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Should burgeoning companies focus on growth or profitability? This classic, critical question continues to challenge entrepreneurs and investors alike.
Since growth is such an important factor in determining the value of a business, one of the most important goals for private equity investors and advocates of value creation like myself is to help our portfolio companies accelerate their growth.
To demonstrate just why growth is such a great priority, here’s a table that illustrates the impact of growth on valuation on two indexes:
- NASDAQ 100 Index (100 largest non-financial companies traded on the NASDAQ)
- NYSE Software and Services (90 software and services companies traded on NYSE)
We divided the indexes of the top 20 percent of companies according to growth and the 20 percent slowest growing companies in the last year and in the last three years. Then we checked the multiples of these data sets.
As the chart demonstrates, the top 20 percent growing companies got a significant premium in their value. For example, the top 20 percent growing companies in the last three years traded under the NYSE Software and Services index were valued at 7.1 times their revenues, while the slowest growing companies were traded at 80 percent of their revenues.
That said, as important as growth is to the valuation of a company, it’s not the only thing that matters. What investors and other shareholders are eventually left with are the companies’ profits, so all efforts made to boost growth should be driven by the ultimate goal of maximizing profits.
Sometimes shareholders are willing to turn a blind eye and invest in companies even during periods when they are not profitable, because they believe that these companies are compromising on short-term profitability in order to invest in technology and operations that will enhance and accelerate their long-term growth and market dominance. But despite their willingness to “forgive” temporary lapses in profitability (even in promising companies), investors still need to see a path to long-term profitability.
A good example of such a company is Amazon.com (refer to the five-year share price performance graph below).
The company’s share price saw a significant rise as long as Amazon’s revenues continued to grow by 20 to 40 percent annually, and many investors were willing to look past its margin issues. Now that the company’s growth is cooling down, many investors are looking again at profit margins that remain very low (less than 1 percent of operating margin). Over the 12 months ending September, 2014, the company’s revenues reached over $85 billion and the company’s losses were over $200 million.
Despite huge revenues, as the Yahoo Finance graph above shows, the share price has declined by approximately 25 percent since the beginning of the year.
So how does profitability impact the company’s valuation?
The table below demonstrates how valuation is impacted by both revenue growth and profitability (EBITDA margin):
We took the same NYSE Software and Services dataset presented above and checked the EV/REV multiples for different growth rates in the last three years and different EBITDA margins.
As you can see, profitability impacts the valuation but mainly for companies with more moderate growth rates. For example, companies that grew between 5 and 15 percent in the last three years were valued at only 1.4 times their revenues when their EBITDA margin was below 10 percent vs. 3.5x their revenues when the EBITDA margin was over 20 percent. This magnitude is less viable in companies that have fast growth, such as the Amazon example.
In summary, it’s a good thing to strive for fast growth for your company, but always aim to stay “lean and mean” to reach significant profitability once you reach scale. This will prove to be especially important should your growth rates cool down.
Amit Ashkenazi is Principal of Viola Private Equity.
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