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Valuing Growth Investments Like the Pros

September 2, 2011 Leave a comment Go to comments

As I mentioned before, a lot of post-IPO investors don’t seem to apply anywhere near the rigor of the VCs who brought the company to that point. This detailed post by Fred Wilson shows how a VC values companies for investing purposes. To do this correctly you need to be able to use metrics that depend on the industry and business model. You can likely get enough information from other public companies to get a rough idea of current and potential future value.

The interesting part is the rate of return you need to make and the failure rate. A VC fund is probably aiming for a rate of return of somewhere around 20-30%, so one 10x gain can compensate for several total losses. A similar model works if you’re a growth investor.

Let’ s say you buy 4 IPO stocks in equal amounts, and guess that only one will be successful while the others will lose 50%. If you want to make an above-average return of 20%/year over the next 3 years, you would need the one winner to be worth 5.4x as much in 3 years. That would require a gain of 75%/year. If you only wanted a return of 15%, the winner would have to gain 66%/year. For a modest return of 10% the winner would have to gain 56%/year.

Here’s the math:

  • $4000 invested to get a return of 20% for 3 years = $6912
  • $3000 of this loses half its value (=$1500 at the end)
  • The one winner must go from $1000 to $5412 ($6912 – $1500) to meet your target
  • $5412/$1000 = 5.412 times the original value
  • Doing the cube root (for 3 years) shows the value must be multiplied by 1.75 every year which is a 75% gain

So if you’re thinking of buying a high-flying IPO or growth stock, that’s the bar you have to clear. You can set your own requirements and figure out what you need. But it seems like the returns you need from the winners are extremely high whatever you do and this route is very likely to lead to under-performing large-cap indexes. On the other hand if you’re looking at private investments this would be a good model to apply and you might actually be able to make the numbers.

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