The effects of inflation on profitability and associated potential deratings of price-to-earnings ratios are topical concerns for investors. Tougher operating markets and rising financial costs are sometimes portrayed as sounding the death knell for growth companies. But is it really time for them all to bite the dust?
The core issue here is market valuation. I read a post recently from an investment bank claiming that “everything is a discounted cash flow (DCF) model”. With respect, alas, I disagree. All models abstract from vital issues. At best, they yield clues about a complex reality. At worst, they miss the point altogether. In finance, they are simply one lens on enduring value.
A DCF model is a time machine allowing us to collapse the future into the present. In the simplest case, projected dividends one year from now, and estimates for the required return on equity and the expected growth rate serve to compute a company’s fair equity value, using a mathematical formula for an infinite series. More complex variants share this structure – inputs and a function that calculates outputs.
Investors sometimes scratch their heads when such valuations go spectacularly wrong, even sophisticated ones. Well, maybe the viewpoint is partial. Something is missing from the picture.
Metaphors help us to interpret the world. In the past, even in finance, they were often drawn from nature. We have lost this perspective and, with it, a lot of investment insight. Yet growth is intrinsically associated with organisms such as the simple flower, rather than a calculating machine.
“Growth is intrinsically associated with organisms such as the simple flower, rather than a calculating machine.”
We can learn a lot by thinking of a company as a plant. This invites us to consider relevant questions. How does it energise itself when there is no sunlight? How strong are its roots and structure to allow a free flow of nutrients? How does it rejuvenate itself each year? How does it survive with other organisms in its environment that is constantly in flux? And many more.
Notice that the concept of change, that old Heraclitean insight, keeps reoccurring in these deliberations. Nature’s growth is enduring – a magical cycle seen in all plants from seed to bud, to bloom. Sustainable growth companies are characterised by this paradox of nature. They thrive over time because they can ‘let go’ and transform themselves into something even greater.
So, the next time you are considering investing in a growth company, ask the CEO what his or her blooming strategy is! Companies with this entrepreneurial spirit do not bite the dust when times are tough. Their quality and inherent dynamism sustain and enhance long-term earnings and value.
Beyond DCF analysis, there is a need for a much broader perspective if we are to identify the blooms that will thrive and revive. Real valuation work is a synthesis gleaned not just from narrow analysis, but from broad experience, and intuition. It is about closing your eyes, freeing the mind… and imagining.
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