Fundamental Investing Criteria : Segment 2 of 10

How do I analyze a “high growth” company?

In February, I summarized the 20 fundamental metrics I utilize to analyze the stability, performance and excellence of a high growth company that I may choose to invest in. Today I will focus on the next two (#3 and #4) criteria that I analyze (All 20 summarized at the bottom of this post):

3) Company Size:  Market Cap and Trajectory – Ability to 5-10x itself 

4) TAM (Total Addressable Market) & Runway – Ability to 5-10x itself?

What do I mean by “company size” or “market cap” or “TAM”?  And why does it matter?  

3) Company Size: “Market Cap” is short for “Market Capitalization”.  It is a straightforward calculation of the size, or more accurately the total dollar value, of an entire company.   Simplistically, the calculation is made by  taking the dollar price of one share of stock and multiplying it by the total number of shares of company stock outstanding. 

Example:  DataDog’s (DDOG) stock price today (May 3, 2021) closed at $80.17.  DDOG has 305.9 million shares of stock outstanding.  Multiply the two and you get a market cap today of around: $24.5B. [B = billion;  T = trillion]

A company’s market cap can vary drastically with the price of the stock and/or if the company chooses to issue additional shares (or to buy back shares).   DDOG’s stock has traded as high as $119 this year; So at that high price the value of the entire company was $36.4B (using the same shares outstanding).  

So what do I mean by “Ability to 5-10x itself”?   Well, specifically, this is my way of weeding out certain companies like Apple, Microsoft and Amazon.  No doubt, these are incredible companies; however, when I consider where to invest my money to grow, a company like these that already has a market cap that exceeds $1T or $2T [TRILLION] dollars could conceivably still double in size over time, but it is highly unlikely to be able to grow its revenues and profits fast enough to justify becoming 5x to 10x times as large (e.g. $5-10 trillion dollar value…currently these three are already the three largest companies in the world).  There is nothing wrong with investing in these companies.  They will likely do just fine over time and provide a nice steady return; however, I am looking for extremely fast growing companies that I can reasonably believe based on their current growth trajectory and size can in the next 3-5 years become 5-10 times as large in value (market cap) as they were when I bought them.   DDOG, for example, reached a valuation of $36.4B this year already when they traded up to $119/share back in February, but when I bought my first shares at around $35 per share in September 2019 (and with 50 million less shares outstanding), its market cap was only about one-third of where it is today, and one-fourth of where it was in February at its high.  Thus, the company has already achieved a valuation 4 times higher in only about 18 months than when I started buying the shares.  I continue to have full conviction that as long as DDOG’s revenue growth, customer acquisition and retention, balance sheet, Gross Margins and other fundamental metrics continue to perform and accelerate, this company can achieve a $100B dollar market cap.  That equates to a little more than 10 times its original size when I bought it around a $9B market cap…and therefore a 10x return on my initial shares purchased.  

In short, I’m not looking for a single or double (to use a baseball analogy) that a company giving me an 8% – 10% return per year would provide, I’m looking for a home run or even a grand slam that multiplies my investment 5 to 10 fold.  I won’t get it everytime and maybe not even 50% of the time, but striving for it enables me to narrow my focus on the best of the best and to “aim small”.  I’m shooting for the stars (light years away), and if I fall short and only land on the moon, I’ve still achieved stratospheric, out of this world returns.  For that, I’m willing to take on the additional risk and ride out the inevitable roller coaster that goes with investing in high growth companies.

4) “TAM” is the acronym in business for “Total Addressable Market” (or also often referred to as “Total Available Market”).  TAM refers to the total potential market demand for a company’s product or service if they could sell it to every single applicable and available customer in a particular chosen geography where they offer it.   As a simple example, if you are selling toothbrushes or toilet paper in the US, you can probably include every person in the US as a customer. Everyone needs it. And naturally, the TAM for those products increases when you choose to sell it internationally outside the US.  If you are selling women’s perfume or brassiers, for example, that TAM is naturally cut roughly in half (assuming men would not be using these items…uhhh…ok, let’s just cut this example short, as I can think of about 5 ways to get into trouble here with all the genders and the politically correct demands of current society…but I hope you get the point  ;). 

Naturally, TAM can be hard to quantify and I will be the first to admit that there are at least four main approaches (you can find easily with a google search, but not the topic of this post) used to calculate it, and there are also quite a few supposedly independent companies such as Gartner group, Forrester, IDC, Nielsen and others who take their own SWAG at it, as well as the individual companies who assess their own product or service, niche, potential customers, etc to calculate their TAM for a particular product or service. Public company’s will often announce their TAM on an earnings call and even put it in a press release.  I take the number with a grain of salt, as it can be calculated in various ways, internally or externally, and using various metrics and assumptions and may not be exactly accurate or an apples to apples comparison to another TAM; however, at the least I can still glean using the 80/20 principle (Pareto’s Law) enough from the disclosure to understand if they have a tiny sliver of a percentage of the Total Available Market or are already the 800 lb gorilla with 90% or more of it.  I can use that data to assess if the company even has a market place big enough to justify growing 10x from their existing size.  If the company then adds a new product or enters a new geography, their TAM for the overall company can double…or more.  

For example, most people are now familiar with Zoom (ZM) and their video conference calling SaaS (Software as a Service) product that has absolutely exploded during Covid-19 and which I’ve written about several times last year.   At some point, investors start to ask how many more potential customers in the US or internationally can they possibly still sell their video conferencing subscription, and whether their growth rate now must inevitably slow down dramatically because they are approaching their TAM.   What is ZM’s solution to this challenge in order to continue their incredible growth?  Are they doomed to slower growth? Perhaps, however the best companies continue to innovate and add new products which bring with them a whole new TAM for that new product…ZM recently added Zoom phone and have very quickly sold millions!!   And they also have other products (like ZM rooms and voice webinars) coming down the pipeline and gaining traction.  With all those existing happy customers, why would ZM NOT find a new product to increase their TAM, continue their growth trajectory if they can, and sell even more to those coveted customers.   [As an aside, I’m not yet sure they will be able to turn ZM phones into the next juggernaut product that will re-accelerate their growth, but it has extended their runway and increased their TAM]

In summary, investors eventually start to worry when a company like ZM grows so quickly and so incredibly that they have nowhere left to expand when they have captured such a large percentage of the TAM (“total available market”).  If those companies can pivot and add new products and services, or increase their global penetration of their existing products, they extend their runway and their TAM.  

If I invest in a company that is the clear leader and has an established moat, or competitive advantage, but has only captured 5-10% of its TAM, I know there is another 90-95% market to capture in that particular product or service alone.  I have much more confidence that the company can 5-10X itself before maxing out in a particular market.  If they are also adding new products, modules or services simultaneously, they could be doubling or tripling their company TAM at the same time, all while they capture higher market share in their original single product TAM.  Companies like Crowdstrike (CRWD), my single largest holding, for example, continually adds and announces new, additional cyber security modules that increase their TAM and they simultaneously sell those additional security modules to already existing customers, while bundling the complementary ones together to sell to new customers.  Furthermore, when they choose to expand their offerings internationally to a new country, region or otherwise outside their original United States TAM, the TAM increases yet again.  

I hope this gives you an idea why company size (Market Cap) and the total market size (TAM or “Total Addressable market) are 2 critical criteria to analyze and understand prior to investing in a company.  It is absolutely critical when building a company to have enough runway to get off the ground.  If there is no one left to buy your product or service because either no one needs it or you’ve already sold it to everyone and there are no more customers, it doesn’t matter how amazing the product, you can’t continue to grow.

[Below for your reference is the original list of 20 criteria that I will be covering this year in 10 posts. This post covered criteria 3) and 4) below.  

My first post (prior to this one) covers criteria 1) and 2) below and can be found here:  

=============================================================

20 Fundamental Criteria for Investing in high-growth companies:

  1. Rapid Revenue Growth (Q/Q & Y/Y); greater than 35% & accelerating
  2. ARR – Annual Recurring Revenue Model (usually subscription based)
  3. Company Size:  Market Cap and Trajectory – Ability to 5-10x itself 
  4. TAM (Total Addressable Market) & Runway – Ability to 5-10x itself?
  5. Customer Growth?  Product growth?  Geographical growth?
  6. Management FLESH:(F)ounder (L)ed, (E)xperienced, (S)H friendly, (H)onest
  7. Net Dollar Based Retention Rate min > 100%; prefer >120%
  8. High Gross Margins min > 50% – stable or increasing – Prefer 70%+
  9. Balance Sheet – Strong “going concern” (Strong Cash with little or no debt)
  10.  EV/Sales – Understand this number is NOT created equal across companies
  11.  Competitive Advantage:  New technology…Leader…Moat…or a niche
  12.  Improving Operating Leverage (Decreasing expenses to revenue ratio)
  13.  Insider & Institutional Ownership (and founder led is a huge plus)
  14.  Consensus:  Motley Fool, Seeking Alpha, Bert, IBD, Institutional buying 
  15.  US based Company – No Chinese companies
  16.  Minimal or limited Cap-Ex requirements – Ability to pivot quickly.  
  17.  Positive or rapidly improving CFFO and FCF
  18.  Profitability or the ability to get there quickly
  19.  Little or no competition unless they are the clear sector leader
  20.  Increasing (hopefully rapidly) earnings (if not rapid revenue growth)

I will reiterate that this is by no means an exhaustive list, but covers many of the more critical KPI’s that I follow when investing in high growth, cutting edge companies.

If you'd like to receive a friendly email each Tuesday morning at 10am (if there is a new post from me) with a summary of my new posts, please provide your email address here, if you have not already done so. Emails will NEVER be sold, distributed or used by me in any other way

...Scout's honor!

Subscribe