Investors expect all companies to grow.
Growth rates and secular growth drivers determine your growth stock status.
If you are a growth stock, what are investor growth expectations?
Growth expectations are relative.
An attractive growth rate represents a function of industry, competitive set, secular growth drivers. An attractive growth rate for one company may not be an attractive growth rate for another.
If growth rates are relative, then how do you determine the optimal growth target for a company?
Question 1: Is Your Industry Growing or Contracting?
If you are in a growing industry, investors will likely want your company to grow faster than the industry growth rate in order to be a growth stock.
Here is a growth stock hierarchy of attractiveness (note that these assessments change depending upon a bull or bear market):
1. Best = Share gainer in growing industry
2. OK = Share gainer in contracting industry
3. OK = In-line growth in growing industry
4. Problematic = In-line growth in contracting industry
5. Problematic = Share donor in growing industry
6. Bad = Share donor in contracting industry
Where your company’s story falls within the above hierarchy will dictate the amount of work the IR team faces to make the story relevant. If the story is complex and falls toward the bottom of the list, more work will be required to make the story relevant. The same holds true for market cap, the smaller the market cap the more work to be relevant to a wide long-term focused audience.
Question 2: How Do You Determine if the Industry Is Growing?
The company can start by looking at third party research such as Gartner, et al., or even sell-side research. These growth rates represent a solid starting point for understanding an attractive growth target for a growth stock.
A more in-depth approach entails the investor relations team doing some comp work. Start with an analysis of the Proxy Filing comps. The Proxy Comps are the comparable companies listed in a company’s proxy for compensation purposes.
Second, compile a list of the Street comps from you Sell-Side Analysts. These comps will allow you understand what might represent an attractive growth target to the sell-side and/or buy-side.
The IR team will want to look at the:
aggregate growth rate,
median growth rate, and
mean growth rate
for each comp set (Proxy comps and Street comps). Ideally, the two comp sets will provide you a growth range from which to build your target growth rate.
Question 3: Does Your Company Benefit from Secular Growth Drivers?
True growth stock that carry premium multiples nearly always benefit from a long-term secular growth driver. In the case of SaaS, PaaS, and IaaS, these companies benefit from the ongoing secular shift from owned, on-premise computing infrastructure to off-premise, shared, and managed computing infrastructure. An example from my time on the sell-side was “digitizing the un-digitized.”
Question 4: What Is the Total Addressable Market (TAM)?
If you are a growth company and benefit from strong secular growth drivers, then the company must provide a thoughtful discussion of the total addressable market (TAM). Discussing TAM gives the investor community guard rails for what your company is playing for in terms of future growth. The TAM discussion also sets expectations as to what your realistic growth opportunity might be. Understanding the TAM provides the necessary color investors need to believe your growth rate and opportunity.
Question 5: How Complex Is Your Story?
Growth stocks with complex underlying stories will almost always face a valuation discount. Having a complex story will likely require a higher growth profile to attract investors. A company might consider the need to drive to a higher growth profile depending on the underlying level of complexity associated with the company.
Question 6: What Is Your Valuation?
Do you know what multiples investors utilize to value your industry? Knowing the primary relative valuation metrics will help you to set guidance on the most relevant growth metrics. For example, if you are a SaaS company revenue growth and billings growth guidance will be essential, where as EPS growth might represent a minor focus. For Defense and Homeland Security, investors will likely be focused on EPS growth and FCF growth/margins. Remember it is all relative, as each sector benefits from different growth valuation drivers.
Once you better understand your growth profile and possible expectations, you can then formulate messaging.
Messaging Growth Expectations
After thinking through the six factors of optimal growth, the company must then think about how to message the growth expectations.
The best way to establish growth expectation messaging will be to use an Analyst Day. The Analyst Day allows the company and CFO to anchor investor focus on the most important financial metrics and growth variables. Optimal messaging will provide a near-term outlook (current year), as well as targets for three to five years out. At a minimum, the company will want to provide long-term revenue and profitability anchors, as these two variables will allow investors to do a back-of-the-envelope valuation analysis.
Once you establish your growth framework, you need to communicate it within the confines of your earnings messaging. If you only provide annual guidance, you will likely find it necessary to provide unofficial / vague qualitative / directional guidance on a quarterly basis in order to maintain control of consensus, typically done during call-backs.
If you provide quarterly guidance, the earnings materials will need to consistently report on your performance toward reaching the target. Additionally, the earnings materials will need to update your guidance accordingly for each quarters performance.
Remember, once you set growth rate and profitability expectations, these expectations then become a golden metric. If the company believes it can do 20% growth on an internal forecast basis, then I would argue the company should set Street expectations at 18%. Throughout my experience with Chinese Internet IPOs and US Internet IPOs, we would always tell management to take a 10% haircut to the estimates they think they can hit. Once you tell the Street X% that goal becomes a golden metric. Performance that falls below the target will result in near-term disappointment at a minimum.
Practical Example: The Rule of 40
A practical example of an industry focused on specific growth and profitability targets is SaaS. Most SaaS investors focus on The Rule of 40, which assess the company’s revenue growth rate and profitability margins. Under the rule of 40, the revenue growth rate should exceed 20%, and operating profit should exceed 20%, some analysts substitute free cash flow (FCF) for operating profit. The summation of these two percentages should yield a result greater than 40%. The higher the result above 40%, the higher the multiple, typically EV/S. For additional information on SaaS, The Rule of 40, et al., check out Tom Tunguz.
Thoughts on The Rule of 40
In my experience The Rule of 40 can be a beneficial analysis for nearly any industry. One can adjust the “Rule” according to the growth profile and margin profile of the given industry. For example, athenahealth (ATHN) sits at the nexus of HCIT and SaaS. The company consistently comes in around 30% because of low operating margins, but retains a SaaS multiple. Running this analysis for Data Center REITs provides a strong illustration of why CoreSite (COR) consistently outperforms, and why QTS (QTS) consistently underperformed in late 2017.
An additional thought on The Rule of 40. Once the analysis is applied to your company, you can quickly understand how well your company might be performing. In the case of DFT, we were generating about 10% revenue growth, but 50% profit margins. The results were signaling that investors likely would have supported us if we lowered profit margin to drive a higher growth rate.
A more recent example comes from the Ring Central Analyst Day, which took place on Thursday, June 14th. Watch the video as Mitesh Dhruv, CFO of Ring Central, does a great job of using The Rule of 40 as the driver of his presentation.
