Why do growth companies have a high P/E?

9 Tem 2023

Namaste!
You must have wondered why growth companies like the following have ridiculous P/E (price to earnings ratio)?
Amazon (314.66 P/E)
Netflix (47.04 P/E)
Tesla (80.80 P/E)
Nykaa (2,007.14 P/E)
Zomato (not profitable/negative P/E)
Paytm (not profitable/negative P/E)
Etc.
Let's find out.

By general definition and understanding, a company is a “money-making machine”. But growth companies defy this rule by not making the money for years if not decades.

Growth companies generally try to avoid the profits. Instead they reinvest the profit to increase sales (by more advertising expenses, more sales employees, more spending on research & development, etc).

Fun fact: Mr Jeff Bezos (CEO and largest individual shareholder of Amazon) used this idea since the beginning of Amazon (before the year 2000). He didn't show the profit in the books of Amazon, but reinvested it to increase sales numbers as much as possible till this day.

Why sales number instead of EPS (earnings per share)?
A: You see the analysts, which include institutions, individual (retail investors), High Networth Individuals (HNI) have something to evaluate the value of any company.
So, there are generally two factors for evaluating any company's value, 1: Its EPS or 2: Sales numbers (growth).
They would look for either P/E (price to earnings) or P/S (price to sales ratio).
The company which doesn't have a P/E (means negative EPS or say a loss), we can value any loss making company via P/S ratio.

So let's take a hypothetical example of 2 different types of companies, 1 is a Value company (like Apple, Microsoft, Reliance Industries, HDFC Bank, etc) and 2 is a Growth company (like Amazon, Tesla, Netflix, Zomato, Paytm, etc).

General Assumption: Let's assume both types of companies make (1) Sales of Rs 10000 crore in the 1st year, (2) a gross profit margin of 50% (means Rs 5000 crore “gross profit”) at the start, (3) a market cap of Rs 50000 crores with 100 crore number of shares outstanding, (4) an uniform tax rate of 30%, (5) a share price of Rs 500 at the start, (6) an owner with 51% stake and (7) both the companies are listed in the year 2020.

Value company: Companies like Reliance, HDFC Bank, etc don't need to and only spend 30% of gross profits every year for expenses and growth. Meaning, its net profit before taxes is Rs 3500 crores. Net profit after taxes is Rs 2450 crores. So EPS would be Rs 24.50 per share and 20.40 P/E.
Net profit or say EPS will be high for the value company because it will try to not incur unnecessary expenses (like more advertisement, increasing the number of sales employees and their salary, more discounts on the products, etc).
Exception: The growth also greatly depends on the nature of business. For e.g. a software company will grow at a very fast pace because its product is a “software”, which is infinitely scalable. More software can be produced “with a single click”. Whereas, for an automobile company, it isn’t the case.

Growth company: This company will spend 90% of its gross profit to increase sales. Meaning its net profit before taxes is Rs 500 crores. Net profit after taxes is Rs 350 crores. So EPS would be Rs 3.5 per share and 142.85 P/E.

Assumption for growth (YoY) for both the companies: It’s most likely the growth company will have a higher growth percentage as compared to value companies because the growth company is taking actions, like spending money to increase sales, spending on research and development, mergers and acquisitions (by share swap deal), etc. Whereas, a value company is trying to avoid unnecessary spending and focus more on profitability i.e. net profit.
So, let’s take 20% growth rate for a value company and 40% growth rate for a growth company.


Lets calculate the sales, gross profit, taxes, net profits before taxes, market cap, price to earnings ratio and earnings per share (EPS) for 10 straight years, assuming the constant rates for sales growth at 20% for a value company and 40% for a growth company every year..

Value company financials chart:

Column heading: 1. Year; 2. Sales (Rs Crore) with 20% growth YoY; 3. Gross profit (Rs Crore); 4. Net profit before taxes (after spending 30%); 5. Taxes (Rs Crore); 6. Net profit after taxes (Rs Crore); 7. Market Cap (Rs Crore); 8. P/E; 9. EPS.

| 2020 | 10000.00 | 5000.00 | 3500.00 | 1050.00 | 2450.00 | 50000.00 | 20.41 | 24.50 |
| 2021 | 12000.00 | 6000.00 | 4200.00 | 1260.00 | 2940.00 | 60000.00 | 20.41 | 29.40 |
| 2022 | 14400.00 | 7200.00 | 5040.00 | 1512.00 | 3528.00 | 72000.00 | 20.41 | 35.28 |
| 2023 | 17280.00 | 8640.00 | 6048.00 | 1814.40 | 4233.60 | 86400.00 | 20.41 | 42.34 |
| 2024 | 20736.00 | 10368.00 | 7257.60 | 2177.28 | 5080.32 | 103680.00 | 20.41 | 50.80 |
| 2025 | 24883.20 | 12441.60 | 8709.12 | 2612.74 | 6096.38 | 124416.00 | 20.41 | 60.96 |
| 2026 | 29859.84 | 14929.92 | 10450.94 | 3135.28 | 7315.66 | 149299.20 | 20.41 | 73.16 |
| 2027 | 35831.81 | 17915.90 | 12541.13 | 3762.34 | 8778.79 | 179159.04 | 20.41 | 87.79 |
| 2028 | 42998.17 | 21499.08 | 15049.36 | 4514.81 | 10534.55 | 214990.85 | 20.41 | 105.35 |
| 2029 | 51597.80 | 25798.90 | 18059.23 | 5417.77 | 12641.46 | 257989.02 | 20.41 | 126.41 |
| 2030 | 61917.36 | 30958.68 | 21671.08 | 6501.32 | 15169.75 | 309586.82 | 20.41 | 151.70 |


Growth company financials chart:

Column heading: 1. Year; 2. Sales (Rs Crore) with 40% growth YoY; 3. Gross profit (Rs Crore); 4. Net profit before taxes (after spending 90%); 5. Taxes (Rs Crore); 6. Net profit after taxes (Rs Crore); 7. Market Cap (Rs Crore); 8. P/E; 9. EPS.

| 2020 | 10000.00 | 5000.00 | 500.00 | 150.00 | 350.00 | 50000.00 | 142.86 | 3.50 |
| 2021 | 14000.00 | 7000.00 | 700.00 | 210.00 | 490.00 | 70000.00 | 142.86 | 4.90 |
| 2022 | 19600.00 | 9800.00 | 980.00 | 294.00 | 686.00 | 98000.00 | 142.86 | 6.86 |
| 2023 | 27440.00 | 13720.00 | 1372.00 | 411.60 | 960.40 | 137200.00 | 142.86 | 9.60 |
| 2024 | 38416.00 | 19208.00 | 1920.80 | 576.24 | 1344.56 | 192080.00 | 142.86 | 13.45 |
| 2025 | 53782.40 | 26891.20 | 2689.12 | 806.74 | 1882.38 | 268912.00 | 142.86 | 18.82 |
| 2026 | 75295.36 | 37647.68 | 3764.77 | 1129.43 | 2635.34 | 376476.80 | 142.86 | 26.35 |
| 2027 | 105413.50| 52706.75 | 5270.68 | 1581.20 | 3689.47 | 527067.52 | 142.86 | 36.89 |
| 2028 | 147578.91| 73789.45 | 7378.95 | 2213.68 | 5165.26 | 737894.53 | 142.86 | 51.65 |
| 2029 | 206610.47| 103305.23| 10330.52 | 3099.16 | 7231.37 |1033052.34 | 142.86 | 72.31 |
| 2030 | 289254.65| 144627.33| 14462.73 | 4338.82 | 10123.91 |1446273.27| 142.86| 101.24|


Advantages and Disadvantages of a growth company:

Advantages:
1. Growth companies have a higher growth percentage than value companies, due to its exclusive focus on spending and increasing market share.
2. Less net profit figure means less taxes paid to the government. So, it can be utilized to further improve the business by other means.
3. Growth companies make millionaires and billionaires faster (maybe in less than a decade), whereas value companies tend to take more than a decade.
4. Many growth companies are new age companies, whereas value companies are old age companies. Since the consumer’s taste keeps changing over time, growth companies have a greater opportunity to “invent the next big thing”.


Disadvantages:
1. Since the growth company doesn’t focus on net profits, it doesn’t have profit money to run or grow the business. They are highly dependent on investor’s funding or debt for their growth.
2. The growth companies are highly vulnerable to interest rate hikes and many fail during rising interest rates. Because interest payment on debt will rise, investor funding will stop because they can get greater return on bank deposits which is much safer than investing in a growth company, demand in the economy cools down for unnecessary things (other than Roti, Kapda aur Makaan).
3. Loans against securities have a higher haircut for growth companies. Means, you will get less loan on pledge of Zomato’s stock as compared to pledge of Reliance’s stock.
4. The growth company either doesn't pay dividends, or pays very little. This is due to their very low net profits and their exclusive focus on growth.
5. The growth rate of a company declines over time when the company gets bigger and matures.
6. The general idea of a growth company is “one day, the company will convert its huge sales number into net profits”. For many growth companies, this doesn’t happen as expected. Because, once the “lucrative discounts” stop, the consumer moves to the next company for a discount. In other words, the sales numbers were misleading and failed to fulfill the promise of profits.

Is a growth company better than a value company?
A: High growth percentage doesn’t come for free. The success rate of growth companies is around 10-20%. Whereas, the value companies have a bigger success rate of surviving (more than 50%) historically. Investing in a growth company is like “taking a bigger risk to earn a bigger profit”.

Conclusion: Value vs Growth company is a big debatable topic which divides investors into two groups, one is believer and one is doubter. It's a much more difficult topic than I explained because I used constant figures for growth. But in real life, growth is not constant due to various factors such as change in market dynamics, actual nature of business, country's economic stability, interest rates, etc. I just tried to explain my understanding of high P/E companies and why they even exist.

Disclaimer: This article should not be considered as a financial advise.

30 Ara 2023

Not

Asset-lite companies and growth companies (Like APPLE, MSFT, AMAZON, NETFLIX, NVIDIA, PAYTM, ZOMATO, etc have book value lesser than value companies and conservative mature companies, because they focus on growth over anything else. The small and infant companies grows and can grow at faster pace until maturing (like Ford, GM, Intel, etc). Intel like companies were growing at very fast space (between 1985 to 2000) until they have matured. Mature and value companies pays dividends, growth companies mostly not.