Venturing Into Early-Stage Growth Stocks

By Ben McClure AAA

For investors, young growth stocks can trigger dreams of wealth - and nightmares of poverty. These companies are often early-stage ventures that offer rapid revenue growth, but have yet to deliver earnings growth or much of a business track record. As such, the potential returns can be enormous, but investing in these stocks can also be risky. There are several points investors should consider when analyzing early-stage growth stocks.

Overview
The key features of early-stage growth stocks are rapid revenue growth but no earnings. Spending heavily to gain a market foothold, many growth companies - even those with strong sales revenue growth - can lose a lot of money in their early years. At the same time, these companies normally have a limited operating history, making it even more difficult for investors to judge the companies' current performance and value.

To stay on the safest side, many investors prefer to steer clear of companies with these risky characteristics. On the other hand, the next biggest and most rewarding stocks may be found among these kinds of stocks. The trick is to size up the risk.

To demonstrate how to evaluate an early-stage growth company's risk, let's consider Nasdaq-listed XM Satellite Radio Holdings (XMSR), a company that has been striving to become an established player in the fast-growing global satellite radio broadcasting market. Turning to XM's 2004 Form 10-K Annual Report, let's go over some key points for assessing the risk of an emerging growth stock.

Sales Growth
For starters, consider this growth trend. XM Satellite Radio delivered staggering sales growth in 2004. Scroll down to Selected Consolidated Financial Data (p.28, or Item 6 on the Table of Contents), and you will see that revenues grew from $0 in 2000, when XM Satellite Radio became publicly-listed, to more than $244 million in 2004. With sales growth of 168% in 2004, XM appears to have successfully taken advantage of growth opportunities. Importantly, the pace of sales growth was steadily upward - absent of unexpected swings - giving investors some reason to be confident that successful sales growth would continue.

Still, investors should take care: while the company's sales-growth record over the five-year period was certainly impressive, there is no guarantee that the company will be able to maintain that rate of growth into the future. In fact, the pace of growth could very well decline as the company satisfies demand for its products.

Profitability
You need to determine whether revenue growth is profitable. Look further down at XM's Consolidated Statement of Operations (p. F-5). The net loss shows us that in 2004, XM lost a lot of money - more than $642 million. That's no surprise: the company spent heavily on sales and marketing and invested in new radio programming content to attract subscribers. If those investments pay off, earnings could materialize.

But savvy investors want a clearer indication that one day the company will produce earnings. A good place to look is the company's profit margins. There should be signs that profit margins are steadily getting better - even if that means the margins are simply getting less negative.

Net Profit Margins = Net Profits after Taxes / Sales

Investors should be somewhat reassured. Although the company's losses accelerated between 2002 and 2004, its net margins saw a dramatic improvement, moving from a whopping -2,174.3% to -188.6% over the time period. Judging by its margin performance trend, XM offered heartening signs that it is moving towards profitability.

Cash Generation or Cash Burn?
Cash flow is another serious issue for newer, unprofitable companies in rapidly growing industries. As it can take time for early-stage companies to generate cash from operations, their survival depends on effective cash management so that they have an adequate cash supply to meet expenses. Emerging growth companies can face years of living on their bank balances. If a company eats through cash too fast, it runs the risk of going out of business.

So, it is good practice to look at the company's cash flow from operation.You will find that figure on XM's Consolidated Statement of Cash Flows (p. F-6). Investors may be discouraged to learn that XM's payments exceeded its cash receipts by more than $85.6 million in 2004 (see "net cash used in operating activities"). On the other hand, that number is significantly less than the $245 million of cash consumed the year before. That could signal a move towards cash flow breakeven.

When analyzing companies like XM that are cash flow negative, it's also worthwhile checking their burn rate, the rate at which a company currently uses up its supply of cash over time.

You will see on XM's Consolidated Balance Sheet (p. F-4) that at end-2004 the company had more than $717 million in cash in the bank. Assuming that annual net cash used in operating activities of $85.6 million and investing activities of $36.3 million (found lower on the Consolidated Statement of Cash Flows) stay at the same level, then XM has nearly six years before it will run out of cash. In other words, XM has a comfortable cushion of cash that will tie it over until it starts to generate cash internally. Investors need not worry about XM being forced to seek additional funds to finance day-to-day operations.

Fair Value
The best way to curb risk is to invest in companies at a fair value. Because a lot of emerging growth stocks like XM have no earnings, investors have to cast aside the traditional price-to-earnings (P/E) ratio for coming up with a fair valuation. In the absence of a P/E ratio, you can calculate the price-to-sales ratio and compare that figure with other, similar companies.

To find XM' price-to-sales ratio, we look at its stock price on the day it filed its 2004 Form 10-K Annual Report, which was on Mar 4, 2005. On that day, the stock closed at $33.11 (see XM's trading quote that day on Investopedia's stock research resource). With 29.11 million shares outstanding, XM's market value was about $7 billion.

So, at the end of 2004, XM traded for more than 28 times its current sales ($7 billion market value divided by 2004 sales of $244 million). At first glance, that appears to be an awfully rich valuation - normally investors look for companies with price-to-sales ratios in the single digits or even lower. However, priced at 28 times sales, XM is still less expensive than its closest peer Sirius Satellite Radio (SIRI), which traded for more than 80 times sales at year-end 2004. New-media technology stocks are typically very pricey - so some investors might argue that the company's rapid rate of growth combined with its steady progress towards profitability justify the high price-to-sales ratio. Then again, a lot of others would steer clear of the stock at that price.

Another way to evaluate fair value is discounted cash flow analysis. It offers a more rigorous approach to valuing emerging growth stocks. The starting point is forecasting the company's free cash flows available to shareholders. These are earnings adjusted for expenses and income that are not in cash (such as depreciation) and adjusted for required investments and changes in working capital. The series of forecasted free cash flows is then brought to current values by discounting with the company's cost of equity or overall cost of capital.

The Bottom Line
Investing in early-stage growth stocks can be a bit of guessing game. These companies are offering new services and products, and in many cases they are creating new markets. It can be awfully difficult to know their prospects with much certainty. That said, there are ways to identify their risks. Analysis of sales revenues, profitability and cash generation can help distinguish winners from losers.

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