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Many growth companies have relatively high valuations and are often perceived by investors as “expensive.” This view, however, can overlook a company’s long-term potential. Successful companies often need time to grow into their valuations. Over the past 10 years, the market has consistently underestimated the magnitude and duration of growth for many companies that are beneficiaries of secular growth.
Valuation is a critical component of Jennison’s growth investment process. The goal of the research analysts’ valuation analysis is to identify underestimated growth opportunities at their inflection point of growth, early on in a company’s life cycle. There is no single overarching valuation methodology used across the firm. Jennison’s analysts use varying valuation methodologies that work best in their particular industry; many use multiple models to arrive at the valuation profile of a company.
P/E can be misleading in high-growth companies
Jennison’s deeply resourced investment team develops an informed view of each company’s earnings profile several years into the future. For companies that are growing revenues and earnings at a very high rate, and trade at high near-term P/E multiples, it is more challenging to forecast a likely outcome over the next several years than it is for companies with slower, but more consistent, growth.
For high growth companies, this year’s P/E, or even next year’s P/E, should not be emphasized because they will not adequately capture the true growth potential.
At scale, Shopify could have very high operating margins. Shopify’s business model is driven by high gross margin subscription services that are augmented by highly scalable fixed fee revenue generated from Shop Pay. Importantly, Shopify is focused on innovating, improving service, and addressing challenges, such as security threats. They continue to add services and capabilities that can benefit merchants of all sizes. In particular, Shopify has made big pushes into cross border ecommerce, shipping solutions, and small-to-medium business lending solutions.
Jennison’s way to value these businesses
In valuing these companies, Jennison’s analysts consider several scenarios based on a range of assumptions regarding growth, profitability, and size of addressable market. Additionally, by reverse-engineering a discount cash flow (DCF) model, we also seek to determine the strength of growth, returns, and length of the competitive advantage period reflected in the current market price of these companies. Ultimately, the objective of these efforts is to understand the value created by both the duration and magnitude of growth – areas that the market often gets wrong, usually by underestimating one or both.
If Jennison’s analysts believe the market is being too conservative, they may see the stock as a very attractive opportunity.
Growth companies must build an expensive moat – fast
The challenge in valuing these high growth businesses is that their growth opportunities and addressable markets are significant, of course. Emerging as an industry leader is critical because the company must take market share quickly and build up barriers to entry in order to lengthen its competitive advantage period. To do this, growth companies must invest a tremendous amount of their cash flow in sales, marketing, and engineering to build out their product suite. These investments will depress margins and earnings over the near term (about 1–2 years), but are necessary for long-term success.
As long-term investors, Jennison looks past these near-term investments and their impact on margins and earnings because their analysts are focused on how these investments will affect the business over the next 3–5 years. Forecasts become more difficult beyond that point. At the three-year period – when the company’s growth is typically more mature, its revenue base is normally higher and it has leverage and scalability. Jennison analyzes the margin structure and discounts the cash flows back to the present. If the discounted valuation is very attractive, Jennison will acquire the stock despite the fact P/E multiples on current earnings may be elevated.
If the analysis described above has correctly captured the growth rate, the duration and magnitude of the growth rate, and the size of the market opportunity, the investment should generate excess returns. If that thesis is not borne out – e.g., the analysis overestimated the size of the market opportunity or the product matures more quickly than anticipated – Jennison exits the position.
As the investment thesis plays out over time, Jennison will begin trimming the position size as the company reaches a more mature state and approaches an internal price target. If the thesis exceeds expectations, Jennison will revise its price targets upward.
Jennison’s growth investing
Most market participants are uncomfortable taking a longer-duration approach to valuation. This is the market inefficiency that Jennison’s market experts – as active fundamental growth investors – seek to exploit. In the long term, the market will always reward the best-positioned company, even if it looks expensive over the short term. The key is to realize when the market is being overly conservative and underestimating the opportunity.
1 China and US data: “How e-commerce share of retail soared across the globe: A look at eight countries,” McKinsey & Company, March 5, 2021.
2 ASEAN data: J.P. Morgan estimates, Euromonitor, EDTA, and MOEA. As of December 31, 2019. Latam: Statista, EBANX; AMI. March and April 2020.
3 Resarchandmarkets.com, June 7, 2021.
4 Statista, as of January 2021
5 According to the World Bank, 1.7 billion adults remained “unbanked” as of 2017 (the most recent data), yet two-thirds of them own a mobile phone that could help them access financial services. World Bank, “The Global Findex,” April 19, 2018.
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Publishing date: September 30, 2021.
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