Article by Harry Griffin for the Times & Transcript published on July 23, 2019

Imagine you just moved to Moncton. You expect a very hot end of the summer, and you want to take advantage of that by getting into the ice cream business. You have two options, you could buy “Ice Cream Shack A” or “Ice Cream Shack B”.

Ice Cream Shack A makes $200 a summer, and the owner is willing to sell you his business for $1,000. With that in mind, how much would you pay for Ice Cream Shack B if it only makes $100 a summer? Well it makes half as much money, so it seems fair to pay $500 (half the value). This is a very simple example of using a valuation multiple in investing. In this case, we are assuming the businesses are worth five times their profits.

matthew henry VviFtDJakYk unsplashAssume the owner of Ice Cream Shack B wants $600 for his business (six times its earnings). According to our multiple this may be too expensive. But what if Shack B is just about to get some new flavors? Let’s say we think that Brownies on the Moon is going to drive much more traffic, doubling our profits. In this case we may be willing to pay a higher multiple. What if a lemonade-stand just opened across the street from Ice Cream Shack A? This might drive away traffic, so we may want to pay a lower multiple. We would rather get a better deal in order to compensate us for the added risk. These scenarios illustrate the two factors that decide what a company’s multiple should be: growth and risk. One company deserves a higher multiple over another if it is either growing faster or is less risky.

Let’s apply this concept to a real-world example. In our last article we touched on Beyond Meat (BYND). The company held their IPO at the beginning of May, and the stock has had a phenomenal run since then. We highlighted that BYND is a very innovative company, taking a scientific approach to designing “plant-based” meat to be used in burgers, sausages, etc… They seem to have struck gold with customers and their sales have been growing at incredible rates. However, what we pointed out in the last article is that despite their growth, their stock simply seems too expensive. What we did not do is quantify just how expensive it is. This is something we can do with a multiple.

In this case it would not make sense to put a multiple on the company’s current profits for the simple reason that they are not yet profitable. But, that is not a deal breaker as the company is growing very quickly and will be profitable. Instead let’s try to think of what the company could be worth in ten years. JP Morgan suggests it may be possible for BYND to do $3 billion in sales by this time. That would be no small feat considering they only did $88 million in sales last year. But we can use this as our estimate. Then we must decide how much profit they will earn on those sales. Management suggests they will eventually be able to retain 15% of sales in profit, but we are going to assume 20%. This gives us an estimate $600 million (20% of $3 billion) in ten years.
Now we can apply a multiple. The average food company trades at about at 12 times multiple, but we really like BYND so we will use 20 times (it may have occurred to you at this point that we are not using conservative assumptions). This gives us a value estimate, in ten years, of $12 billion ($600 million x 20). This works out to $200 per share when divided by the number of shares. Today, the share price is $170. Which means our estimates only imply a $30 increase over ten years, or a 1.6% return per year. This is lower than the return we would get on a 10-year US government bond.

Remember, the two factors that decide what a company is worth are growth and risk. That means one of three things can be happening. The first possibility is that our growth estimates are too low, but they already feel very aggressive. The second possibility is that BYND is less risky than a US government bond. This is easy to rule out, it implies the odds of BYND meeting our estimates are higher than the odds the US Government can pay interest on its debt. The third possibility, and what this author feels is by far the most likely, is that this stock is too expensive. That is not to say there is anything wrong with this company, but when the market gets excited it can price stocks incorrectly. In this case, we are assuming incredible growth and we would still not be compensated for the risk of buying the stock.