Often when a business has a record of strong growth, investors are willing to pay a premium multiple if they expect that growth to continue. Earnings multiples of 50x, 75x, or more than 100x are not uncommon, especially for businesses that are just starting to ramp up their profitability. But how much should investors pay to participate in this strong growth? This blog will attempt to provide a high-level framework for how the Montaka team thinks about valuation for high growth businesses, and in particular online technology platforms.
What should be noted at the outset is that not all growth is created equal. Whilst a business that is growing revenues at 100 percent per annum sounds impressive, there are more factors that need to be considered before concluding that this is a great business worthy of investment.
Firstly, what are the margins on those incremental revenues? If all the extra revenues are at very low, or even negative margins, then this could reduce the attractiveness of that business. Secondly, what level of capital expenditure is necessary to achieve those revenues and earnings? These capital outlays will determine the company’s return on invested capital, and whether any business growth will be value accretive. Thirdly, investors must consider how sustainable this growth is. For example, if a business is a first mover in an industry it may have produced a strong track record of growth. However, in the absence of genuine barriers to competition, competition may be heating up, and this will most likely erode away future economic returns.
Finally, if we conclude that a business is attractive on the above dimensions, the discussion then pivots to what price to pay for this business. We are seeking to identify value opportunities – in other words, companies that are trading for less than our estimate of their worth.
Given the broader considerations discussed above, multiples are an overly simplistic way to think about valuation for high growth businesses. There is absolutely a world where a business on a 100x forward earnings multiple is extremely cheap. Multiples pay no attention to all these other factors, instead providing a numerical output that trades usefulness for simplicity.
It’s worth reiterating the fact that the value of a business is the present value of all future cash flows – said another way, how much cash can you extract from that business over its life? This is precisely how we think about valuation, and we make an assessment around what the likely future cash flows of a business will be. This assessment of value can be complicated when analysing online technology platforms, given that these businesses have real options.
We have written in the past on online technology platforms (OTPs). Companies such as Facebook or Tencent are OTPs, and the OTP model has enabled them to build enormous user bases. When combined with sizable R&D budgets, and the acknowledgement that there’s the perennial need to stay ahead on the technology curve to maintain leadership, these businesses possess real options to create, and quickly scale up new businesses across these large user bases.
If one were to consider just the core business when projecting the cashflows for these OTP businesses, they are ignoring the potential future returns that a business like Tencent could get on its R&D. These returns on R&D for tech platform giants such as Tencent are potentially much greater than traditional companies by virtue of their enormous user bases. For example, if Tencent were to introduce a new service, it can feed it to its approximately 1 billion monthly active users. What happens is that there’s the potential for this new service to ramp up and gain scale faster than has ever been achievable by businesses historically, and this has been enabled by the internet and low costs of marginal production and distribution.
There’s the potential for investors to either underestimate, or completely ignore the value embedded in these real options. At the same time, you don’t want to be paying a rich price for future businesses that you have absolutely no visibility on – this would require venturing into the realm of speculation which is not how we operate at Montaka. An ideal scenario is when the core business is priced at such an attractive level that the implied value of these other potential businesses is low or even negative. In a situation such as this, it is hard to lose money, and any new businesses that are created in the future are just an extra kicker that can juice the investment returns.
The human mind is typically woeful at visualizing and interpreting exponential growth patterns, and these OTP businesses, given their real options to create new businesses in the future, hold the potential to surprise on the upside (see the graph below).
As Bill Gates pithily observed, “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten”. We are trying to recognize growth where it exists, but will always require that we pay only a sensible price to partake in this growth.
Montaka owns shares in Facebook (Nasdaq: FB)
George Hadjia is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.