How Should We Value High Growth Companies?

When you look at fast-growing companies listed on the stock market, you may realise that some of them are trading at astronomical price-to-earnings (PE) ratios of 50, 60, or even 100 and more.

Given the high PE ratios, many investors would feel that these companies are wildly overvalued. But is that really the case?

Don’t jump to conclusions

You may be surprised, but not every company with a high PE ratio is overvalued. In fact, some high PE companies may even be undervalued. A company’s growth is a function of its value. If we assume a high growth figure for a company, our estimated value for the company would effectively be much higher as compared to a scenario where we assume low growth rates.

But there is a problem with our own ability to predict a reasonable future for a high-growth company. This is because many fast-growing companies are market disruptors. Therefore, it is extremely difficult for investors to predict how they will grow and how the industry they are operating in would change in the future.

For example, a well-known fast-growing company started life merely as an online book seller in the 1990s. If an investor back then was only able to see a future for the company that was locked within the book industry, he would have grossly underestimated the future value of the company.

Often, the growth path of high-growth companies are unclear, even to the company’s management. This is because these companies may be experimenting with many ideas and seeing which ones would grow in the future.

It seems unlikely that management of the online book seller mentioned above had plans to grow the company into what it is today – an online e-commerce platform selling almost anything, as well as the largest cloud computing company in the world – since its inception. To me, it is way more likely that management was figuring out future growth areas for the company to expand into on the go.

So, the real problem with valuing high-growth companies is how we can correctly predict the future of a company even when its management may not have a clear idea what that future will be.

Becoming a better growth investor

A useful but easy way to be a better growth investor would be to review the progress of a high-growth company more often than other types of stocks. For example, a telco company would have a stable business model that may not require constant review. But, for a high growth company, an investor may need to redo a valuation estimate every quarter or as and when new information is shared by management on the company’s future growth potential.

So, if you are looking to be a growth investor, be prepared for the extra work you would need to put in as well.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.