues are available in the years before.

Blog post series on growth

Growth and Value: Thoughts on Google, Groupon and Green Mountain

Growth (Part 2): Scaling up Growth

2011-10-26T10:47:00.000-07:00

As companies get larger, it becomes more difficult to sustain high percentage growth rates in revenues for two reasons. The first is that the same percentage growth rate will require larger and larger absolute changes in revenues each period and thus will be more difficult to deliver. The second is that a company's success will attract the attention of other firms; the resulting competition will act as a damper on growth.

I know! I know! You have your counter examples ready: Apple and Google come to mind. First, note that even these exemplars of success have seen growth rates decline over time. In fact, I posted Google's revenue growth (in dollar and percentage terms) in a prior post and while growth rates remain healthy, they have declined over the last decade. Second, the very fact that you can name these great growth companies is an indication that you are talking about the exceptions rather than the rule. Could the company you are looking at right now be the next exceptional company? Sure, but do you want to value your company to be the exception? I would not, since pricing your company for perfection will open you up to mostly negative surprises in the future.

Metrick and Yasuda, in their book on venture capital, have a sobering study on the persistence (or lack thereof) of growth at high growth companies. They compared the revenue growth rates at companies at the time of their IPOs to the average for the sector to which they belong and then followed up by looking at these growth rates in subsequent years.

Reading the graph, the revenue growth rate of the "median" IPO company is 15% higher than the revenue growth rate of other companies in the sector one year after the IPO, drops to 8% two years after, to 5% three years after and to the sector growth rate 5 years after. Put succinctly, company-specific growth at the typical high growth company dissipates in about 4 to 5 years. Even the star IPOs (in the 75th percentile) see precipitous drops in the differential growth rate over the five year period.

Given this evidence that growth decelerates quickly at companies, how do we explain valuations where analysts use 50% compounded growth rates for 10 to 15 years or longer? I think the problem lies in the "percentage illusion", where analysts feel that their growth assumption is not changing if they keep the growth rate unchanged. However, delivering a 25% growth rate is far easier in year 1 than the same firm delivering a 25% growth rate in year 9. The best way to introduce some realism in growth rates is to convert the percentage growth rate in revenues into dollar changes in revenues and consider what the company will have to do in terms of operations to deliver that change. When valuing a retail company, for instance, computing that the company will have to open 300 new stores to deliver a 25% growth rate in year 10 (as opposed to 30 in year 1) may quickly lead to a reassessment of that growth rate. I have a very simple spreadsheet that does little more than this: convert percentage growth rates into revenue changes each period. As an exercise, take any young, growth company that you want to value, put in the current revenues and try different compounded revenue growth rates. The power of compounding continues to amaze me!

Blog post series on growth

Growth and Value: Thoughts on Google, Groupon and Green Mountain

Growth (Part 1): The Limits of Growth

2011-10-26T09:36:00.000-07:00

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:

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).
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.
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