With great reviews come great expectations! When we are in the era which sets price-to-sales multiples numerically higher for growth stocks than for the given price-to-earnings multiples in the previous market cycle, expectations are clearly high.
With so many new age companies entering the exchanges, starting with Zomato this year, the markets have been so strongly caught up in their growth story that some like PB Fintech are even trading at levels up to 60 times their sales! Zomato and Paytm are trading at about 50 and 30 times the sales now. Is there a way to this madness or are we replaying the dotcom or housing bubble?
The narrative from the bulls in the market is that the large sales multiplier of these companies is justified based on their revenue growth projections, even if they are currently incurring losses, some on the EBITDA level as well. They are also quick to highlight the performance of new company stocks in the United States over the past decade.
However, if one delves into the data, that is only half the story. A study of new age companies that have traded in the US in the past decade shows that one of the main reasons (besides strong business performance) has been their stellar returns since listing or the beginning of the last decade (Amazon stock at 35 percent compound annual growth rate, compound annual growth rate on LinkedIn from 34 percent), is that most of them also came out with an initial public offering at a much lower multiplier.
The odds are not in favor
There are two primary factors to long-term stock returns – one, business growth (where stocks track revenue/earnings growth), and the other, multiple expansion. With modern Indian companies listing/trading in too many sales, it appears that this leverage for future returns has already been tapped.
Furthermore, the study indicates that the odds are strongly stacked against valuation based on multiple sales if EBITDA margins are low/negative. Investing with high multiples on the basis that companies will become profitable in the future does not seem a wise strategy (see table). Companies like Groupon and the new Indian company of the past decade, MakeMyTrip, have given sub-par returns after listing with plenty of fun pricing. Thus, strong revenue growth and good margins appear to be prerequisites to justify higher valuations.
The best in class
In contrast, best-in-class companies with low profit margins such as Amazon and Netflix have generated significant returns for investors over the years, in part because they were pricing on exchanges with modest 2x and 1x sales, respectively in 2011. When Amazon was 15 US dollars. The company’s market value reached 20 billion during 2005/2006, and its sales amounted to more than 8 billion dollars.
In contrast, Nykaa was a $15 billion company for a while before the latest market correction, when its sales were just $320 million in fiscal year 21. Amazon, too, had its share of foam multipliers trading more than 30 times that of Revenue during the dotcom boom, but it crashed 90 percent of those peaks and it took 10 years to make up for those levels. In 2012, if Amazon hypothetically had Nykaa-level returns of nearly 40 times, its investors would lose their fortune at a compound annual growth rate of 2 percent so far despite the company’s revenue growth of 26 percent CAGR during the same period.
Thus, investors who tend to join the new age wave must first ascertain what companies have to offer in the future, and determine if this is realistically feasible, before crashing.