Searching for Value Using Base Rates
Finding what's priced in and comparing it to historical precedent.
Stocks are expensive. This is not news.
You often hear that companies are "priced for perfection," but when you back into some of the expectations implied in today's prices, many of them appear to be priced for the history books, not just perfection.
Recently, I found the exercise of measuring what is priced in and comparing it to historical base rates very helpful in providing perspective on valuation. I did simple reverse DCFs on some well-known, high-multiple names to see what kind of growth expectations were being priced in. These numbers (as of 12/3) include recent sell-offs that heavily affected most of the names below.
The above percentages are what I believe the market is currently pricing in with respect to compound annual revenue growth over the next 10-years. I'll explain the methodology for calculating price implied expectations later, but it comes from Michael Mauboussin's Expectations Investing framework, which starts with the current share price and solves for the inputs implied by that price. These should be thought of more as ballpark estimates than exact predictions.
At first glance, many of the numbers seem high but not insane. It's not unheard of for companies to double revenue year-over-year, and what about work from home? Full self-driving? AI? Won't those themes lead to massive outcomes?
Compounding is not intuitive
Unfortunately, compound growth rates are not intuitive, and it's easy to overestimate the likelihood of achieving high CAGRs based on what you think can happen in the near term. Look at the year-over-year growth rates for Deckers Outdoor, which end up at a 10% CAGR:
Runaway valuations pricing in deceivingly high growth begs the question; what is the historical precedent for high compound annual revenue growth?
Over the last 10 years, there are 51 companies that have achieved a revenue CAGR in excess of 20%; 19 companies in excess of 30%. This base rate shows that sustaining high growth is unbelievably rare.
When I see companies with expectations that imply revenue growth of 20%-30%, I refer back to the chart below, which shows all 51 companies with 10-year revenue CAGRs above 20%. This represents about 1% of all US-listed companies. Is it impossible? No, but it's not likely. The above group is just a small sample - there are hundreds of companies currently pricing in growth that would put them in this upper echelon of revenue compounders.
Understanding what's priced in
My most recent effort as an investor has been around gaining a better understanding of value and price. It's one thing to identify a quality business, but another thing entirely to build conviction about what to pay for it. Just last week during an interview at the Sohn Hearts and Minds conference, Charlie Munger said "There’s no great company that can’t be turned into a bad investment just by raising the price.”
On the topic of value, reading Mauboussin's Expectations Investing was a revelation (summary here). Rather than attempting to model everything and arrive at a valuation independently, one way to put value into perspective is to start with the current price, figure out sales and margin assumptions implied by that price, and decide whether your own view of those metrics is more or less optimistic than the market's.
If you think Company A has an intrinsic value of $15B and your friend thinks it's more like $10B, where does the difference come from? Do you think they will sell more units? The same number of units at a higher price? The same units and price, but with a higher net margin? The expectations investing framework grounds your debate in tangible metrics rather than abstract concepts like valuation.
The obsession over revenue growth comes from the fact that it is the "value trigger" (a term from the book) that most often has an outsized impact on returns over time, especially for high-growth businesses. When you do a reverse DCF, you are essentially trying to guess what the broader market is assuming for variables like free cash flow margin (or its components), cost of capital, beta, terminal growth rate, and revenue while solving for the current share price. It quickly becomes clear that in the vast majority of companies, the model will be most sensitive to revenue growth. I think it's appropriate, then, to boil down expectations to a revenue CAGR for the sake of simplicity.
Searching for Value
With the mandate of finding quality companies where my own expectations outstrip those implied by the current market price, opportunities seem very few and far between. As discussed, stocks are expensive - especially those of quality businesses, and even more so for businesses with great growth prospects. The market seems to have an endless appetite for raising the price of long duration, growth-oriented companies, but many have not internalized that a higher price means that the company must clear a higher expectations bar to generate a good outcome for shares.
If you perform a reverse DCF to find the expectations embedded in a stock's price, then measure the 10-year revenue CAGR (assuming a 10-year DCF is used), time after time you will find that quality businesses are pricing in a decade of 15%, 20% or more compound annual revenue growth. The simple exercise of looking at the historical base rates puts that level of success into perspective. How many companies have 20%+ 10-year revenue CAGRs? Is this company in question on par with those historical examples in terms of management, execution, market size, etc?
Here is a sample of some of the highest returning stocks with some of the most impressive long-term sales growth - a sort of hall of fame of the last decade.
You can see that many of the highest returns were accompanied by multiple expansion, so yes, you can have a great outcome with a lower revenue CAGR, but look at the price-to-sales multiples in 2011. Most of them were expanding off of single-digit bases. It's difficult to look at multiples today (often many times those of 2011) and think that multiple expansion is going to be a big driver of returns.
If you are looking at a company that currently trades at 25x NTM revenue and is pricing in (via reverse DCF) 30%+ revenue growth, as many in the first table at the beginning are, refer back to this hall of fame. Keep in mind, you have to believe that a company will meaningfully outperform the expectations embedded in its price to result in a great return. Price increases come from upward revisions in future expectations. If the company meets expectations, you can expect a market return.
So, in 10 years, will we look back at Asana, which trades at 37x NTM revenue and implies 32% 10-year compound revenue growth, and see that it has meaningfully exceeded those expectations? And what's the base rate for that level of success? My guess is that it's less likely than most investors acknowledge.
Of course, it's more helpful to look at base rates for companies in similar industries at similar stages in their growth cycle. Here are the revenue CAGRs of some well-known companies since they hit $1B in revenue:
If you're looking at an enterprise SaaS company, will it be better than Atlassian? A fintech company better than PayPal? This is bordering on being too simplistic, but I find the context useful. Everywhere I look, there are unproven companies priced as if they will enter the hall of fame. Some of them will; most of them won't. And the downward revisions in expectations along the way will cause investors who failed to understand what is priced in to lose money.
On a less pessimistic note, this exercise works just as well in the opposite direction. If you believe a company is pricing in single-digit growth, and your own expectations are higher, it may be undervalued.
Because it’s more of a directional insight than a precise one, the delta between what is implied by the price and what you think will happen should be significant. If you think Company A’s shares imply a 5% CAGR and you believe they can comfortable grow at 7%, don’t get too excited, especially if the base rate for similar companies is in the same ballpark. However, though they aren’t abundant today, the market will inevitably hand those who are searching the occasional drastic mispricing.