Guess The Valuation – Inaugural Edition

As a fundamentally and valuation driven investor, I am continuously amazed at some of the equity valuations the public market bestows on growth companies, even in an age of near-zero interest rate borrowing conditions.

So for those valuation-driven readers, let me present the first of what I will simply call “guess the valuation.” I present you with financial metrics and you tell me how much you think a growth investor, at most, should be willing to pay in total equity market capitalization terms.

Before the comments start coming, understand that I am fully aware that this exercise is overly simplistic and one would want to have more data before answering such a question. Humor me please to play along, and feel free to give the company below the benefit of the doubt (within reason).

Unidentified Company X

Financial results for the first 9 months of 2019

Revenue: $1 billion (+50% yoy)

Gross Profit: $600 million (+50% yoy)

R&D Expenses: $250 million (+50% yoy)

Marketing Expenses: $350 million (+35% yoy)

General/Admin Expenses: $125 million (+60% yoy)

Operating Loss: $125 million (-35% yoy)

Operating Cash Flow: $20 million (N/M)

Okay, guess the equity value assuming zero net debt on the balance sheet…

8 thoughts on “Guess The Valuation – Inaugural Edition”

  1. Good quiz !!

    If this is a SaaS company, public markets will pay between 15-20 times revenue for this.

    But this is clearly a “price” not a “value”. Even VCs would have paid “only” 10x revenue 2 or 3 years ago.

  2. I’ll preface this by stating I’m a credit analyst, and equity investing is more a hobby for me.

    The thing that stands out to me is that gross profit is growing in line with revenue and a steady margin implies linear marginal cost of production, so I conclude (perhaps incorrectly) this isn’t a software business. Assuming that the growth rate is sustainable in the near term and the absolute cash burn gives them a descent runway, I’d take a speculative position at around 5x revenue and be prepared to be very patient (I’m relatively young). The market, though, seems very irrational when anything presents growth, so I’d expect the price to be a ridiculous multiple of sales and my valuation to be a pipe dream!

  3. Is it possible that a company can invest in different parts of their financial statements and that perhaps this is hiding some value creation?

    For instance, if you were an investor in Walmart at its IPO in 1970, when do you think you saw it generate positive free cash flow? Would it surprise you if the answer was the late 1990’s?

    If a company grows by investing in human capital and intangible assets (such as computer code) that flows through the income statement and is expensed 100%, are those investments any better or worse than depreciation which reflects only a portion of the cost of capital expenditures and in reality does a poor job of reflecting actual economic earnings particularly in inflationary environments?

    The honest answer is it’s tough to tell sometimes what the value of and return on investments in intangibles is, whereas growth investments in the form of capital expenditures on new stores or new manufacturing capacity lend themselves to easier understanding of profitability of new stores/capacity, especially in conjunction with metrics like comparable store sales.

    So the answer to your question is there is not enough information given to make an even remotely educated guess. With that said, the growth in sales despite slowing sales and marketing expenses is a positive sign for the viability of the business. Businesses with constant customer acquisition issues face continually high sales and marketing expenses as a % of sales.

    1. I agree that today’s financial metrics are not going to be very predictive for those 10 years from now. Just because this company loses money now does not mean the business model is broken. What we can do is look at more mature firms in the same sector and extrapolate a reasonable valuation today assuming strong growth assumptions that are possible but far from assured.

      I am not sure the Walmart example is ideal though, because they were making profits on the existing stores even as they were reinvesting those profits into building new ones. The unidentified company in this post has been in business for 13 years. If you look at Walmart’s 1975 annual report (13 years after they opened the first store in 1962), you will see that WMT grew revenue by 40% in fiscal 1975 and earned an operating margin of 6%. The stock traded for 16x trailing earnings and 2.5x trailing sales.

      Companies growing 40% today are often losing money and trading for 5-10x that multiple of sales. While we don’t know their ultimate future, we can make certain assumptions about revenue growth over the next decade, the ramp of margins during that time, and determine a reasonable valuation today for such projected growth. I just don’t think the current market environment is doing that very effectively, by assuming that every high growth business today is going to compound at similar rates for many, many years.

  4. Looks like Shopify?
    I can’t really comment on the valuation because I haven’t looked at SHOP in detail. That said, I notice there are a number of well-regarded funds on the holders list: e.g., Lone Pine, Coatue, Whale Rock, Baillie Gifford. Before bashing the valuation and madness of crowds, maybe try to consider what these investors are seeing in the business model / shares?

    1. Yes, it is Shopify (SHOP), trading at more than 20 times projected 2020 revenue.

      I think you are right that tech investors right now are focused on finding the best companies (as judged by sales growth/new customer growth) and are setting aside valuation completely (at 20x sales I don’t think that is an unfair statement). The big question, to me anyway, is whether or not valuation at some point can/should negate the strong growth profile of the business.

      In the case of SHOP, let’s assume they grow sales by 35% next year as expected, and then do another 25% annually for 5 more years. By 2025 revenue will quadruple over 2019 levels, to roughly $6B. Let’s further assume that they somehow get profit margins from negative today into the black handily (25% net margins) by then. Investors at today’s prices would need the stock to fetch a 50x P/E in 2025 in order to earn 10% annually between now and then. So a very bullish 6-year outlook by any measure yields “average” returns. The risk/reward just seems out of whack to me.

      I get that the Amazon’s and Google’s of the world have made it seem like valuation doesn’t matter over the last 10-15 years, but I just don’t buy the argument that the tech revolution is so impactful that all money-losing SAAS companies can trade at 10-20 times sales today and still make outsized returns for their investors in the coming 5-10 years. Sure there will be a handful that deliver on the promise, but I don’t think most will. So the question becomes, what price, if any, is too high…

      1. Let’s go back to the start of the year. This would have been a 16b company. On your (admittedly bullish) math it’d be trading at less than 11x 2025 net income (before adding back share based compensation which people like to do).

        Give me a lot of software companies have fcf similar if not higher than net income, this could conceivably have looked like a double digit fcf yield company 5-6 years out. For some investors that might have looked pretty attractive even with a forward sales multiple at the time likely above 10x.

        But to your point, i agree there are clearly valutions where your future expected returns won’t make sense, but on the other hand if investors think they are looking at some kind of category killer, they may be able to get there even at double digit sales multiples. Especially if there are some optionalities which could accelerate growth (in this case, perhaps shop has the potential to be an amazon lite, plus a big financial services business given they see their merchants revenues on a real time business)

        1. There is such a big difference between 10x sales and 20x sales, which is why I was not writing about SHOP at $140/share but did at $365. I can understand why a supposed best in class operator would be justified at 10x to many growth investors. After all, 5-8x sales is probably about right for most of these businesses at maturity/scale, so paying 10x for the best positioned that are growing 30-40% today is rich, but not crazy. But once you get to 15-20x sales, the math starts to look problematic. Thanks for the comments.

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