When it comes to growth stocks with nosebleed valuations, the whole point of buying them for the long haul is that investors expect these stocks to continue to grow rapidly, and, indeed, one day grow into their nosebleed valuations. Thus, while the valuation may look ridiculous today, it won’t look so ridiculous in five years when the company’s profits have risen by 1,000%-plus.
That’s the theory. In reality, though, not every growth stock will make it. For every unicorn that does grow into its valuation and the stock rises rapidly alongside multiple compression, there’s a handful that don’t, and their stocks fall in a big way.
Consequently, when it comes to growth stocks with nosebleed valuations, selectivity is an investor’s best friend.
To help investor’s selectivity with richly valued growth stocks, I’ve compiled a list of five big growth stocks that have successfully grown into their valuations over the past five years, thanks to continued robust revenue and profit growth. Which stocks are on this list? Let’s take a closer look.
Forward P/E Multiple 5 Years Ago: 45
Current Forward P/E Multiple: 24
Stock Price % Gain Past 5 Years: 210%
Most Recent Quarter Revenue Growth Rate: 26%
At the top of this list is Facebook (NASDAQ:FB), the hyper-growth digital ad giant which has gone from nosebleed valuation back in 2014, to a digital ad average multiple today.
Broadly speaking, Facebook just hasn’t stopped growing. It hasn’t stopped adding users. It hasn’t stopped attracting more advertising dollars. Nor has it stopped expanding revenue capabilities on Instagram, WhatsApp and Messenger. Net net, the company has simply continued to grow users, advertisers and revenue streams over the past five years. The result? Revenues have consistently risen north of 30% per year.
At the same time, scale has driven operating leverage, margins have expanded, and profit growth has broadly outpaced revenue growth. That has allowed the multiple on FB stock to come down from 45 five years ago, to 24 today, and still enabled the stock to rise more than 200% during that stretch.
Going forward, so long as Facebook does keep growing at a healthy 20%-plus rate, then today’s 24 forward multiple is reasonable enough to continue to power robust gains for FB stock.
Forward P/E Multiple 5 Years Ago: 100
Current Forward P/E Multiple: 68
Stock Price % Gain Past 5 Years: 510%
Most Recent Quarter Revenue Growth Rate: 17%
Next up we have the king of growth stocks, Amazon (NASDAQ:AMZN). At one point in time, Amazon was considered a barely profitable, hyper-growth e-commerce giant with a sky-high triple-digit forward earnings multiple. Today, the narrative has completely changed. Amazon is growing at a much more tempered rate. But, margins are sizable and quickly moving higher, while the valuation is rapidly falling.
What enabled this narrative pivot? A few things. First, Amazon’s e-commerce business hit scale, and started turning a mild profit. Second, Amazon built out the much more profitable Amazon Web Services business, and ramp in AWS has helped improve the company’s profitability profile. Third, Amazon has also jumped into the digital ad world, which has very high margins, so ramp in digital ads has likewise boosted margins.
Overall, then, Amazon has leveraged scale and new, more profitable business ventures to dramatically improve the company’s profitability profile. In so doing, the company has powered robust profit growth over the past five years, the likes of which has allowed the forward earnings multiple to fall from 100 to 68, while the stock still rose by over 500%.
Going forward, this dynamic will persist. Ramp in higher margin cloud and digital ad businesses will continue to push margins higher. Against the backdrop of ~20% revenue growth, that will spark huge profit growth. The multiple will keep falling, and the stock will keep rising.
Forward P/E Multiple 5 Years Ago: 45
Current Forward P/E Multiple: 24
Stock Price % Gain Past 5 Years: 71%
Most Recent Quarter Revenue Growth Rate: 51%
For the third stock on this list, we will venture across the Pacific Ocean and take a look at the “Amazon of China,” Alibaba (NYSE:BABA), where the stock has risen dramatically over the past five years (over 70%) despite the multiple being nearly cut in half during that time.
Sounds a lot like Amazon, right? It does. But, the narratives actually couldn’t be more different. Over at Amazon, it was slower revenue growth and robust margin ramp that produced huge profit growth and enabled multiple compression. At Alibaba, it has been the exact opposite. Margins have actually struggled. But, revenue growth has consistently remained north of 50%. Thus, robust revenue growth has driven robust profit growth, and that has enabled multiple compression.
The problem here is that the law of large numbers states that revenue growth will naturally slow over time. Quite simply, 50%-plus revenue growth isn’t sustainable forever. Thus, as that revenue growth rate comes down, Alibaba is going to need margin expansion drivers to power robust profit growth to continue this dynamic of Alibaba stock growing into its valuation. Right now, those margin drivers are nowhere to be found.
But, they won’t be missing forever. Most of the margin compression over at Alibaba is a result of growth-related investments. Once the company stops growing at a 50%-plus rate, Alibaba will pull those growth-related investments because they won’t be necessary anymore. That will provide an immediate lift to margins. Then, the company’s new businesses in cloud and offline retail will scale, which will create recurring tailwinds for margins.
Overall, then, Alibaba is still in the early stages of growing into its valuation. Over the next several years, revenue growth will slow and margins will ramp, creating a healthy dynamic for further gains in BABA stock.
Forward P/E Multiple 5 Years Ago: 180
Current Forward P/E Multiple: 38
Stock Price % Gain Past 5 Years: 23%
Most Recent Quarter Revenue Growth Rate: 18%
Following in Facebook’s footsteps over the past several years on the “growing into your valuation” front has been Twitter (NYSE:TWTR).
Twitter was once one of the most richly valued stocks on the market. Five years ago, the forward earnings multiple was up near 200. But, over the past few years, Twitter has regained momentum in its digital ad business (which is growing at a high teens rate right now) and substantially improved its profitability profile. This combo has driven healthy and big profit growth for Twitter.
The impact on the stock price? Twitter stock today trades near multi-year high levels, but the valuation is actually well off multi-year high levels. Thus, today’s price tag on Twitter stock looks much more reasonable and fundamentally supported than it was at previous highs.
Going forward, Twitter should continue to leverage secular digital ad tailwinds to produce healthy revenue growth, which on top of gradual margin expansion, should lead to healthy profit growth. Healthy profit growth for a stock trading around 40-times forward earnings should allow Twitter stock to continue to grow into its valuation.
Palo Alto Networks (PANW)
Forward P/E Multiple 5 Years Ago: 385
Current Forward P/E Multiple: 42
Stock Price % Gain Past 5 Years: 260%
Most Recent Quarter Revenue Growth Rate: 30%
Last, but certainly not least, on this list of growth stocks growing into their valuation is cybersecurity giant Palo Alto Networks (NYSE:PANW). This stock has staged a huge rally over the past five years (up 260%), and did so without any multiple expansion. Instead, the stock’s forward earnings multiple actually dropped a whopping 90% during that stretch, from nearly 400 to right around 40.
How did that happen? Much like Facebook, Palo Alto Networks just kept growing. The company has continued to leverage secular cybersecurity tailwinds and a market-leading solution to drive consistent 20%-plus revenue growth over the past several years. At the same time, margins have moved higher thanks to improved scale. The result? Big revenue growth on top of big margin expansion, which has driven doubly big profit growth.
Doubly big profit growth is how you get a stock to more than triple at the same time that its earnings multiple drops 90%. When you step back and think about it, that feat is actually almost jaw-dropping impressive.
Going forward, this dynamic should persist. Palo Alto Networks is still growing at a 30% rate. Margins are still moving higher. And, the tailwinds across this market are still there to support continued red-hot growth for the foreseeable future. As such, big growth is here to stay, meaning that PANW stock will continue to grow into its valuation for the foreseeable future.
As of this writing, Luke Lango was long FB, AMZN, BABA and PANW.