Evaluating disruptive companies is a completely different beast in comparison to evaluating value companies. The things you look for are not the same as value company and if you apply techniques that work with value companies you will end up with a ridiculous valuation. The valuation will make no sense and would most likely deter you from investing in any of them.
In this post, I’ll be going over 6 things to consider when evaluating disruptive companies. Hopefully, by the end of the post, you’ll have a better idea of evaluating disruptive companies.
1. What Is the Total Addressable Market of the Company?
The total addressable market of a company will give you a good idea of the growth potential it will have in the future. The total addressable market is how big the market is for the sector a company is a part of (e.g. automobile).
To understand how important the total addressable market is, let’s take a look at an example of a niche portion of a sector with a total addressable market of 10 billion dollars. If a company is already a 5 billion market cap, then they are already 50% of the entire total addressable market. This means no matter how much the company can still grow they will hit an upper cap when they reach 10 billion. From this example, the return investment would be capped at 100% even if the company grows many times than they are currently. Although 100% return on investment is nothing to laugh at you don’t want to be limited on the upside for a disruptive company since they are higher risk than value companies.
2. Does the Company Have a Product Out?
Taking a product from a prototype into the real world is a difficult task. Many companies fall flat at this critical step and eventually disappear. So, when you’re looking at a company it is really important to see if they already have a product out. If they do have a product then find out how do people perceive them as that can give you a good idea of how the adoption of the product would be on a large scale. Pay close attention to the problems people say they are having and determine if those are issues only early adopters are willing to put up with.
3. Can the Company Scale?
Putting a product out is tough, but scaling a product is many times tougher. Even successful innovative companies in the early adopter phase will struggle with scaling a product for the mass consumer market. There is a big difference between a few weeks to deliver one product vs thousands within the same time frame. Companies that fail to scale their product will eventually go away since they can’t penetrate the mass consumer market.
4. How Is the Management Team?
The management team of a company is often something that is not considered by investors when it comes to evaluating companies. For big value companies, you can get away with that but when it comes to disruptive companies that are often on the smaller side the management team makes all the difference. Do the people in charge have a proven track record on execution? Have they been successful in getting funding? Are the people in charge knowledgeable on the topics the company is trying to deliver?
5. When Was the Last Time There Was a Disruption in the Industry?
The longer it has been since the industry that a disruptive company is trying to change the bigger the impact can become. The reason for this is because competition is what helps drive innovation. If an industry hasn’t experienced any changes over a long time then the big players in that industry are less likely to keep innovating. Signs of this is when many of the big companies in that industry stay the same and are giving out a bunch of dividends. If a company is giving the majority of the profit out to shareholders as dividends then they are not reinvesting it back into the company to grow.
When an industry is filled with companies that are not trying to grow it usually means the industry is ripe for disruption if someone can come in and cause one. Best of all is that these companies will not be set up to innovate even if they want to when the time comes. The DNA of the company has shifted away from innovating and it will require a long time to change. During that time, the disruptive company is already changing how that industry will be in the future. Should the disruptive company reach success, they’ll be miles ahead of the rest and become the leader of that industry as things shift.
Some good examples of this are the oil and automobile industry. Renewable energy and electric vehicles are slowly causing a disruption in those industries. For many decades these two industries have been undisturbed and the big players have been the same companies.
6. How Is Investing Into Disruptive Companies Different From Other Companies?
By now, if it is not apparent, investing in disruptive companies is not the same as investing in value companies. Evaluation goes right out the window. What becomes really important are the 3 criteria:
- Does the company have a product out?
- Will the company be able to scale?
- How good is the management team?
Unless the 3 criteria check out the chance of success becomes substantially lower.
I hope this post was helpful to you. If you found this post helpful, share it with others so they can benefit too.
If you want to learn about investing in value companies you can visit my post about things to consider when choosing a company to invest in. To learn more about actionable steps you can take during a bear market you can check out my post on navigating a bear market. If you’re new to investing and need a guideline to help you start your investment journey you can check out my post on setting yourself up for financial success.
To get in touch, follow me on Twitter, leave a comment, or send me an email at steven@brightdevelopers.com.