Does valuation matter?
We recently compiled a fairly detailed note for investors and subscribers that addresses an evergreen question: how much can an investor safely pay up to own a high-quality, fast-growing business?
Given the valuations currently on offer for high growth businesses - and the prices being offered in M&A transactions - we believe it is a sensible time to try and unpack this thorny issue.
Fundamentally, the main challenge lies in understanding whether the current price quoted by the market already reflects the inherent quality and future growth prospects of a business. If it does, then it logically follows that paying the current price will not lead to superior long-term results, as all the future ‘good news’ is already capitalised in the price quoted today.
The note provides a framework to evaluate embedded expectations in a stock price, by using high-quality and high-flying software company Snowflake (a business and management team we genuinely respect) as an example. This framework is a simplified version of the approach we use when evaluating investment opportunities at AIM.
Our analysis concludes:
- Starting valuations matter, even when investing in faster-growing opportunities. It is absolutely possible to overpay for a high-quality, high-growth business, and price agnostic investing usually does not end well.
- Businesses requiring many years of sustained high revenue growth to justify the current valuation carry high risk. In most cases, history suggests that these high long-term growth rates are unlikely to materialise in the vast majority of cases.
- Balance in portfolio construction is important. Any portfolio might benefit from one or two hyper-growth businesses that can deliver an extremely positive outcome, but to have a portfolio filled only with businesses trading on such extreme valuations does not tend to end well.
Download the full note: What Test Cricket Can Teach Us About Valuation & Long-Term Investing?
We hope you find it interesting.
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