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