Evaluating Mature Growth Companies
In this chapter of "The Little Book of Evaluation," the focus shifts to evaluating mature growth companies. This article provides a comprehensive overview of the challenges and valuation approaches for companies that have transitioned from young growth to mature growth.
Company Characteristics
When evaluating mature growth companies, several characteristics distinguish them from their younger counterparts. Although these companies have grown significantly, their financials remain dynamic, with numbers changing on a year-to-year basis as the company continues to evolve. Additionally, mature growth companies may start to issue debt, a practice that was uncommon during their younger growth stages. Furthermore, the market price history of mature growth companies tends to be short and unstable, making it challenging to rely solely on past prices for risk estimation.
Accounting Issues
One of the primary challenges when evaluating mature growth companies, especially in the technology sector, is the treatment of intangible assets by accountants. R&D expenses, which are critical for technology companies, are often treated as operating expenses, leading to potential distortions in profitability measures. Therefore, it is essential to clean up the accounting for these expenses before proceeding with the valuation process.
Valuing Operating Assets
In valuing the operating assets of mature growth companies, factors such as historical revenue growth, market saturation, competition, and product quality need to be considered. As companies scale up, the historic growth rates may no longer be sustainable, and a more conservative approach to future growth estimates becomes necessary. Additionally, considering the competitive landscape and market share dynamics is crucial for projecting future revenue growth.
Free Cash Flow Estimation
Forecasting the free cash flow for mature growth companies involves estimating revenue growth, improving margins, and determining the reinvestment rate. In the case of Google (Alphabet), a significant player in online advertising, a modest revenue growth rate coupled with cost-cutting measures leads to a gradual improvement in margins over time. By estimating the reinvestment rate based on the sales to capital ratio, the expected free cash flow for the firm can be projected for the next 10 years and in perpetuity.
Risk Assessment
While mature growth companies are generally money-making enterprises, they still carry residual risk. Estimating the cost of equity and debt based on the business operations and market conditions is essential for determining the overall cost of capital. As the company evolves, the cost of capital may decrease, reflecting changing risk factors and financial structure.
Valuation and Pricing
The article explains the steps involved in valuing the operating assets of a mature growth company, using Google (Alphabet) as a case study. Making assumptions about growth, margins, taxes, and capital structure, a value for the entire business today is derived. As for pricing, various approaches, such as comparing the company's price-to-earnings ratio to the sector, computing the PEG ratio, and using regression analysis, are discussed to gauge the fair pricing of the mature growth company.
In conclusion, evaluating mature growth companies requires a thorough understanding of their unique characteristics, accounting treatment, operating dynamics, risk factors, and pricing metrics. As companies transition from young growth to mature growth, a nuanced approach to valuation and pricing becomes essential for making informed investment decisions.