There are many valuation metrics out there: price to sales, price to earnings, EV to EBITDA, Sales to EBITDA, etc… Which are the important ones?

Do they even matter when it comes to evaluating investments in growing companies?

People can estimate what this year’s earnings may be.  They may even be able guess what next year’s earnings will be.  However, projecting earnings three to five years out, particularly for growing companies, is extremely difficult.  However, this is really what one needs to be able to do, to successfully invest in high-growth, small companies.

Let’s create an example:

Suppose you have a dry-cleaners business.  Each dry-cleaner costs $1MM to build.  After it has been built, it produces $2MM in revenues and $300K in profits.  (Note:  I have no idea what the margins of a dry-cleaning business are like so I am simply making up numbers here).

Note: Using the numbers above, it takes 3.3 years to pay for each new dry-cleaner.  This means the return on capital is 30%, which is quite good.

Let’s assume the following:

SG&A is largely a fixed cost to manage the dry-cleaning businesses.  However, it will increase (non-linearly) as the number of dry-cleaners increases.

At first glance, the company looks fairly valued at 12x earnings.

However, if the company can get to 30 dry cleaners within 2 years, it is valued at ~3.5x future earnings.  This means that if the projections hold up, an investor could make over 3 times their money in 2 years.  The questions that need to be asked are:

• Can this dry-cleaning business expand to 30 cleaners?

• How long will this take?

• Can the management team execute on this plan?

• Is more investment needed to get to 30 cleaners? Etc…

If it costs $1MM to build a dry-cleaner location, that is not the total cost.  Other costs include hiring and training store staff and corporate management, as well as advertising and marketing the business.  Let’s say this costs $100K (total) to pay for such expenses.  Then the company will require $1MM in working capital to grow from 10 cleaners to 20.

As a result, the “real” earnings today are actually $1MM.  As a result, the company is actually valued at 24x earnings!  If we are confident in the potential of the dry-cleaning market and this management team’s ability to take the company to 30 cleaners, the investment is likely a fantastic one.  The current earnings are not as important as the management’s ability to grow the business.

Takeaways:

Rapidly growing businesses do not show much income (aka earnings)!

The income only appears when the growth rate slows!

By this time, your investment is quite likely a fantastic one.

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