That, to me, is the problem with using valuation to rule out companies that are just killing it.
While the roots of a valuation approach to investing come from Benjamin Graham and his “Value = Current (Normal) Earnings x (8.5 plus twice the expected annual growth rate)” formula, there are still practitioners today like Aswath Damodaran who perform very detailed DCF (Discount Cash Flow) analysis with lots of equations and charts to justify their stated company value, and yet consistently miss out on growth companies.
The equations got more complex, and Graham provided additional rules and formulas, but in my view those just mask the flaws inherent in the simple equation as well. With any equation, it pays to look at the inputs:
• Current Earnings
• Expected Annual Growth Rate
When you look at those, it’s easy enough to understand how value hounds get it wrong - they simply under-estimate the “expected annual growth rate.” Because, when you think about, that itself is a calculation, which in turn is based on assumptions the valuator is making.
For instance, a currently well-respected Value Hound is Aswath Damodaran, who continually missed out on Amazon over many years (http://aswathdamodaran.blogspot.com/2018/04/amazon-glimpses-… ). As he admits in that linked blog, that was because his assumptions turned out to be wrong. As he says: I have consistently under estimated not only the innovative genius of this company, but also its (and its investors’) patience.
While part of this is from Amazon pouring most profits back into expanding and improving the company (reducing the “Current Earnings” part of the equation), a bigger part of it in my view is from Amazon expanding where people didn’t think it could, or even should, go. And I’m not just talking moving from an online bookseller to an online everything-seller. I’m talking about Amazon creating the cloud hosting business with the introduction of AWS in 2006. There is no way any valuation exercise can accommodate that kind of business invention. This is like what Apple did in 2007, or what NetFlix did pivoting from DVDs to streaming.
DCF and other valuation exercises work best on stable, steady companies, like big conglomerates and utilities. Then again, one only has to look at GE and PGE to find failure cases even there.
For the companies we discuss here, such valuation forumula don’t apply. Period.
What’s more interesting is finding the future Amazons and Apples and NetFlixs. A lot of the companies here are one-trick ponies. Don’t get me wrong - they’re really good and profitable tricks. But, the companies do basically one thing, do it well, and when the growth is over, we move on. That’s OK, but finding those companies that have true staying power would be beneficial. I don’t have a good way to do that, but I think it’s something to look out for and a discussion worth having.