In his last memo, Howard Marks, founding partner of Oaktree Capital Management, commented on the dichotomy in the market between growth companies and companies of value. He claims to have been heavily influenced by the debates with his son, Andrew Marks, a growth investor. In the memo, Marks discuss that growth companies and value companies are not different types of investments.
What's the difference between growth and value companies/investors?
The value investor's job is, at all times, to make a comparison between the company's value and its market price. When the value is lower than the price - and considering a discount margin - the investment must be made.
The growth investor seeks companies that are going through a period of intense growth. Therefore, he agrees to pay higher multiples for these assets, understanding that, over time, the increase in the company's profits will cause the multiple to contract.
Howard Marks argues that there is no distinction between the two approaches. Its central point is that the growth investor continues to make comparisons between price and value to make the investment decision, however, in these cases, the value is more distant in the future. He argues that investing in value is not just about buying companies with multiple lows, but evaluating qualitative issues for companies, which will keep them growing over the years.
How can we define this?
In this sense, then, how can we analyze whether a growth company is at a reasonable price, which does not imply paying too much for future growth (which, therefore, is more likely to not be delivered)?
Aswath Damodaran's valuation book, one of the main references on the subject in the world, he comments on this topic:
The first challenge encountered in valuing fast-growing companies is that their growth rate needs to decline over time, since a company that has grown its profits 80% in the past five years has multiplied its profit 18x ??over the time.
Thus, the speed of the decay of growth, the new entrants to the market and the risk of accelerated growth are important factors to take into account when projecting the future of growth companies. However, it is difficult to estimate when that growth will decline.
5 important points to take on consideration!
The starting point for designing valuation for growth companies is, therefore, the correct es
timate of revenue growth for the following years. Additionally, it is also necessary to understand that, at the beginning of their operations, technology companies (Netflix, Tesla and Uber), mainly, have very low or negative margins, in order to conquer the market.
So, the second relevant point to evaluate this type of company is to adjust the operating margins in the future, seeking to understand what the future margins of these companies will be. One idea is to make a comparison with more mature companies in the same sector. However, if the company is disruptive, presents growth by offering innovative products or services and is able to charge high prices, it is to be expected that, in view of the growth, new entrants will act in the market, correcting the margin downwards with the passage of time.
The third relevant point is the need for reinvestment for the company to keep growing. Some companies need a lot of working capital to grow, while others can be financed without using a lot of cash.
The fourth important issue concerns the company's capital structure, as it determines what the discount rate of the cash flows generated by the company will be. This rate is equivalent to the company's capital cost - the participation of the capital of companies, partners and debt to promote its growth.
The last point to consider is how all of these elements will stabilize in perpetuity. That is, if the company must remain operational for the long term, how should its margins, reinvestments and the cost of capital behave. After all, the company cannot grow forever at a rate greater than that of the economy itself; it cannot earn operating margins above the average, as this, in general, would attract new competitors; and reinvestment needs to converge, as it must pay its debts and remunerate its shareholders.
Having fulfilled these main requirements, the growth investor must compare the present value, found with the market price at which the company is being traded, and analyze whether it makes sense to materialize the investment.
