Goldman Sachs’ Portfolio Strategy research published their most recent US Weekly Kickstart investment newsletter on Friday. GS analysts David J. Costin et al. make the case that companies with a high enterprise value to sales multiple (above 10) — often called high growth stocks — tend to perform relatively poorly compared to companies with lower EV/sales ratios.

Growth stock “party” may end soon

The GS analysts describe their investment thesis and research methodology below. “Growth companies such as Facebook Inc (NASDAQ:FB), Yelp Inc (NYSE:YELP), and Alexion Pharmaceuticals, Inc. (NASDAQ:ALXN) have returned more than 30% YTD and trade at high valuations that imply market expectations for strong future growth. With the market at full valuation many investors wonder what amount of growth is necessary to sustain the lofty valuations and fulfill the expectations embedded in premium multiples. To answer the question we analyzed the historical performance of stocks across the Russell 3000, examining EV/sales ratios in order to include smaller growth companies.”

Growth stock EV-sales

Last year’s strong growth stock performance contrary to historical norms

The report also points out that growth companies significantly outperformed an already strong equity market last year, but argues it was just a one year blip from an historical perspective and is unlikely to continue for much longer. “Many investors find the historical example surprising given its contrast with recent trends. The median Russell 3000 (INDEXRUSSELL:RUA) stock with a EV/sales ratio above 10x one year ago returned 34% during the past 12 months, outperforming the index’s median stock by 500 bp.”

Extreme revenue growth required to meet high expectations

It boils down to the fact that it’s almost impossible for revenues to grow fast enough to meet inflated expectations. Kostin et al highlight the fact that even if companies manage to double or triple revenues in just a year or so, that is often not enough to meet the expectations built into the high multiple. “The median stock in this category underperforms its sector peers in most cases. For example, even stocks able to double or triple sales in a year have historically lagged by a median of 10 pp during those 12 months. Only stocks that grew revenues by more than 500% over a five year period (43% CAGR) typically outperformed, and then by less than 5 pp.”

GS recommended strategy

Kostin et al. rather obviously suggest that investors can take one of two tacks in light of this data on the long-term underperformance of high EV/sales ration stocks: “(1) Target the stocks priced to grow the fastest and either ride the current wave of popularity or aim to beat the historical odds by identifying the outliers; or (2) invest in stocks with low multiples and outperform as a base case, with larger returns as a bonus for identifying the firms that actually deliver the fastest growth.”

Growth stock Ranking

Growth stock highest ranking

The GS report also assists investors by providing two useful charts listing the 40 Russell 3000 companies with the highest and lowest EV/sales multiples.