Go beyond valuations when analysing ‘death or glory’ disrupters

Rankings of companies with fast sales growth like the FT 1000 are interesting to investors for one main reason. Some of them will turn into businesses that produce fast growth in cash flows too.

A few may already have achieved that status. Plenty of the others will fizzle out or implode, contributing to the roadkill that is the byproduct of healthy capitalism.

Growing fast and dying young is easy enough. First, make a convincing pitch for investment in some modish area such as meal-kit deliveries. Next, spend more money providing your product or service than customers are willing to pay for it. Call it “acquiring market share”. TV advertising is a quick way to lighten the cash burden.

Then hit the conference circuit to share the secrets of your entrepreneurial success. Sooner or later, creditors will call in your debts and a gimlet-eyed insolvency practitioner will be running your business.

Such rake’s progress is particularly frictionless in fields where it is possible to register sales without receiving cash payments. Over-optimistic revenue recognition is the leitmotif of European corporate disasters. Changes to accounting rules are intended to discourage bombastic bosses from, for example, claiming too much of the value of an extended contract upfront. But squeeze a balloon in one spot and it will pop up somewhere else.

Cash returns are the acid test of viability

Cash returns are the acid test of viability. Accounts that show smoothly rising sales and profits but stubbornly low free cash flow are a red flag. That banner was flourished memorably by Quindell, a disastrous legal services group.

A lesser warning signal is the attenuation of investment in a business that a private equity owner is about to sell. Buyers are meant to imagine margins marching forever upwards. A visit to the headquarters of the business may reveal scuffed carpet tiles, aged computers and dispirited workers.

Mature listed businesses are rated according to their ratio of price to earnings, as a proxy for yield. But here too, error lurks, especially for people who cling to numbers as a source of certainty in a chaotic world. Stock analysts and financial columnists are among the worst offenders. One trademark delusion is that a business whose price is high relative to forecast earnings is inevitably overvalued. The stock may be cheaper measured by expected profits in five years. But there can be few certainties that far out.

By that logic, no one would ever have invested in Amazon, Facebook or Google. It makes more sense to take a view on whether a business has good prospects of doing the incredible thing it claims it will do. Futurologists talk of paradigm shifts. Old-school City of London stockbrokers called them “death or glory stocks”.

Analysts specialising in tech companies are fond of measuring them by multiples of sales. This is commonest in the US and Asia, given that Europe often misses out when it comes to tech floats. Sales multiples are a legitimate benchmark, providing their weighting in decision-making is relatively light and you also take a view on whether death or glory awaits the company.

But such ratios derived from private funding rounds are insubstantial. The sale of 2 per cent of a private company’s shares is an unreliable guide to what a stock might be worth after an initial public offering of 70 per cent of its equity capital. These transactions can be another form of pre-IPO window-dressing.

Even by those standards, investments in Uber by SoftBank and other backers in the past year have shown a wide range. These have valued the ride-hailing business at six times or nine times 2017 sales, depending which version of the truth you prefer to believe.

Valuations of online businesses reflecting average monthly users should also be viewed sceptically. An unknowable proportion of those users will be bots.

The entrepreneur who believes sales of his or her start-up will continue rising after the development capital is spent is guilty only of simple human optimism. Now and then, he or she will be right, leaving professional cynics to eat their own words. The aim of the investor should be to rise above both kinds of bias.

The writer is head of Lex