How to value a company when its earnings are low but growing in double digits?
By Amr Hussein Elalfy, MBA, CFA
7/26/19 3:26 AM
Nowadays, investors in the Egyptian stock market are looking forward to the upcoming initial public offering (IPO) of electronic payment solutions provider Fawry. It is the long-awaited IPO, almost 10 months after the latest one by Sarwa Capital (EGX: SRWA), which left investors with bad experience after its stock had fallen soon after to below its IPO price. This is one reason why investors are wary of the Fawry IPO. Another reason is the seemingly-high valuation the company is being priced at based on one famous metric: the price-to-earnings (P/E) ratio.
For beginners, the P/E ratio is simply the price per share divided by earnings per share or the company's market cap divided by its earnings. Usually, investors would prefer looking at forward earnings (i.e. earnings over the next 12 months "NTM") instead of historical earnings (i.e. earnings over the last 12 months "LTM") because the former captures future short-term growth. But looking at Fawry's LTM P/E reveals a valuation of 80x, which is quite a hefty premium compared to the market's 15x (as measured by EGX 30 index). So, how can investors value a company like Fawry?
Back to valuation basics, there are three main valuation methods to use when valuing companies: (1) the cash flow-based method, (2) the multiples-based method, and (3) the assets-based method. For a company like Fawry, it is probably best to use the first two methods in assigning a value for the operations. But to manage your expectations, I will not venture into valuing the company in this post, so you should refer back to your financial advisor or broker. That said, what I will do in this post is scratch the surface as to how best to value similar companies, i.e. companies with low earnings but growing in double digits.
First, let's consider the cash flow-based method, such as a discounted cash flow (DCF) model. To build this model, we need four key factors: cash flows, a discount rate, a terminal growth rate, and a time when this terminal growth rate will kick in. For the cash flow, we can either look at free cash flow to the firm (FCFF) for which the discount rate would be the weighted average cost of capital (WACC) or look at free cash flow to equity (FCFE) for which the discount rate would be the cost of equity (COE). For a company like Fawry, both cash flow metrics can be used, but I would prefer to use the FCFE since this is a zero-debt business. Furthermore, it would capture all investments that the company has which are not consolidated into its operating cash flows. FCFE can simply be calculated as Net Income – Reinvestment (which includes capex and working capital investment less depreciation). COE can be calculated as an Egyptian pound-based risk-free rate + Egypt Equity Risk Premium, assuming a beta of 1. Once discounted, the sum of these FCFEs and the terminal value would be Fawry's equity valuation.
Second, let's consider the multiples-based method, such as the P/E ratio. But instead of using LTM, we would use NTM P/E. However, in view of the company's abnormally-high growth rate, we can use the PEG ratio instead, or P/E divided by Growth. A fairly-valued stock is said to have a PEG ratio of 1. So, let's assume if the long-term growth rate (the compounded earnings growth for the next say five years) of Fawry's earnings were 40%, then a fair value would be 40x NTM earnings. Another metric to use under the same method could be price-to-sales; again it's better if we use NTM sales. One can take the average of both metrics to come up with one value under this multiples-based method.
To reach a final valuation for Fawry, you can consider a weighted average of both methods mentioned above depending on your preference. As a sanity check, we can calculate the terminal growth rate, the NTM P/E, and P/S implied by Fawry's IPO price to see if they make sense, especially when compared to similar or peer companies.
So, how would you value Fawry in view of the above? Let's start the conversation!