Valuing and comparing High Growth companies requires a different approach than those generally used by investors to value and compare more stable and established companies.
In the last blog post we discussed calculating the justified PE ratio of a company based on the gordon growth model. Using the gordon growth model is inappropriate for high growth companies though, as high growth companies may have a terminal growth rate that is approaching or even exceeding the cost of equity of the company. Additionally, high growth companies may not be able to make a profit. In either case, this renders the PE ratio and the gordon growth model quite useless in determining the fair value of stock in the company.
In valuing high growth companies there is more guess work than with established companies, especially companies that produce a new product that will form a new market.
When I am trying to put a value on a high growth company I use the following framework as a reference point (although it is by no means the only way or the definitive way of determining the value of such a company):
1. Estimate the potential size of the market for the product the company is producing;
2. Estimate the potential market share that a firm could expect to control in such a market;
3. Estimate a cost structure for the industry;
4. Estimate the size the company needs to be in order to be self-funding;
5. Estimate a sales growth profile for the company;
6. Estimate the amount of capital the company requires in order to reach it's self-sustaining point;
7. Construct a simple DCF.
8. Estimate a probability that a market will be successfully established for the product, then probability weight the DCF.