BY ROBERT CYRAN

Top-line growth is the surest way to create wealth. But Wall Street has taken the idea too far lately by ignoring the importance of profit and cash flow.

Among top-performing stocks, revenue growth accounts for the majority of wealth creation over a decade, according to consultancy BCG. Take Microsoft, with a $2.5 trillion market value. Over 20 years, revenue grew nearly sevenfold. Net margin improved slightly, so earnings grew by a factor of eight. Investors reckon the company is worth something over 30 times estimated earnings, about what they paid two decades ago. Microsoft’s stock is worth 10 times as much, as of mid-December, largely because revenue grew.

Unlike Microsoft, Amazon.com took years to become profitable in an accounting sense. But like Bill Gates’ firm, it threw off cash early, so it didn’t need additional capital to grow. Sales growth is one key ingredient, but profit and/or cash flow is another.

Contrast that with WeWork. The office-sharing startup was valued at $47 billion based on revenue doubling annually prior to a failed 2019 initial public offering. But the company wasn’t profitable and couldn’t fund itself. When investors got tired of injecting capital, WeWork’s valuation plummeted. It was worth $6 billion in early December.

That lesson seems to have been forgotten. The median enterprise value-to-sales ratio for technology-sector IPOs in the first 10 months of 2021 was 15, according to Jay Ritter at the University of Florida. The only time it has been higher in 40 years was prior to the dot-com

crash in the early 2000s. Already-listed e-commerce firm Shopify is valued at around 30 times estimated revenue, according to Refinitiv data for December. Five years ago, it was valued at just 6 times.

This creep has spread to less established firms, including some with almost no revenue, let alone profit, like Rivian Automotive, an electric-truck maker with a market capitalization above $100 billion.

Shopify, like the growing Amazon, can bankroll its own expansion. But many firms with huge valuations are unlikely to do that for many years. Rivian’s valuation, for example, is based on the promise of uninterrupted future growth combined with a second promise that sufficient profit will eventually materialize. In buoyant markets investors forgive such optimism. But any blows to confidence in 2022, whether economic, pandemic, political or otherwise, should sort the durable Amazon. coms from the hyped-up WeWorks. 

First published December 2021