- This market is all about growth stocks, so we should know what drives and how it impacts growth stocks.
- With one example, I’ll show how the change in growth impacts a stock’s price.
- It’s important to look at real growth possibilities as the market often gets extremely exuberant when looking at a few quarters with increasing growth rates.
The current stock market is all about growth, and valuations don’t matter that much anymore. The question now is how to analyze growth stocks and what metrics to take into consideration when creating a risk reward model for any given growth stock.
Amazon’s (NASDAQ: AMZN) revenue has grown 10-fold in the last 10 years while its net income is at $2 billion for a price to earnings ratio of 288. A value investor would immediately call such a price overvalued, but perhaps there is some method behind the madness of a 288 PE ratio.
AMZN’s market capitalization is $546 billion while its revenue is $161 billion and its net profit margin is 0.003%. The growth in revenue for the previous 3 quarters was 23%, 24%, and 35% for Q3 2017.
Let’s imagine that AMZN manages to grow its profit margin to 3% and continue to grow at 27% per year for the next 10 years. After 10 years, AMZN’s revenue would be $1.7 trillion and its net income with the 3% net profit margin would be $52 billion.
An important factor to look at when analyzing AMZN is the operating cash flow. The operating cash flow is at $16 billion which is 10% of revenue and leads to a price to operating cash flow (P/OCF) ratio of 34, which isn’t that high.
Nevertheless, the main questions with Amazon are whether or not the company will continue to grow at the staggering rates it has been growing, and can the growth continue for the next 10 years? These questions led me to today’s topic of how to analyze growth stocks, and a method called “the delta of the delta.”
The Delta Of The Delta
When analyzing growth stocks, your biggest fear is a change in the pace of the growth, thus a change in the change, or the delta of the delta. If AMZN is expected to grow at 27% per year and operating cash flows are expected to remain at 10% per year, any surprise in those metrics—even if minimal—could lead to shocks to the stock price.
AMZN is not a stranger to such shocks.
In 2013, AMZN reached $400 only to fall below $300 in January 2015. In December 2015, it reached $662 only to fall back to $500 in February 2016. Such sharp declines are due to surprises in growth.
In the first two quarters of 2017, AMZN was growing at 25% while the surprise growth of 34% in the last quarter pushed the stock price from $980 to the current $1,154.
This volatility in growth is normal for a business, but investors don’t like anything that isn’t linear. The consequence is the relative volatility in AMZN’s stock. Therefore, if you want to invest in growth stocks, you have to analyze whether the volatility in a company’s growth is temporary or a structural decline or increase.
I’ll now show you how just a small change in growth impacts a stock’s price. As mentioned before, it’s all about the delta of the delta.
Let’s imagine that investors expect AMZN to reach a 5-year forward price to cash flow ratio of 10. Thus in 2022, AMZN’s operating cash flow would be at $56 billion and revenues at $560 billion. This would mean that AMZN would have to grow at an annual rate of 28.4% over the next 5 years.
Now, if AMZN slows down just a bit and let’s say the growth falls to 23%—thus by 20%—which would still be a staggering number, the calculations change abruptly. 2022 revenue would be $450 billion and operating cash flows $45 billion which is then a 20% cumulative decline. You could expect a similar decline in the stock price if such a slowdown happens. However, there’s more.
If AMZN’s growth slows down, the expected 5-year forward price to operating cash flow ratio (P/OCF) of 10 would also be adjusted by the change in the growth. A 20% lower P/OCF of 10 leads to a new P/OCF of 8. If I multiply AMZN’s 5-year forward operating lower cash flows with 8, I get to a market capitalization of $360 billion.
So a 20% slowdown in growth would lead to a 35% decline in AMZN’s stock price. Similarly, a 20% increase in growth would lead to a 35% increase in AMZN’s stock price. The point is that if the growth slows down, the valuation gets lower and vice versa. That is why even if the slowdown in growth might look meaningless as both a 28% and a 23% growth rate are still wonderful, the decline in the growth rate has a very detrimental effect on the valuation of a growth company.
Try To Estimate Future Growth
So when investing in growth companies, it’s more about the growth in the growth rate than the actual growth a business manages to deliver. Be especially careful when investing in a company that has declining growth rates as if lower growth rates persist, a stock can get really punished.
What’s also extremely important is to use a bit of common sense and project whether the expected growth rates are actually possible in relation to the growth in the economy, sector consumption, etc. Just because you can buy dog food online doesn’t mean that the amount of dog food sold will double in the future.