Let me betray a frailty -- I don't really know what to do with companies growing at lightning-fast rates. The inevitable tendency among investors is to look at companies growing very, very quickly and to assume that this growth will go on for a long, long time.
For some, like eBay
While there are more Internet Capital Groups than eBays, the lightning-fast grower that justifies a (seemingly) sky-high valuation does exist. Historically, you'll find that they traded at nearly astounding multiples to current performance, yet because they had such long growth periods in front of them, they more than justified their lofty valuations. Look at the incredible growth stories of eBay, Amazon.com
1. First-mover advantage. One of our Hidden Gems recommendations, Ctrip.com
2. An enormous addressable market. For a company to be a value at enormous ratios, most of the market that it will reach must be currently unreached. eBay is a perfect example here -- when its multiples hit their highest levels, it was at the beginning of reaching into new markets. In fact, eBay created these markets. In Ctrip's case, the Chinese economy has just begun showing some of the attributes of mass consumerism, and travel tends to be a large part of these trends.
3. A defensible moat. The reason that companies garner large multiples is that investors expect them to grow profitability and cash flows for an extended period of time. A company that grows 80% one year and then trickles downward, or remains stagnant, will fail to live up to these expectations. But the market -- in the U.S. as well as in China -- is remarkably efficient in one way: If there's opportunity available, competition will come to fill (and overfill) that need.
None of this is to say that companies with all of these attributes trading at high multiples will succeed. The market is littered with companies that exhibited traits of greatness and failed to deliver -- Metricom, Globalstar, Iridium, to name a few. One thing that my colleague Tim Hanson points out to me is that you don't miss out on stock growth by waiting for growth companies to be profitable. That may be the key element -- make sure the company is making money before you ever step up to the plate.
Remember that Ctrip just posted $27.8 million in profits. The model is working. To see what other small caps Fool co-founder Tom Gardner and I have in the hopper, click here to be our guest at Hidden Gems free for 30 days. There is no obligation to subscribe.
Dell, eBay, and Amazon are Motley Fool Stock Advisor picks.