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The Dangers of Valuing Companies Based on Growth Alone

Updated: Feb 19

Investment decisions are rooted in a mix of science, art, and intuition. At the heart of this decision-making process lies the task of company valuation. One of the most attractive attributes investors often focus on is a company's growth. After all, growth can indicate innovation, market domination, and strong leadership. However, there's a cautionary note to be considered: relying solely on growth can be a perilous endeavor.

Why Growth is Important

Before diving into the pitfalls, it's essential to understand why growth is so prized.

  • Revenue Growth: Demonstrates the firm's ability to expand its market share or increase prices.

  • Earnings Growth: Indicates rising profitability and potentially increasing margins.

  • User or Customer Growth: Especially crucial for technology or service companies, this can show the growing adoption of a platform or service.

For instance, Amazon in its early years demonstrated immense revenue growth even when it was not profitable. Investors who backed Amazon banking on its revenue growth potential were handsomely rewarded. Similarly, Facebook showed phenomenal user growth before its IPO, which became a significant part of its investment narrative.

Pitfalls of Looking at Growth in Isolation

  • Unsustainable Growth: Fast growth, especially in younger companies, can sometimes be unsustainable over the long run. For instance, Groupon experienced rapid growth in its initial years, attracting many investors. However, the growth was fueled by heavy marketing and a business model that was difficult to sustain. When growth slowed, the stock price plummeted.

  • Quality of Earnings: A company might demonstrate earnings growth, but the quality of these earnings is equally crucial. If earnings growth arises from one-off events, such as asset sales or tax breaks, it might not be replicable in the future. It's essential to differentiate between operational earnings growth and one-off boosts.

  • Neglecting the Competitive Landscape: Rapid growth might make a company overlook its competition. BlackBerry was once a dominant player in the smartphone market with consistent growth. However, the rise of competitors like Apple and Samsung eventually overshadowed its growth narrative.

  • Ignoring Valuation Multiples: A company might be growing rapidly, but if it's too expensive compared to its intrinsic value, the investment might still not make sense. Investors who paid premium prices for tech stocks during the dot-com bubble of the late 1990s learned this lesson the hard way.

  • Overemphasis on Short-Term Growth: Companies might undertake risky ventures or make short-sighted decisions to fuel short-term growth. For instance, a company taking on too much debt to finance its growth might face solvency issues if the expected returns from growth initiatives don't materialize.

  • Macro-Economic Factors: Sometimes, growth can be more attributed to favorable macro-economic conditions rather than company-specific factors. Ignoring the bigger economic picture can lead to over-estimation of a company's individual growth prowess.

  • Operational Scalability: Not every company can handle rapid growth. If the operational backbone, be it supply chain, human resources, or technology, isn't robust, growth can lead to more problems than benefits. For example, a rapidly growing e-commerce company that doesn't invest in logistics might struggle with delivery delays, leading to customer dissatisfaction.

Growth, while an essential component of company valuation, should never be looked at in isolation. For seasoned investors, a holistic approach that takes into account the broader context, financial health, competitive landscape, and market valuation is imperative. While growth can be the engine driving a company's value, it's the myriad other factors that determine whether that engine runs smoothly or breaks down.

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