Valuing High-Growth Companies
Valuing high-growth, high-uncertainty companies is a challenge; some practitioners have even described it as hopeless. We find, however, that the valuation principles in this book work well even for high-growth companies. The best way to value high-growth companies (those whose organic revenue growth exceeds 15 percent annually) is with a discounted cash flow (DCF) valuation, buttressed by economic fundamentals and probability-weighted scenarios.
Although scenario-based DCF may sound suspiciously retro, it works where other methods fail, since the core principles of economics and finance apply even in uncharted territory. Alternatives, such as price-earnings multiples, generate imprecise results when earnings are highly volatile, cannot be used when earnings are negative, and provide little insight into what drives the company’s valuation. More important, these shorthand methods cannot account for the unique characteristics of each company in a fast-changing environment. Another alternative, real options, still requires estimates of the long-term revenue growth rate, long-term volatility of revenue growth, and profit margins—the same requirements as for discounted cash flow.489
Since DCF remains our preferred method, why dedicate a chapter to valuing high-growth companies? Although the components of valuation are the same, their order and emphasis differ from the traditional process for established companies, and this chapter details the differences. ...