You are Probably Looking at Valuations Wrong
- 3 days ago
- 4 min read
A general misconception that I have seen with investors especially on the institutional side is that they nearly always consider that exit multiple of their investments will be lower than the multiple that they are buying at.
This thought process is based on an assumption that overtime a company’s growth rate will reduce and thus so will the valuation multiple that it trades at. But the reality is that even though growth rate is a major driver of valuation multiples, there are more nuances to what multiple a stock trades at; and within that the major aspect is the perceived risk factor around a business or a stock.
In my experience in the markets and this primarily holds true for small & mid cap companies is that as a business & company grows in size, its valuation multiple tends to expand despite a bit of slowdown in its growth rates.
For a small cap company, the primary thing working in its favor is the relatively higher growth rate vs larger companies. But despite a higher growth rate smallcaps tend to trade a much lower multiples than larger companies.
This is because they might have one or more of these issues like they won’t have the best balance sheet, they would have poor CFO conversion, would have lower ROCEs, won’t have an established track record and will suffer from lack of discovery, liquidity and information.
In totality, they are perceived riskier and/or do not offer the same level of comfort to investors as their larger counterparts.
However, overtime as these small companies continue to grow and become larger in size a lot of these issues like balancesheet strength, cashflows, track record etc gets taken care of automatically and with that the discovery, liquidity and availability of information also improves. And during this journey of becoming larger in size, these companies start attracting capital from a different set of investors who have a lower return expectations but do require a higher level of perceived safety which they can now find in the same company (at its new larger business/market cap size).
As a result, the valuation multiples tend to expand overtime for smaller companies if they continue to grow at a good enough growth rate.
A practical example to highlight here would be a company like Aditya Vision. When we bought into this stock back in 2022, it used to trade at low 30s TTM multiples despite having a very strong growth of 30%+, while some of the larger companies in other retail segments like say Vmart used to trade at >50x multiple despite much lower growth.
The reason for lower multiple was that there were perceived risks like sustainability of growth as general market perception was that it being a single state business would find hard to sustain growth beyond a point, the accounting practices were not top notch, there was lack of information as company did not hold concalls and so on.
However, as company successfully expanded into other states, built a track record of sustained growth and many of other smaller issues getting resolved automatically like accounting etc (as business became bigger), it started attracting capital from institutions including the likes of Capital Group and got rerated to 50x+ multiples despite growth rate slowing down to 20s range now vs earlier 30%+.
And Aditya Vision is not an isolated case, we have seen the same thing play out with our other investments like Ethos, Safari, Tips Music, Garare Hi-tech etc. In all these cases as well, the growth rates have reduced a bit over the years, but the valuation multiple have only expanded as these companies grew in size.
So as an investor if you are buying into a smaller company and do believe that it will continue to grow for a decent time period of next 3-5 years and would become a much larger business, then ideally you should expect that valuation multiples would re-rate when you build your expectations & eventual exit.
As a thumb rule, one can consider 1-1.5x growth rate as a good entry multiple in a small cap with an expectation that the multiple would re-rate to 1.5-2x growth rate if the company does grow & becomes a bigger company. The caveat here again is what I shared earlier that though growth rate is a big factor that determines valuation multiple, there are other nuances as well and thus there would be cases wherein the above thumb rule might not hold true due to other factors in play.
This though process and thumb rule has served me well in my investing over the years and continue to work well in the investments that I make.
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