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No. of Recommendations: 13
The title of this post has nothing to do with what it is about...I'm just a little salty about getting yelled at by Saul and crew for an identical post I made over there. I requested that the post be taken down so I'm posting it here in the hope that it is a better fit for the discussions here.

High growth stock (aka Saul stock) valuations and sales growth

A widely held tenet of stock investing is that most of the “value” of a common stock is for activities/profits the business will be doing/generating five or more years in the future. It makes sense, therefore, to contemplate how growth during a five year time horizon might impact a company’s financial metrics.

For (hopefully) obvious reasons this writeup will focus on sales and use S for shorthand. The subscript “0” will be used to index the current year, the subscript “1” one year from now, “2” two years from now, etc. etc.

Suppose we have a fictitious company that has current sales of 100 million. So, S_0 = 100. If this company grows sales at a constant 50% for the next five years their sales will progress as follows:

S_0 = 100
S_1 = 150
S_2 = 225
S_3 = 337.5
S_4 = 506.25
S_5 = 759.375

So, in year 5, our fictitious company will be generating ~760 million in sales, or ~7.6 times as much as they are currently.

Because I have assumed a constant 50% growth rate an equivalent way to get to this number is to use financial mathematics — the sales at year five will be (1.50)^5 times the current sales. Formally:

S_5 = (1.5)^t * S_0 = 7.59375 * 100 = 759.375.

We can use this “trick” to examine various multipliers implied by various growth rates over a five year time horizon. But we need slightly more sophisticated notation to keep track of what growth rate is being assumed over those five years. To introduce this notation consider S_5(40) which denotes the multiplier for five years assuming a constant 40% growth rate during that time. Here are some values:

S_5(40) = 5.4 * S_0
S_5(50) = 7.6 * S_0
S_5(60) = 10.5 * S_0
S_5(70) = 14.2 * S_0
S_5(80) = 18.9 * S_0
S_5(90) = 24.8 * S_0
S_5(100) = 32.0 * S_0

A metric that is widely used to value Saul-type stocks is Enterprise Value divided by Sales or, EV/S for short. Introducing our subscripted notation, the metric would be EV/S_0 — enterprise value (today, obviously) divided by this year’s sales.

Given the rapid rate of growth of Saul-type stocks a valuation metric that could be quite illustrative is EV/S_5(x).

By way of example consider CRWD. According to YCharts, their enterprise value is around 49 billion and their revenue was around 761 million for the trailing twelve months (YCharts only has Oct-31-20 data). This implies an EV/S_0 of around 64.5. That seems expensive. But what about growth?

For those ttm data CRWD’s revenue grew ~53%. If CRWD is able to maintain that 53% growth rate for the next five years this implies their EV/S_5(53) = EV/(8.38 * S_0) = 7.7.

But what if CRWD grows by 80% per year for the next five years? Well, look up the S_5(80) multiple above (it’s 18.9) and divide it into EV/S (which is 64.5) for an EV/S_5(80) of 3.41.

What about 40% growth? EV/S_5(40) = 64.5 / 5.4 = 11.94. You get the idea.

Obviously, growth does not occur at a constant rate. Luckily, it’s fairly straightforward to adjust EV/S_5 to accommodate whatever growth profile you want to assume. Let’s suppose that CRWD’s growth is non-constant and slows down over the next few years: 60% this year, 50% next year, 40% the year after, then 30%, and finally 20%. Figuring out the multiple is pretty easy. You just add one to each growth rate and multiply them all together:

S_5(*) = 1.6 * 1.5 * 1.4 * 1.3 * 1.2 * S_0 = 5.24 * S_0.

Notice that for this non-constant growth schedule the average annual growth rate is 40%. Also note is that S_5(40) = 5.4, pretty close to the 5.24 multiplier for the non-constant growth rate just above that averages 40%. This is a nice feature in that no matter what you assume in terms of changing rates of growth through time, the multiple will be fairly close to the S_5(x) for the average of those annual rates of growth. So just dividing by a few different S_5(x)’s gives a decent idea of what annual growth rates would need to average in order to justify a particular valuation.

So what valuation seems reasonable? At the end of the day that’s up to you. But, once you fix on what EV/S “should be” for your company given its stickiness, gross margins, etc. etc. you can use the S_5(x) to back into a growth rate the market would be assuming at that EV/S.

Example: Maybe for a company like CRWD EV/S “should be” around 5 if the company was mature and growing “around” 20% in five years time. If the EV/S today is around 65 then the market would be implying that sales will grow 13 times in the next five years. Looking at the values for S_5(x) above this implies the market is assuming CRWD’s sales will grow at at an average of ~ 65 - 70% per year. Given CRWD’s recent growth rates that seems fairly reasonable. Or if you’re more pessimistic about that average growth rate in sales it could suggest some over optimism at current prices. Or that CRWD’s steady state EV/S “should be” higher...
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