How I Value Growth Companies In Two Steps—And Sample Lemonade Valuation
Learning how to properly value unprofitable growth companies is a superpower.
Most of the success we had and our portfolio returns in the last three years can be attributed to two factors:
Picking the right foundational stocks.—
Significant appreciation of our growth positions.
Yet, even in the face of a significant drawdown in one of our foundational positions, our portfolio kept thriving.
So, we may owe this success more to the latter factor—picking the right growth stocks.
Though our growth picks have an interdisciplinary philosophy behind them that largely feeds on industrial organization and theories of competitive strategy, in the face, we have three guiding principles:
We pick the businesses transforming traditional industries.
They benefit from new technologies like AI, not disrupted by them.
They can erect some sort of moat that prevents customers from easily switching.
These are qualitative criteria for selection. And then we have some quantitative criteria: They have strong balance sheets, and they should be, preferably, profitable.
Yet, such promising companies that are overlooked by the market are often unprofitable. This is exactly what creates the opportunity.
Once they are profitable, they get derisked, they become eligible for being added by all institutional managers, and the stock skyrockets…
What does that mean? The reward is greatest if you can spot and buy them before they are profitable on a GAAP basis.
This is exactly when we opened our starter positions in most of those growth stocks that have become multi-baggers in the last 2 years.
Naturally, one of the questions I get asked often is “How do we value unprofitable growth companies?”
Let me tell you this outright—this is not the hardest part in investing in such a business.
The hardest part is picking a business that can fulfill the story you tell in your valuation.
Today, I am going to explain what’s the right way to value growth stocks and try to explain what’s the biggest mistake most people make when valuing growth stocks.
Let’s cut the BS and get started!
What Exactly Is Valuation??
We were discussing with friends working in hedge funds last week, the question we couldn’t agree on was “what actually is the valuation?”
One friend says a partner in their firm has a very concise definition for it—valuation is the process of finding the intrinsic value.
I said that was bullshit.
I’m gonna be straightforward: Valuation may have nothing to do with intrinsic value.
Let me ask you a question. What’s the value of a 30cm x 22cm x 13cm handbag?
If you believe valuation is the process of finding the intrinsic value, you would ask me what material to use first. Let’s say it’s high-quality leather. Then, you’ll try to calculate how big a piece of leather that bag would take, look at the free market price of that leather, and then add some premium for labor and such.
You’ll at most come up with something around $500. Well, think again.
Hermes Birkin bags in the size of 30cm x 22cm x 13cm cost anything from $16,000 to $90,000 with a median price of $30,000.
And I am telling you, you can never convince a Birkin owner to sell her bag to you for $1,000 because it’s the intrinsic value. That’ll never happen.
Why is this the case? Hear the Hermes Creative Director explain it:
You see what he does?
He tells you a story about the brand—Hermes represents the peak of the quality, and the price you are paying is just the cost of it.
The price tag on Hermes bags is the value of that story, not intrinsic value based on objective terms like utility to the user, etc.. No, it’s the value of the story.
When it comes to products, this comes very naturally. Everybody says, ‘Well, of course it’s the story.’
But when it comes to equity valuation, people think they can expect to see something objective. It’s bullshit. If it were, nobody would ever make any money in the stock market, as the market would have incorporated all the future value in price.
No. In equities, too, valuation is the process of finding the fairly reasonable intrinsic value of the story you tell about the company. Nothing else.
Not the intrinsic value of the business, intrinsic value of the story.
Aswath Damodaran puts it best—“without a story, you don’t have a valuation, you just have a spreadsheet.”
Yet, this definition brings up another question: How do we calculate the intrinsic value of the story?
That’s now well established.
Intrinsic value of the business is the sum of all future cash flows the business will generate in the future, discounted to the current moment at an appropriate discount rate.
So, the intrinsic value of the story is the sum of all future cash flows the business will generate in that story, discounted to the current moment.
That’s all. This is what we call valuation. It’s not an objective value, it’s not set in stone, it’s a construct.
Naturally, the first step is crafting the story.
1️⃣ Crafting The Story
This is the most important stage of valuation.
When looking at valuations created by finance professionals, most people are puzzled by how nice their spreadsheets look. Look at this beautiful imaginary sample:
Cost of goods sold, interest paid, inventory levels… You have everything there.
It looks detailed and complicated, most people are impressed by that. So they think crafting a spreadsheet like this one is the most important part.
Hell no.
These professionals prepare those spreadsheets this way exactly because they know that this complexity and detail impress people and make their statements more convincing.
However, in essence, what a spreadsheet should be doing is just quantifying your story, nothing else.
So the real question is—how do you craft a nice story that has a fairly high chance of being realized?
This is the most important thing, this is what determines the value of the company.
If the story realizes the value created by your numbers also materializes, if the story fails, numbers mean nothing.
It’s counterintuitive. The most important part in the process that most people deem quantitative is actually the qualitative.
As Aswath Damodaran says, a good valuation is like a bridge that connects the story to numbers. But for the numbers to come up, you need the story first.
So, how do you craft such a story?
It’s more of an art than a science. But there are some starting points, of course.
Obviously, the total addressable (TAM) market is where you start from.
Think of it like the universe comprising all probabilities.
If the TAM is $10 billion, the business can generate an annual revenue of anything between 0 and $10 billion, but it can’t be $12 billion.
This helps you to understand the runway for growth, how attainable your numbers are, etc…
Imagine you are looking at a $10 billion TAM. You assume that the company you look at will grow 30% annually for the next decade, reaching $3 billion in annual revenue.
Is this reasonable? It depends.
If the market is extremely fragmented, and the largest provider owns just 5% of the market, your assumption is indeed extremely ambitious. It has a very low chance of realization.
Does this mean you can’t value that and bet on it? Of course, no, but you have to reflect that risk in your valuation.
Let’s say you run the numbers for this scenario, and it gives you a discounted cash flow value of $7 billion.
Is this the intrinsic value of the scenario?
Yes, but only if you assume it’ll happen 100%.
If you believe there is only a 70% chance that this scenario will occur, the value declines to $4.9 billion ($7 billion x 0.7).
If the market currently values it at $5.5 billion, you would say it’s undervalued based on the first scenario, and overvalued based on the latter.
You see how important the story is? It literally determines everything.
So, in sum, you have to first craft a nice story that tells us what the growth rate, margins, tax rate, return on investment for now, and the terminal period, etc.
And this story you come up with should be fairly reasonable based on the total addressable market, the current market structure, and likely developments in the industry.
2️⃣ From Story to Numbers
This is where most of the people who get the story right struggle because they are trying to replicate the fancy spreadsheets created by finance professionals.
Now, let me ask you this—do you really need to replicate those detailed spreadsheets?
Well, does it help doing it? Does it improve the accuracy of your valuation? For most cases, the answer is no.
Here is a part of a professional DCF on Alibaba at the time of its IPO:
See? It has everything.
Segment-by-segment forecasts for revenue, a detailed breakdown of expenses, and even interest expenses were calculated.
You expect such a valuation to be fairly accurate, right?
It was way off the mark…
They forecasted that the company would generate 207,477 million Yuan in revenue in 2022. The real number? It generated 853,062 million Yuan.
Well, that’s a nice surprise, and the owner of the DCF is probably not frustrated by his analysis if he still bought the shares on his conservative scenario, but you get the point.
This big of an error doesn’t stem from a few points of deviation in details, it stems from the story. Whoever did this, his story was too small for Alibaba, and his details added nothing to the quality of the valuation.
Again, I’ll reference Aswath Damodaran here—the best valuation is the simplest one.
You don’t need all those fancy details; a nice story already builds those details in.
If you have a fairly reasonable assumption for operating margin, why would you try to calculate cost of goods sold, SG&A expenses, and R&D expenses one by one? Operating margin already accounts for them all.
That’s what you need. You need to have fairly reasonable assumptions for the key value drivers, you don’t need to project everything one by one.
Trying to do so only increases the risk of your valuation; it doesn’t improve its quality.
More variables, more chance of error.
In essence, you only need to forecast a few variables that drive the value of the business.
These are very simple things:
Revenues
Operating margin
Return on investment
Tax rate
Cost of capital
This is it.
What’s even better is that you don’t need to get too creative for most of these.
In the terminal stage, you'd better go with the average return on investment in the industry. You can adjust it a bit higher if you believe the business will have a durable competitive advantage.
Final operating margin won’t likely deviate much from those of the mature companies in the industry. Again, you can do small adjustments if you believe the company will be an exceptional one.
We all know the marginal tax rate, and you can find the effective tax rate in company filings. The cost of capital for industry and the current cost of capital for the company can be easily found on the internet. Just Google them.
The critical thing is that these assumptions should stem from the story.
If you forecast 30% annual revenue growth for the next 5 years, you should be explaining what properties of the business will drive this.
Let me give you an example: If I can assume 8% annual revenue growth for Coca-Cola, I have a story that will drive this. It’s simple. Coca-Cola has immense pricing power. Even if the volume grows only 3%, it can drive 8% growth by raising prices easily by 5%. Nobody will stop drinking Coca-Cola just because it’s 5% more expensive.
But if I assume 25% revenue growth, I have no reasonable story for that. Assuming a 5% price increase, the volume should still grow 20%.
I don’t know where that could come from? 99% of the people in the world who could drink Coca-Cola are already drinking it.
Another example—let’s say you believe the business will have a competitive advantage.
If the industry-wide average operating margin is 25%, you can assume 30% for the business you are looking at. But assuming 50% would cut the predictive power of your model.
And finally, you must honestly assess the success chance of your scenario.
After running the numbers, the final value you get is the value in case of a 100% chance of success. It’s never 100%.
You must explain the probability that this scenario will occur. If it doesn’t occur, what are the other possibilities? What would be the value in case of other possibilities?
After accounting for them, you get to the real value of your scenario.
🍋Lemonade Valuation
Now let’s run through an example.
Lemonade is one of my highest conviction stocks currently. It’s growing fast, and it’s unprofitable.
Let’s see how this method works to value a business like Lemonade.
First things first, the story.
Lemonade is a direct-to-consumer insurance provider active in pet insurance, renters’ and homeowners insurance, and car insurance.
The business has grown pretty fast in the last five years:
Here, I am crafting my story:
Though it looks like the growth has slowed down recently, it’s due to the company trying to reach its target of becoming EBITDA positive by 2027, not because of the slowing of the demand.
Further, it’s set to accelerate rolling out the car insurance this year. They already have 700,000 people on the waiting list for car insurance. Once they do this, the growth will accelerate.
They are heavily using AI systems in onboarding and claims processing, allowing them to have lower operating expenses. So they are scaling rapidly while their headcount remains stable.
They pass some of the gains from this operational efficiency to their customers, resulting in a 68% lower price than the competitors.
As insurance is basically a commodity business, I believe this price advantage will keep attracting users, and the growth will accelerate with the rollout of car insurance.
This is why I believe 25% average annual revenue growth is reasonable in the next 5 years. After that, I assume the growth will converge to 3% in the terminal year, which will likely be the long-term inflation rate.
Now this is my story.
Let’s do a reality check!
Property & Casualty insurance in the US is a $1 trillion market. Even if Lemonade grows 20% annually for the next 10 years, it’ll end up with $6 billion in revenue. Even if the market remains stable, it will have only 0.6% market share. This is pretty doable.
The story is grounded.
Now let’s turn to other value drivers.
Established businesses in the industry have around a 14% operating margin. Given that Lemonade has higher operating efficiency than they do due to AI, I believe it can end up with a 15% operating margin. Pretty reasonable.
It’s a bit hard to calculate its return on investment as it’s unprofitable. This is why I resort to what Aswath Damodaran recommends in such situations: Sales-to-capital ratio.
This is basically: Revenues/(Total Equity+Total Debt-Cash and Equivalents)
This tells us how much revenue the company generates per $1 invested.
For Lemonade, it’s currently around 1.60.
I assume, after becoming profitable, its return on invested capital will converge to 15%, which is the average for established businesses in the industry.
As it’s unprofitable, it won’t pay taxes until it becomes profitable, and then the tax rate will gradually converge to a marginal tax rate of 25%.
For cost of capital, it’s currently around 11%, and I believe it’ll converge to the average of all mature companies, which is 7%.
Let’s see what these assumptions give us:
The intrinsic value of this scenario is $40.
What are we missing?
We haven’t incorporated any chance of failure…
Let’s asses how likely our scenario will occur.
This is a pretty conservative scenario that assumes only a 0.6% market share for the company. Thus, I believe we have a fair 70% chance of success.
Failure? I will divide failure into two: Failure of the scenario, and total failure.
In the event of this scenario, I believe the business will deliver only half of the performance that I forecast here. In this case, the fair value per share will also be cut in half to $20. I give a 20% chance to this. In total failure, the business goes bankrupt, fair value is 0, I think this is unlikely, 10% probability reflects the risk.
Here is what the final value gives us:
= ($40x0.7)+($20x0.20)+(0)
= $32
Meaning, the fair value of all the scenarios, including the chances of failure and success, is $32 per share.
The stock today is trading at $32.5 per share.
Meaning it’s fairly valued. If this is enough for you, you can buy at the current price; if you want some margin of safety, you should wait for a lower price.
This is all there is to valuing growth companies.
🏁Final Words
There is nothing complex to valuation when you understand that it’s your craft, not a hidden objective value that you should discover.
What you should discover by yourself is the possible path before the company and how likely it’ll materialize.
You should always remember that the quality of your story determines the quality of your valuation.
If your story was off the mark, no matter how detailed you go in your spreadsheet, it won’t save you. We saw this in the Alibaba valuation above.
Once you have the story, keep it simple. You don’t want to break a nice story with unnecessarily complex and boring details. This harms your valuation.
There is nothing to study on the quantitative side. If you want to improve, work on the qualitative side. Improve your business knowledge, industry knowledge, etc..
And always remember that the valuation is your product; it’s not set in stone.
You can design that product to be easily reachable, very hard to reach, or fair.
In the case of valuation, a fair product will work best.
https://youtu.be/mHkEBlz4GXw?si=5BnOLpnNRJDnEqwH