High-Growth-Investing 101

Everything you need to know to get started

What is High-Growth-Investing?

The great successes of Warren Buffet have made value investing popular in recent decades. Value investing is an investment style in which buying and selling decisions are made primarily by comparing the stock price with the real value of the company's shares. This means that buy and sell decisions are based on the relationship between the current price, i.e. the share price, and the value in real life, independent of the stock market.

The share price is understood as the current price tag attached to a company's shares. The theory behind this was developed by Benjamin Graham. The basic idea is that the real value of a share and its price can diverge significantly, but in the long term they will always converge.

High-Growth-Investing is modern Value Investing

Even when investing in fast-growing companies (= high-growth investing), a stock is nothing more than a specific stake in a company. And just as in the case of classic value investing, there is a fair price for this share that has to be estimated.

In high-growth investing, we look for companies whose intrinsic value (in the real world outside the stock market) grows as rapidly and exponentially as possible over time. The stock price will fluctuate more or less sharply around this intrinsic value. It will, however, also tend to rise rapidly over time as it approaches the intrinsic value in the long run.

So we let time work for us.

This is an important principle of growth investing.

A stock should be bought when its price is far enough below its fair (= intrinsic) value. Value investors call this difference the "margin of safety". It represents the short- to medium-term potential of the stock.

In general, you should try to estimate the fair value of the company in 2 to 3 years to determine the medium-term potential. If this calculation shows a potential of at least 50%, or even better 100 %, the stock is a buy candidate that you should take a closer look at.

Just as with traditional value investing, you should make sure that you don't pay too much when you start. Because here, too, the profit lies in the purchase.

You should consider selling the stock when the price has risen well above its intrinsic value and shows little potential for the next 2 to 3 years.

This article aims to give you some advice on how to estimate intrinsic value and thus decide when the stock market valuation of a growth company is acceptable. And when to assume overvaluation and refrain from buying.

Unlike traditional value investing, we do not even try to buy a stock as cheaply as possible. This is because really cheap growth stocks (in the classic value investing sense) are virtually non-existent. And if there is a supposed bargain, it is pretty safe to assume that the technology or platform on offer is probably not as promising as the marketing would have us believe.

Why the rules are different for high-growth stocks

The usual metrics of traditional value investing, such as price/earnings or price/book ratios, are often not useful for evaluating growth stocks. As a result, the classic value investing approach has never really worked in the high-tech sector.

This is because high-growth companies are generally in "land-grab mode", focused on maximising growth in new markets, while profitability is not yet the focus of management. As a result, profit-based metrics such as P/E ratio (price/earnings ratio) make little sense.

The most important assets of such companies are often intellectual property and network effects. These assets do not appear on the balance sheet, but only become visible when another company is acquired by one of the tech giants at a breathtaking price. As a result, book value or ratios based on it, such as the P/B ratio (price-to-book value ratio), say little about the "true" value of a growth company in the real world.

Excluding oil giant Saudi Aramco, the world's seven most valuable publicly traded companies at the end of 2023 were Apple, Microsoft, Alphabet (Google), Amazon, Nvidia, Meta, and Tesla - with market capitalizations ranging from 3,000 billion USD to 800 billion USD.

However, a value investor would probably never have invested in any of these “Magnificient Seven” in their early stages, as they always looked overpriced and risky by traditional standards. It is only in later stages - usually when growth flattens out - that these high-growth companies become real money-printing machines.

That is when they are discovered by value investors. Even Warren Buffet has been successfully investing in Apple since 2016, despite his previous aversion to high-tech.

Assessment of the potential of a high-growth stock

In the case of growth companies that are already profitable, traditional methods of fundamental analysis can also be used to assess the potential of a stock, as with any other stock:

The "fair" price of a share is calculated (in very simplified terms) as the product of the expected earnings per share for the current year and the normal price-to-earnings ratio for the industry. So if a company makes a profit of 10 USD per share and a P/E ratio (price/earnings ratio) of 15 is common for comparable companies, a fair price might be 150 USD.

It is sometimes difficult to find the appropiate P/E ratio for the industry. As far as I know, there are no generally available statistics, so you often have to rely on comparisons with other companies in the same sector. For example, you could compare the P/E ratios of Apple, Google, Amazon, Microsoft and Meta. However, this is a bit like comparing apples and oranges, but more on that later.

Once the 'fair' price has been determined, compare it with the current price. This will give you the short to medium term potential of the stock. In addition, you should always calculate the fair price on the basis of the expected profits for the next year and the year after to determine the longer-term potential. If this calculation results in a potential of around 50% to 100%, the share is a buy candidate and should be looked at more closely.

The dilemma of high-growth stocks

So far, so good. This sounds logical and is, so to speak, the basis of equity valuation - regardless of the sector.

Unfortunately, at least in the case of young technology and platform companies, such a classic assessment of potential does not work. This is because there is usually no profit and therefore no P/E ratio. In fact, the company often consumes a lot of cash during its period of rapid growth.

This is not a weakness of these companies, but a clearly articulated and perfectly sensible corporate objective at this stage in the company's life cycle.

Book value is also often not really relevant for technology stocks. This is because the assets, such as the intellectual property of the technology and possibly network effects, are generally not reflected in the balance sheet. On the other hand, after initial acquisitions, there are sometimes relatively large intangible assets on the balance sheet and it is difficult for an outside private investor to assess the value of these items.

Maybe that sound a bit complicated.

The good news is that, in my experience, balance sheet analysis is nowhere near as important in high-growth-investing as it is in traditional value investing.

So the big question is: how can you still try to estimate the future value of a company, and therefore the potential of a share, when all the classic traditional methods of calculating fair value fail?

The concept of Enterprise Value

Firstly, it is important to understand the term "Enterprise Value". It is often confused with market capitalisation, but can be quite different, especially for smaller technology companies.

Market capitalisation is the share price multiplied by the number of shares issued.

Enterprise Value (EV), on the other hand, is essentially the market capitalisation adjusted for debt and cash.

EV = market capitalisation - cash + debt

In a nutshell: Enterprise value is the theoretical price at which the naked company would be acquired in a takeover.

For example, a strategic buyer may be willing to put 1.5 billion USD on the table for a technology company with 500 million USD in cash and no debt. In this case, the amount required for the bare bones of the business (e.g., customer relationships and technology) would be 1.0 billion USD because the buyer is also getting the $500 million in cash.

The EV/Sales ratio for the valuation of high-growth stocks

If you divide the Enterprise Value by one year's sales, you get the most popular metric for valuing a technology company that is still losing money.

In our example, with a market capitalisation of 1.5 billion USD, 500 million USD in cash, no debt and a turnover of 250 million USD, the EV/Sales ratio is 4.

EV/Sales = (Market Capitalisation - Cash + Debt) : Sales

What EV/sales multiple is considered cheap depends on a number of factors such as:

- The attractiveness of the market in which the company operates, measured by the size of the TAM (Total Addressable Market).

- The company's position in that market

- The growth rate of the company

- The business model or the type of revenue the company generates (revenue mix)

Of course, this one valuation ratio alone tells us relatively little. Too little to make an informed judgement about how expensive or cheap a stock really is. The business models and the value creation and profitability resulting from the different models are too different.

Therefore, in the following sections you will be introduced to another important ratio. You will learn how to use it to estimate profitability even when a company is still in the red instead of making a profit.

The Gross Margin

For me, the second most important metric of a growth stock after EV/Sales is gross margin.

Gross margin is a good indicator of the profitability of a business model. It is calculated as the percentage of sales remaining with the company after deducting direct production costs.

Gross Margin (%) = (Sales - Cost of Sales) : Sales

The higher this percentage, the more money a company has available to cover the other so-called overhead costs that are incurred independently of product manufacture.

Overheads are generally divided into four cost blocks, which are also shown in the profit and loss account:

- Sales and Marketing (S+M)

- Research + Development (R+D)

- General administration costs (G+A)

- Capital costs

In addition to these overheads, there is also the need to finance investments and leave a surplus for shareholders that is as attractive as possible.

There are striking differences in the gross margins of high-growth companies in particular, which can tell you about the quality of a business model at any stage of a company's development.

Understanding the business model

You may be wondering what constitutes a good gross margin. To be able to judge this, you first need to take a closer look at what is known as the sales mix. Only when you understand how a company makes its sales, can you assess the gross margin and derive an estimate of the company's fair value.

At the very least, you should be able to distinguish between the following sources of revenue for a company:

- Hardware sales (all physical products)

- Services

- Software licence sales

- Support and maintenance contracts

- Subscriptions / subscription models

- Software as a Service (SaaS) / cloud subscriptions

I will discuss each of these in more detail later. These revenue streams vary considerably in terms of profitability.

The highest gross margins are generally achieved with software: Once the software has been developed, only minor production costs are incurred in the following years to maintain and support the software. Gross margins of well over 80% can therefore be achieved in this business.

Gross margins are generally lower for hardware products. They vary greatly from sector to sector. In the consumer electronics sector, between 50% and 70% is considered a profitable and functioning business model. For car manufacturers, on the other hand, a gross margin of 25% is considered good.

Services are a tedious business that scales much less well than the software business. If a company wants to double its turnover with services, it also needs twice as many people to provide these services (while prices remain the same). Achieving gross margins of 50 % with a services business is a major challenge. Higher values are unrealistic in most cases, and gross margins are often significantly lower.

Because of these differences in profitability, it is logical that a company's software sales are valued much higher by the financial markets than its services or hardware sales. If a company's sales mix shifts from services or physical products to software, sooner or later the share price will be revalued.

The visibility of future sales through recurring revenues

In the past, the software industry sold mainly licences, often together with a software maintenance contract. The problem with this business model - despite the high gross margins - has been the relative lack of stability: It is difficult for management to predict which deals will be closed and when, especially in the case of expensive enterprise software with correspondingly long sales cycles. This led to uncertainty in quarterly sales.

But the financial markets hate uncertainty, so they have been cheering the trend towards software subscriptions for several years now. Virtually all modern cloud-based software is now priced according to a Software as a Service (SaaS) usage model. Like a lease, the customer pays a fixed amount for the duration of use, rather than buying a one-off software licence.

This means that licence revenue from the existing customer base is regularly recorded each month. An increase (at constant prices) results from new users acquired during the period. Adjustments are made for the number of customers who have left the company and cancelled or not renewed their contract.

If you know this "churn rate" (the proportion of customers who let their contracts lapse in a given period), and if you can make a reasonable estimate of new business, then you can very accurately predict the future SaaS revenues.

In this context, investors pay great attention to the "net retention rate". This describes the sales growth (expressed as a percentage) from the existing customer base, excluding new business. The best companies achieve net retention rates of over 120%, i.e. they grow by 20 % p.a. without acquiring a single new customer.

I hope this has explained why the value of revenue streams varies so much depending on the revenue mix. In essence, it's about the potential of the business model: how much money can you generate with this model in the future, and how stable and predictable is the business through recurring revenues?

How is the fair value of a company estimated?

In my experience, the fair value of a company can be roughly estimated using the sales multiples mentioned below. The calculation should be based on expected sales for the next 12 months.

- Hardware components = 2 x Sales

- Services = 1 x Sales

- Software licence sales = 3 x sales

- Support and maintenance contracts = 3 x sales

- Software subscriptions = 6 x sales

- Software as a Service (SaaS) / cloud subscriptions = 6 x sales

Of course, the prices paid on the stock market fluctuate considerably depending on market conditions and can sometimes be well above these valuations in good market times. But on average over a full economic cycle, this kind of thumb's-up estimate works pretty well.

So if you know the sales mix of a company, you can roughly calculate where the fair value should be.

Example:

An older software company generates a total turnover of 1 billion USD per year. Of this, 150 Mio. USD comes from subscriptions to new cloud-based software, 450 Mio. USD is from licence sales and maintenance of an older software product and 400 Mi0. USD is from services. The fair enterprise value could then be estimated as:

150 Mio. USD * 6 + 450 Mio. USD * 3 + 400 Mio. USD * 1 = 2.65 billion USD

Another SaaS company also generates 1 billion USD in revenue from its cloud subscriptions and has no other significant sources of revenue. The fair company value is then:

1 billion USD * 6 = 6 billion USD.

If you then compare these fair values with the current valuations of the companies on the stock market, you can get a first idea of whether a share is cheap or expensive. Remember, however, that market capitalisation is not the same as enterprise value and must be adjusted for cash and debt!

So you can see that, depending on the sales mix, completely different valuations can be justified for the same revenue.

Of course, this is only a very rough estimate that does not take into account many other parameters such as growth rate, market position, market size, churn rate or customer acquisition costs.

I can only warn you against investing solely on the basis of such a superficial assessment. However, this rule of thumb can be surprisingly useful in quickly identifying when a stock is over- or undervalued.

If I myself suspect a significant undervaluation, my motivation to take a closer look at the company and keep the stock on my watchlist increases.

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In this article, I have introduced you to some of the basics of my high-growth investing strategy, which I discovered for myself and have been refining for years. On this Substack I will publish more articles around my stock picking strategy as well as concrete investment cases. So stay tuned…

There are certainly other promising investment strategies out there. The important thing is that you have a strategy that fits your personality, that you follow consistently, and that you adjust as you learn. Then you too - if you have the patience - will achieve above-average returns on the stock market over the years.

In this case, success can be planned. And don't forget: In High-Growth Investing, time works for you!