A growth stock in our portfolio that multiplies 10 times in value is what we all dream of.
A rocket like that can make up for losses in other shares, plus leave plenty for you to pocket. You can own five other growth shares that are $0 losers, but you’d still have doubled your money!
But those 10-baggers, and indeed 5-baggers, are difficult to pick.
If it were easy, everyone would be doing it.
Conventional analysis just doesn’t cut it for 10-baggers
“If investors cast their eyes back over the last two decades, it’s obvious the stock market’s massive winners and 10-baggers – the likes of Amazon.com, Inc. (NASDAQ: AMZN), Alphabet Inc (NASDAQ: GOOGL) and Afterpay Ltd (ASX: APT) – have always looked overvalued and uninvestable based on conventional valuation methods,” read a memo from Ophir Asset Management.
“Many investors wielding traditional valuation tools shunned these stocks and missed out on staggering returns.”
The trouble is that these future 10-baggers are usually early-stage companies. And those growth shares usually don’t have enough history to evaluate them via traditional metrics.
“Many of the stock standard valuation metrics such as price-to-earnings (P/E) ratio or price/earnings to growth (PEG) can be completely useless when analysing immature companies,” stated the Ophir investment strategy note.
“Without years of financial data to rely on, early-stage companies and their investors must employ more creative ways to substitute these inputs.”
The Ophir team took Afterpay to demonstrate why conventional metrics fall over for many growth shares.
“How can it be valued so high when it doesn’t make a profit?… Our answer is simple: Afterpay’s valuation, such as its P/E, is so high because it is deliberately keeping the ‘E low to non-existent by reinvesting for future growth.”
So how do we measure the worthiness of early-growth companies? How can we find our next 10-bagger?
Ophir suggested four ways investors can increase their chances of landing one of these beauties.
What does this growth stock actually own?
The Ophir team suggested “identifying assets” as one way to validate how an early-stage business compares to its peers.
“You list the company’s assets which could include proprietary software, products, cash flow, patents, customers/users, or partnerships,” the memo read.
“Although you may not be able to precisely determine (outside cash flows) the true market value of most of these assets, this list provides a helpful guide through comparing valuations of other, similarly young businesses.”
Seek alternatives to revenue
Revenue growth is certainly important, but it might not be enough to understand the potential of the business.
“In addition to (or in place of) revenue, we look to identify the key progress indicators (KPIs) that will help justify the company’s valuation,” the memo read.
“Some common KPIs include user growth rate (monthly or weekly), customer success rate, referral rate, and daily usage statistics.”
The team admitted finding these other measurables can sometimes be difficult.
“This exercise can require creativity, especially in the start-up/tech space.”
Are returns greater than capital costs?
The answer to this may seem obvious but can get lost in the fervent search for the next hot growth stock.
Growth can only happen if the return on capital is positive.
“A key element in determining the quality of growth is assessing how much the firm reinvests to generate its growth,” the Ophir report stated.
“For young companies, reinvestment assumptions are particularly critical, given they allow investors to better estimate future growth in revenues and operating margins.”
Change in wind direction
Companies starting out in their journey can have their fortunes made or broken from certain events.
So the Ophir team recommends keeping an eye on the possibility of coming catalysts.
“When a young company achieves significant milestones, such as successfully launching a new product or securing a critical strategic partnership, it can reduce the risk of the business, which in turn can have a big impact on its value,” the memo stated.
“Significant underperformance can also result when competitive or regulatory forces move against a company.”