Some Lessons I Learned About Growth Rates

How come these took me so long to learn? While the title suggests there are only 5 lessons, this is inaccurate. In today’s blog post, I am only going to cover 5 but I will release another post with another 5 lessons around what I have learned about growth rates. 

This post goes over some of the lessons I have learned around future growth rates for investing purposes. Next post will include more focus on acquisition based growth and looking at low growth or declining industries. 

This is all my opinion of course. You should form your own opinion. 

When I first started out in investing, I did what most do, I “modeled” every company. I did a ton of discounted cash flow (DCF) work to try and figure out the “intrinsic value” of a company. I knew how sensitive the fair value was to the different inputs, so I would be conservative. Too conservative sometimes. 

As time marched on and I got better at this investing thing, I noticed that companies with lower growth rates usually traded at cheaper valuations. Although the companies that were growing fast, would always seem too expensive for me to purchase. 

I wanted to go over what I learned specifically around growth rate assumptions. In my opinion, mindlessly plugging in growth rates is a recipe for disaster and here is what I, previously,  failed to consider:

1. How much incremental capital will be required to continue growing.

This is very hard to quantify and I just want to understand if incremental growth will require a bunch of capital. We all like fast growing businesses, but will they have the capital to do so?. Some businesses require a high amount of working capital to sales, whereas some don’t and some will even shift as they grow. 

For example, XPEL has started acquiring install shops and entered new markets. The business, itself, is different from 5 years ago.  There has been growth, but the incremental amount of capital to get the next dollar in revenue has grown as well. 

They had a relatively stable amount of working capital to revenue during some very high growth years. As of late, they have grown slower and had to increase their working capital. You can look at the CCC and see a similar theme.

I’ll see all the XPEL fans in the comments. 

2. How likely is this business to grow at the rate that I’m assuming.

Do you know the number of businesses that start with some material revenue and  grows over 20% per year for 10 years? I don’t. It’s probably smaller than we think. 

I ran a screener in TIKR for businesses listed in US and Canada that grew revenues 20% CAGR for 5 and 10 years with 10% or less dilution and less than 10 billion USD market cap. Only 33 companies did this out of like 50,000. That’s 0.07% and (in a prior life) I would have thought my businesses would do this.  Change that to 15% growth with the same dilution and we get 85 companies. Now, I could have run the screen wrong and missed something but my point stands that finding high growth companies that don’t dilute is hard. I never understood the base rates for growth for a long time. 

3. Once the high (or hyper) growth is done, what is the business likely to grow at?

Similar to the previous point,  trying to get a handle on what happens after (hyper/high) growth is important. It is safe to say, pretty much every company hits some sort of a limit. So let’s say, I can model 20% growth for 5 years but then what? Even if the company hits that mark, what kind of growth will they see after 5 years and what kind of multiple will the market pay? If they start growing at a more modest 5-10%, the market may only pay a mid-teens multiple. 

I have mentioned BioSyent in the past, but they are a good example of this. From 2010 – 2014 the yoy growth was 53.2%, 67.1%, 78.9%, 55.2%, 56.6% then 2015-2019 of 26%, 16.5%, 15.8%, 3.7%, 0% and last two yeas have been -2.4% and 13.1% respectively. I have no opinion on RX, but I feel it presents a good example of my point. 

The first 5 years, 2011-2015, you can see the market didn’t catch onto the high growth rate for a while but then it gave RX.v a very high multiple at over 40x EV/ttm EBITDA just in time for growth to slow. 

2015-2019 shows a high(ish) range of 15-20x EV/EBITDA and eventually the market gave up and started pricing it under 10x EV/EBITDA. 

Last 3 years have shown the multiple bottom and trend sideways. The stock has performed better recently. 

Please note I have no opinion on RX.v.

4. If they do grow quickly, what do margins look like now and later?

Reflecting back, I think this is a mistake I make with growing companies. We  have all heard that “not all growth is good growth”. For some reason, I have a tendency to assume that all companies will scale well with growth. I know that was  my assumption with OSS.v and that has largely played out. Despite hoping for it, many companies never reach “scale” regardless of having higher revenue than previous  years. 

For example, look at Tattooed Chef. 

47 million in revenue in 2018 vs 230 in 2022. Gross profit went from 3 million to negative 22 million. Negative scale. WTH.

Another example would be UBER, they had to do nearly 37 billion in run rate revenue to hit break even. In 2023, they did 37.3 billion in revenue and 1.9 billion in EBITDA. In 2016, they had just under 4 billion in revenue and had negative 2.7 billion EBITDA. They essentially 10x revenue to get to profitability. Of course the amount of shares outstanding went up as well, but that is besides my point for this one. 

5. Is the company growing within the industry?

This helps me understand if they are gaining market share. I generally like the industry to have tailwinds, but not too many tailwinds if that makes sense. I don’t like playing in the “sexy” pond. I prefer the growing-faster-than-most-but-priced-like-it’s-not-growing pond. I like to have businesses that are growing, at least, as fast as GDP + inflation. Many industries are growing faster than GDP and their potential TAM is expanding. 

For this example, I’ll use VMD. It isn’t a perfect measure of their TAM, as they have been providing additional services outside of their original bread and butter of non-invasive ventilators. However, their revenues have tripled since 2018 and their vent patients have doubled. I think it’s safe to say they are growing within the industry itself which is growing faster than GDP. Though I am happy to see this, I always want to make sure that they aren’t growing for the sake of growing and that they are adding value to all stakeholders with their growth. 

Closing Thoughts

We know that the market tends to pay up for faster growing businesses but, at times, the market tends to get ahead of itself when it comes to growth. Growth is neither good nor bad, but nuanced. I think it makes sense to take a step back and understand where the growth is coming from and what are the implications. 

I hope you found this useful and it saves you some money. If you have more examples, feel free to leave them in the comments below. 

Thanks for reading. 

Dean