The Smart Investor
    Facebook Instagram
    Monday, June 5
    Facebook Instagram LinkedIn
    The Smart Investor
    • Home
    • About
      • About Us
      • Careers
    • Smart Investing
      • Getting Started
      • Investing Strategy
      • Smart Analysis
      • Smart Reads
    • Special Free Reports!
    • As Featured on BT
    • Our Services
      • Our Services
      • Subscribe now!
    • Login
    • Cart
    The Smart Investor
    Home»Growth Stocks»Did Investors Overpay For Growth Companies Last Year?
    Growth Stocks

    Did Investors Overpay For Growth Companies Last Year?

    With stock prices of growth companeis falling hard, did investors overpay for them last year? Or are stocks now just too cheap?
    Jeremy ChiaBy Jeremy ChiaMarch 28, 2022Updated:March 29, 20224 Mins Read
    Facebook Twitter LinkedIn Email WhatsApp
    Question Mark over Face
    Share
    Facebook Twitter LinkedIn Email WhatsApp

    Investors who have had a vested interest in high-growth stocks in the past year, myself included, have (to put it mildly) experienced steep drawdowns.

    This begs the question, did we overpay for these companies? 

    Many high-growth stocks in early 2021 were trading at high valuations and it was not uncommon to find such stocks trading at price-to-sales (P/S) multiples of more than 30. Their P/S multiples have since collapsed. Was that just too expensive or are multiples too cheap now?

    Mapping the future

    To answer this question, we need to make certain assumptions about the future. Let’s make the following conservative assumptions.

    First, in 10 years’ time, a company’s valuation multiple will contract and will then trade between 25 to 40 times free cash flow. Second let’s assume the business in question can have a 20% free cash flow margin by then.

    The table below shows a scenario of a company that initially had a P/S multiple of 50 and managed to grow revenue by 40% per year for the subsequent 10 years.

    Source: My Calculation

    Without diving too much into the details, in the above scenario, I worked out that investors who paid 50 times revenue for the company would still enjoy a nice gain on the investment in 10 years of between 60% and 180%(depending on the free cash flow multiple it trades at in the future).

    To be clear, I also included a 3% annual increase in share count to account for stock-based compensation which is commonplace for high-growth companies.

    Looking at the table above, we can see that just because a company traded at a high multiple, does not mean it is doomed to provide poor returns. If the company can keep growing revenue at relatively high rates while eventually producing a healthy free cash flow margin, investors can still make a respectable return.

    Bear in mind, many of the companies that were trading at 30 times revenue or higher in 2020 actually achieved faster growth rates than 40% in 2020 and 2021. This means their future revenue growth rates can fall below 40% for investors to still achieve fine returns.

    It is also worth pointing out that many companies that were trading at high multiples also command high gross margins and have the potential for higher free cash flow margins than 20% (which was my assumption in the example above) at a mature phase. This means that even if the company grows revenue at a slower annual pace than 40%, investors could still make a handsome return.

    Sieving the wheat from the chaff

    Although the above calculations give me confidence that paying up for a company can provide good returns, not all companies have such durable growth potential.

    During the bull run of 2020, there was likely too much optimism around mediocre companies. These companies don’t actually have the addressable market or the competitive advantage for them to keep growing to justify their high valuation multiples. These companies will likely never be able to return to their peaks.

    When paying a high price for a company, we need to assess if the company has a high probability of growing into its valuation or if it is simply overpriced.  

    Final thoughts

    Just because stock prices are down now doesn’t mean those who paid a high price would not eventually yield good results. Zoom-out and look at the long-term picture. If a company can keep growing its business, then a high stock price may be warranted and still provide very respectable long term returns.

    But at the same time, be mindful that not all companies will exhibit such durable growth. Make sure to assess if your companies are the real deal or just pretenders.

    Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.

    Looking for investment opportunities in 2022 and beyond? In our latest special FREE report “Top 9 Dividend Stocks for 2022”, we’re revealing 3 groups of stocks that are set to deliver mouth-watering dividends in the coming year. 

    Our safe-harbour stocks are a set of blue-chip companies that have been able to hold their own and deliver steady dividends. Growth accelerators stocks are enterprising businesses poised to continue their growth.  And finally, the pandemic surprises are the unexpected winners of the pandemic. 

    Want to know more? Click HERE to download for free now!   Follow us on Facebook and Telegram for the latest investing news and analyses!

    Disclosure: Jeremy Chia does not own shares in any of the companies mentioned.

    Share. Facebook Twitter LinkedIn Email WhatsApp

    Related Posts

    Rebate

    Get Smart: Earning Rebates from the Stock Market

    June 4, 2023

    Top Stock Market Highlights of the Week: Trust Bank, AIMS APAC REIT and SATS

    June 3, 2023
    Danger Sign (Yellow)

    18 Psychological Pitfalls to Watch for When Investing

    June 2, 2023
    Facebook Instagram LinkedIn Telegram
    • Careers
    • Disclaimer & Privacy Policy
    • Subscription Terms of Service
    © 2023 The Smart Investor. All Rights Reserved. The Smart Investor, thesmartinvestor.com.sg, an investment education website managed by The Investing Hustle Pte Ltd (Company Reg No. 201933459Z) is not licensed or otherwise regulated by the Monetary Authority of Singapore, and in particular, is not licensed or regulated to carry on business in providing any financial advisory service. Accordingly, any information provided on this site is meant purely for informational and investor educational purposes and should not be relied upon as financial advice. No information is presented with the intention to induce any reader to buy, sell, or hold a particular investment product or class of investment products. Rather, the information is presented for the purpose and intentions of educating readers on matters relating to financial literacy and investor education. Accordingly, any statement of opinion on this site is wholly generic and not tailored to take into account the personal needs and unique circumstances of any reader. The Smart Investor does not recommend any particular course of action in relation to any investment product or class of investment products. Readers are encouraged to exercise their own judgment and have regard to their own personal needs and circumstances before making any investment decision, and not rely on any statement of opinion that may be found on this site.

    Type above and press Enter to search. Press Esc to cancel.