The second stage of the industry life cycle typically witnesses the venture capital firm progressing into a period of rapid growth. The product or service has been developed and marketed to the point of consumer acceptance. The untapped market envisioned by the entre- preneur begins to be tapped. Little competition usually exists for the first to market. The firm faces a wide panorama of demand—a void to be filled. The first successful personal computer manufacturers and the first successful Internet service providers are examples.
profits from untapped and expanding markets. The demand for the product or service probably cannot be meet. The firm can charge high prices without fear of competition. Expected and actual earnings growth is extremely rapid. Investors focus on the expected earnings aspects in their valuations almost to the exclusion of the other factors. Why not? The expected earnings growth is so large that changes in any of the other factors in the Equation (3) valuation framework are usually small by comparison.
The expected earnings in the numerator of the Equation (3) val- uation framework are rapidly rising. This swamps the effect of any upward change in interest rates, inflation, equity risk premium, size, business, finance, or marketability risks in the denominator. For ex- ample, a relatively large increase in interest rates from 7% to 8%, about a 7.1% change, would have much less effect than a 40% or more upward change in expected earnings on the common stock price valuation. As long as the rapidly increasing expected earnings growth continues, the Equation (3) valuation framework numerator continues to overpower changes in the denominator.
The Equation (3) valuation framework for a rapid growth stage corporation looks like:
P ⫽ E1/r ⫹ E2/r ⫹ E3/r . . . En/r
This represents the present value of the expected earnings each year for the future life of the corporation. Each successive year’s earn- ings will be higher since this is a rapid growth stage company.
The common stock price literally grows into the earnings as time passes, as long as the actual reported earnings meet or exceed expec- tations. A relatively smaller increase in the required rate of return (r) in the denominator is overpowered. For example, as time passes, a 40% increase in earnings that is now discounted one less year will never be offset by a lesser increased change in the required rate of return. As a year passes, the much larger earnings in year two (E2) and each successive future year have more upward impact on the common stock price (P) than they did one year earlier. The time discount for which the investor must wait is one year less. The present value of those earnings is greater because the wait is one year shorter. The current common stock price is higher. This process continues as time passes. As the growing expected earnings are realized, the present value is higher.2
A rapid growth stage common stock price continues rising as long as the expected earnings are realized. The risk is that expected earn- ings will not be realized. The downward impact on the stock price is usually immediate and large if realized earnings are less than ex- pected. Not only are the current year’s expected earnings reduced, but all future year’s expected earnings that have been extrapolated on the large expected growth rate must also be reduced. The impact is cumulative as far as investors can see over the life of the corporation. The present value in each future year is lowered by the reduced earn- ing expectations. The reduction may be very large. The cumulative negative effect on the current common stock price is even larger.
The rapidly growing earnings in the Equation (3) valuation frame- work do not continue. Competition is attracted by the abnormally high profitability of the first success to emerge from the venture cap- ital stage into the rapid growth stage. Improved product or service variations and/or reduced prices are competitors’ entry tactics.
Profit margins fall for all, from the first success to the most recent entering competitor. The first success that gleaned the highest prices and profit margins must lower its prices and profit margins or lose market share. The latest competitive entrants have already reduced prices and profit margins as the cost of entry. All competitors may stay the inevitable decline from abnormally high profits to lower, more normal profits. If there are economies of scale, costs are reduced simultaneously with reduced prices. The rapid expected earnings growth is prolonged. However, market growth, upon which the econ- omies of scale are based, must slow as the market saturates. Produc- tion efficiencies must eventually become few and less effective. The rapid growth is over unless underlying technology or other changes reinvigorate production efficiencies and/or the saturated market de- mand.
The duration of the rapid growth stage for any corporation de- pends on the ease and speed with which new competitors can enter the market. Throughout the duration of the rapid growth stage, ex- pected earnings are met or exceeded. The common stock price con- tinues to rise. Investors look for industry characteristics associated with prohibiting or delaying competitive entry. These characteristics include the pricing behavior of the first success and the combination of necessity, consumability, and monopoly.
The superior profitability of the first successful entrant into the rapid growth stage partly depends on the high prices it can charge as
the only supplier of a product or service to an unsaturated, large, and growing demand. The next entrant usually cuts prices. As long as the first success maintains prices, the competing entrant need not cut its prices any further. On the other hand, if a price war emerges as new competitors enter the market, profit margins shrink, profits fall, and the expected high growth rate in earnings envisioned by investors is jeopardized. Common stock prices fall.
The longest duration in the rapid growth stage is characterized by a combination of necessity, consumability, and monopoly. Necessity fosters purchase. Consumability fosters repurchase. Monopoly fosters repurchase from the one high profit margin producer. If the monop- oly becomes too effective and anticompetitive, government regulation usually ensues, and the superior profitability is diminished. Pharma- ceutical manufacturers that have strong patents lasting many decades on effective medicines may operate for a while under those char- acteristics that prolong the rapid growth stage. The image of a critically-ill person turning to the doctor and saying “No thanks, I will wait for the development of competing drugs to lower the price” is not realistic. Necessity mandates the patient buys the drug. Con- sumability mandates the patient buys the drug again. The produc- er’s protected patent position mandates the patient buys the drug from it.
Investors look for numerous techniques that discourage competi- tive entry. Brand identification and loyalty are cultivated so that con- sumers specifically request and are willing to pay a higher price for the brand relative to its generic competitor. Few ask the grocery store clerk for facial tissues while many ask for Kleenex, a brand name. Few with bleeding cuts on their arm run down the hall asking for a plastic adhesive bandage, while many ask for a BandAid, a brand name. Few ask for a cola, while many ask for Coke, a brand name. The successful differentiation of the product in the consumer’s mind prolongs the rapid growth stage.
Superior distribution channels and techniques prolong the rapid growth stage. Avon Products overcame the limits of a relatively un- trained sales force through door-to-door personalized selling. The long-term personal interaction between the customer and the salesperson, often at relatively low compensation per hour, fostered a unique, profitable distribution channel. However, the inevitable change in society that sent the “at home” customer to work narrowed the Avon distribution channel and profits. Commanding shelf space
for consumer products in retail stores, Internet e-commerce sites with customer loyalty, and larger Wal-Mart stores using quantity pur- chasing power to underprice single-unit local merchants are a few examples.
Physical limitations sometimes discourage new competitive en- trants. The first cable television service in the area tends to be the only cable television service in the area. The cost of overlaying a competing cable service may be prohibitive to a second entrant. Yet the inevitable entrepreneurship of the capitalistic system will encour- age competition, such as satellite television, to speed the cable in- dustry through the rapid growth stage.
Superior technology may discourage competition and prolong the rapid growth stage. Faster, more powerful computer chips, unique software programs, and superior cement formulations are examples. The money market fund and the cash management account super- seded the prosaic passbook savings account.
The continuing combination of necessity, consumability, and mo- nopoly prolongs the rapid growth stage. The failure to maintain one of the components causes diminished earnings growth prospects and abruptly lowers the common stock price. The Polaroid instant camera had the technological monopoly. The courts upheld that position and helped force the Kodak instant camera off the market. Yet Polaroid earnings growth faltered because the product was not particularly consumable and was susceptible to new technology. The instant cam- era market saturated. The video camera was more appealing.