If you’ve been a part of the stock market for the past 4 months, you would know that all the high-flying tech stocks have fallen, but some have fallen as much as 80%. Since we all know that most share price movement is the result of institutional buying & selling, it would suggest that these funds were able to mathematically value these companies as worth it at $100/share, and say that at $20/share it is now fairly valued after only a year and little company-specific news. The reason for this is the hyper-sensitive models required to forecast growth stock prices. For you to understand you need to look at the theoretically correct way to value growth stocks:
While the slow-moving value stocks have a DCF model estimating the value of their future cash flows & discounting them, growth stocks have an exit multiple model which projects the company’s growth rate over a period of time, finds the revenue at the end of the period, gives it a profit margin and determines the valuation it deserves based on the remaining growth rate.
As an example, let’s take a company like Twilio. If we take their own 30+% growth estimates for the next 3 years, and therefore get a rate of around 28% growth for 5 years, and give them a 24% growth rate for the 5 years after that (which assumes a slight slow down), and give them a 15% net margin (based on their 65% gross margin target range, this is relatively reasonable), and determine that the f p/e for such a company should be 40, then at an 11% discount rate, you would get a current value of 100B starting with next year’s sales…
At the same time, if you gave them just 25% sales growth for the next 5 years, and then 18% after that, with a 30 fp/e for such a company and only 10% net income margins, all possible moderate downgrades based on uncertainty, together with the same discount rate, you would get a value of 36B. This is 3x lower.
What just happened? Well, as you can see, the models are incredibly sensitive. Since growth rates are compounded over 10 years, small changes mean big downgrades in end-price. Also, net margin is incredibly tough to forecast for unprofitable companies, with gross margin being the only semi-accurate indicator. Of course as the determinant for profitability 10 years from now, any change is a big deal. Also, as valuations in the market change, so too do your estimates for how this company will be valued in the future. Say all tech stocks take a 20% haircut, then your comparables for how this company should be valued also go down. There is also variability in using the future or current sales of a company. The future sales are more optimistic but might be a better measurement if this year’s growth is substantially higher than normal and you want to forecast using the same growth rate for a certain amount of time.
Finally, and arguably most importantly, risk tolerance can change. Specifically, the determinant of this is bond yields. If, as happened for the past two years, bonds yield close to 1%, people will be much more likely to take risks since the reward could be proportionately much higher. Unfortunately, when yields move higher so too does risk tolerance move lower and the required rate of return for people to invest goes up. Why is this important? Well, the rate of return is discounted yearly and compounded over our 10 year period, so when it goes up, your present value is much lower. Not to mention that high growth companies are valued on cash they will produce far in the future, which is worth much less on a higher discount rate. In our case, 10yr Treasury Yields are approaching 3%. from a low of below 1.5%, clearly impacting the discount rate being applied to companies. Additionally, the uncertain environment, with rate hikes, Ukraine and other economic worries is making the perceived risk much higher, and making seemingly safer companies more important.
By: Mateo Gjinali
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