Investors in the current markets are increasingly facing the value vs growth dilemma. On the one hand, as stocks continue to race ahead, sticking to value investing implies limiting oneself to the ever-shrinking list of value stocks. On the other hand, to take the plunge in growth stocks implies abandoning valuation warnings. Examples abound in sectors such as e-commerce, defense, hospitals, hotels etc where high double-digit PE and triple-digit PEs are the norm.
How exactly can an investor reconcile this conundrum? Should a common investor too have the approach of a venture capitalist, focusing on a credible story while ignoring bloated valuations today? Here’s one way to approach investing in such sectors.
The end-market size
Growth investing entails sizing up the end-market opportunity when it matures to a reasonable level, assessing the extent to which a specific company can scale up in the sector and figuring out the sustainable margins it can achieve. Based on this, an investor needs to make a call on what price he/she is willing to pay today for this opportunity.
Take, for example, quick commerce. The two listed entities — Eternal and Swiggy — boast of a revenue growth of 30-50 per cent per year. The Eternal stock trades at astronomical valuations of 260 times one-year forward earnings. Such valuations obviously raise alarm bells for value investors. Even hardened growth investors will have a tough time backing their thesis: “Growth at any valuation”. But looking at them from the end-market dimension can bring the perspective needed to judge their valuation.
While by one measure (explained below), quick commerce opportunity can be valued at a maximum of ₹4 lakh crore, the two leading companies are now valued at around 75 per cent of that or ₹3 lakh crore. Compared to getting driven off track by a dizzying PE of 260 times, investors can wrap their mind around the 75-per cent mark to make the investment call.
Indian consumer spending on groceries amounts to ₹50 lakh crore a year. This comprises 30 crore households of four members and an average per capita consumption of ₹3,500 per month. Assuming 7.5 per cent distribution margins, a geographical reach of 60 per cent and a peak penetration of 20 per cent in the addressable market, the quick commerce industry should target revenues of ₹45,000 crore per year. By applying 6-8 times price to sales multiple for quick commerce, we can assign a market cap of quick commerce industry of ₹2.7-3.6 lakh crore. The two companies are currently valued at ₹2.4 lakh crore for Eternal and ₹85,000 crore for Swiggy. This includes food delivery business also, which is just as large if not larger. Such information will enable an investor to make a better investment decision.
Please note the illustration above is given to provide a perspective and is not a forecast on the quick commerce opportunity.
Employing an end-market method allows greater clarity on investment than allowed by valuation metrics. As one can toggle the penetration targets, distributor margins or geographical reach. As these assumptions are tweaked, the value, too, will change wildly. Each investor must discern for oneself on the right assumptions to make. One can then assess if the company’s current valuations are aggressive or benign on their assumptions.
The glaring drawback in this approach is that the market share will be fluid between the current 4-5 players before a phase of consolidation begins. But which ones will be the final two-three players remaining, as in most tech companies, will be an unknown. Apart from the final market share, the method also ignores the efficiency of each of the companies, the external environment of gig workers’ compensation and the impact of regulation. This is the reason venture capitalists spread their bets over many companies in the same industry rather than double down on a specific company.
By pegging market caps to the end-market’s perceived value, investors can gauge the true extent of over or under valuations.
This approach can be applied to other sectors such as defence, hotels or hospitality as well, where the prohibitive PE multiples will knock off value investors. For example, post Operation Sindoor, Indian defence stocks are rallying on not just the domestic opportunity, but export potential as well. Investors are likely factoring in strong export potential in the valuations following a resolute display of technology. Across drones, radars, electronics, munitions and naval variations of the same and the real-time display in operations, it is likely to drive international enquiries. How justified this optimism is from an investing perspective can be ascertained by following the above approach.
In following this approach, investors would do well to err on the side of caution to factor for unknown risks that may play since these bets are sized up based on the opportunity for potential that will be realised years down the line and a lot can change in the intervening period.