Companies Rarely Grow Into Their Valuations (Nnamdi Iregbulem)

Nnamdi Iregbulem on why high-multiple companies rarely grow fast enough to justify their valuations.

Why it was kept

The passages Kyle kept on multiple compression and what drives valuation, saved in late January 2022 as the market turned.

As Kyle captured it

• Companies Rarely Grow Into Their Valuations by Nnamdi Iregbulem
  • Most often, companies don’t grow fast enough to compensate for rising valuation multiples. Instead, high valuations today imply slower value appreciation in the future, i.e. lower returns.
  • Think of the “multiples are higher today because multiples will be higher tomorrow” justification as a sort of “bubble mentality” or “greater fools” explanation. Someone else will pay more for this later, so I’m OK paying more today. This of course can’t go on for long: bubbles eventually pop; manias eventually subside. So, here too, multiples return to “normal.”
  • “both Wall Street and Main Street believe… the expected cash flow process is the main economic force driving asset price variations”
  • “cash flow expectations alone explain 99% of the price-dividend ratio variation, while return expectations only explain about 10%.”
  • When financial researchers do look-backs, they find that high valuation multiples precede low returns. In fact, they literally predict lower returns.
  • High valuation multiples corresponds to lower returns, and vice versa. After periods of frothy valuations, returns end up lower than expected, bringing lofty valuations multiples back down to reality.
  • Despite this sobering reality, investors are extremely stubborn about future return expectations, even in the face of rising prices. Undeterred by nose-bleed valuations, they continue to expect roughly the same return in all periods
  • If anything, the high variability of startup growth may be a cognitive trap, seducing us to think that herculean growth alone can shoulder weighty valuations.
  • The burden is on venture investors to prove there’s something special about the asset class that will help it escape the fateful relationship between valuations and returns we see in public equities.
  • Until then, growth is just a cop out.