Amazon is worth more than Zscaler

I admit, that’s a click-bait title. But hear me out. This is a response to a recent post by Brittlerock (https://discussion.fool.com/saul-i-fully-understand-and-agree-wi…) which I think encapsulates two things:

  1. The angst some of us are feeling over the valuation contractions for our stocks
  2. Confusion about whether “valuation matters.” (Some people think Saul says valuation doesn’t matter…I’m not sure about that.)

My take on #2: of course valuation matters. Why is Amazon worth more than Zscaler? If valuation doesn’t matter, there is no reason.

Brittlerock said: I think valuation is important if for no other reason because it is important to other investors

Well, I think valuation is important because things have value – even if we can’t pinpoint what that value is. We know it when we see it. Amazon is worth more than Zscaler. Microsoft is worth more than Shopify. Google is worth more than Chipotle. On that scale, no one debates these statements: they are facts. But should Zscaler be worth more than MongoDB? Or should Zscaler be worth 12 billion or 6 billion? The answers there are less obvious.

The reason some things are worth more than others is because of what they are likely to do in the future. That’s not a perfect way to put it, but you get the idea. Google is expected to generate billions in profit each year, for many years – probably decades – to come.

Now what about #1? – the angst. Brittlerock concludes What to make of all this with respect to investing decisions? He didn’t say what decision he was struggling with – He mentioned that he hasn’t sold everything to buy gold – but I think we all wonder sometimes if we should take money off the table.

What I do is compare all the companies I own, or am considering owning, on a daily basis. Usually things stay within ranges I find reasonable, and so I don’t adjust anything based on relative valuations. But recently Zscaler had a PS ratio 50% higher (maybe more) than other somewhat similar companies. It was fair to ask why. I didn’t know why, so I reduced my position. Now that ZS is back in a reasonable range, I’ve added back. I’ve done the same with CRWD and OKTA.

What might be more scary is that the market seems to have re-priced the set point on the kind of stocks we own. We don’t know that there’s a floor there. Actually, there isn’t in any literal sense. The market could decide these amazing companies are only worth a PS ratio of 10, or less! But I don’t think that will happen. Because on every trade there are two sides. And if these stocks are sold below a certain floor, savvy investors will swoop in. The secret is out. Not only is the SaaS model powerful, but these companies have game changing products. As long as they have the best offerings and their customers keep needing what they’re selling, they’ll have more and more revenue in the coming quarters and years, and they’ll become more valuable.

We can’t expect the market to be reasonable. The market is over-correction personified, and stocks are wild stallions. When hot, they run up far beyond what logic or analysis can support, and when out of favor, they fall to levels beyond “cheap.” But we can expect buyers to be greedy, and some of them to be smart, and to know a great deal when they see it. So we can expect our companies to have a floor. We just can’t pinpoint where, or when. So just make sure you can ride the waves down and then back up again, and then up further and further. Don’t mortgage your house to buy at these levels – or any levels! But don’t get out at these levels either. We have to be patient.

I’m not sure how comforting that is. It helped me.

Thanks,
Bear

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Looking for comfort has a deeper question. Why do we need to look for comfort?

Why is it that in the shorter term we need to rationalize price swings and movements. We think we are not emotional, but too many times our investments are emotionally driven. We feel good about ourselves while our investments sky rocket, but when those same investments correct we feel the opposite. We need comfort.

I learned somehow quite some time ago to take all emotion out of investing. Not sure how that happened. Maybe owning my own private business, maybe something else.

I do look at my investments in publicly traded companies the same way as my investments in a private company. I don’t worry about the price of a stock so much while I’m invested in the company. When investing privately I don’t see a daily price going up or down, I only know that I’m invested in a company that I believe in. I’ll worry about the price, or what my investment is worth when I am ready to sell, or the company is sold.

So a sell off like we are having? Well it helps to have cash of course. Dry powder to put to work during these sell offs. If you don’t, well then in hindsight unemotionally you should have raised some mid year when the valuations really did get out of hand. When too many IPOs were coming to market at ridiculous valuations. When a correction was really needed for the longer term health of this sector. But of course hindsight is just that.

So if starting Monday you couldn’t see the daily price movements in MDB, ZS, AYX, TTD, if you were investing in these companies without seeing the stock prices, would you be invested in them?
That’s the question I ask myself anyway.

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Bear,
Thanks for the reply. I admit, my post had an undercurrent of fearful reaction to the current erosion in my portfolio. I’m back to where I was in early March. Yes, I’m still up for the year, but considerably down from my most recent high. Yes, it is unnerving. I admit, I’m struggling a bit with keeping my emotions in check. The rational part of my thinking (which I like to think dominates) says relax. Nothing has really changed. There’s been no wholesale disruption to the SaaS subscription model. There’s been no competitive threat to suddenly and simultaneously appear against virtually all the companies we are prone to hold, including the dubious PANW claim about displacing Zscaler.

Just think about that for a moment. Put yourself in the IT executive’s position who decided to displace the elegant, near flawless, negligible latency solution Zscaler provides for a bunch of appliances which are only good for situations where a perimeter can be defined but provides no protection for cloud hosted apps. So instead of the Zscaler solution, we’re going with a clunky, complex hybrid solution. I didn’t make purchasing decisions in the job I had before I retired, my job was to research and provide technical advice (different folks provided financial advice). I can’t imagine anyone advising to displace Zscaler with the Palo Alto solution. But, I digress.

Yes, I did write,
I think valuation is important if for no other reason because it is important to other investors
But I also wrote,
In other words, valuation is not irrelevant, it’s just awfully hard to assess.

I think both statements are valid. We don’t have a good model for evaluating these companies. Anyone who has done a bit of due diligence has come to realize that the commonly employed traditional valuation models such as DCF do not provide meaningful results for this business model. We’re pretty much stuck with blunt instruments like EV/S and even it suffers from flaws such as not recognizing the profound influence of margins (as Saul recently pointed out). Someone with more patience than I might create a new valuation method for the SaaS subscription model, but what’s it going to be worth. The ability to back test for validity is limited in that there’s not much history to back test with. Certainly none that encompasses both expansion and contraction in the economy. Really, just about the only thing we have to go on is a blunt instrument and relative comparison with other companies using the same business model. But even that suffers many flaws. While the business model might be common (and in some cases like TWLO, it’s not), the markets and products are not common. Does it make sense to compare MDB with ZM based on EV/S? I don’t really know, but my impression is that it’s not a very meaningful comparison.

Some folks pay more attention to valuation than I do. Maybe I’m over-thinking it.

Bear also asserted, …we can expect buyers to be greedy, and some of them to be smart, and to know a great deal when they see it. So we can expect our companies to have a floor. We just can’t pinpoint where, or when.

I’m not sure how that aligns with my other point about algorithmic trading dominating the market. In fact, as I noted, this type of trading tends to set off a blind cascade of orders. But, I’m puzzled about what finally applies the brakes. Something must because as Bear noted there appears to be a “floor.”

I really don’t have any idea of what has caused the deterioration of stock prices pretty much across the board for these companies. Companies with high EV/S were hit, but so were companies with low EV/S (relatively speaking). So far, the most reasonable of all the somewhat dubious explanations I’ve read is it was simply profit taking by heavy hitters. I’ve not gone back to examine trading volumes in these names, but that would be a clue I think. If it is due to profit taking, that’s somewhat of a relief. It would indicate simple market forces at work but not fundamental change in the business environment.

What about a recession? I don’t want to get into an argument about whether this is a near term threat or not as it would rapidly become a political argument. We each are entitled to an opinion. Mine is that it’s nearly inevitable. I’ll leave it at that. Recessions typically last about 18 months. Will the next one be “typical” (irrespective of when it occurs)? Typical or not, does it make sense to hedge or take other defensive measures at this time? As I said, I’ve not sold all my equity positions and retreated to gold or diamonds or whatever is considered “safe.”

I don’t think I even know what’s safe. Is a non-productive asset safer than a viable, dynamic business carrying zero debt? That’s a tough call IMO. Even though it’s OT for this board, maybe it’s a good time to study up on option strategies of which I’m mostly ignorant. I’ll drop that line of reasoning, or pursue it elsewhere.

This post and my last are somewhat rambling and maybe completely OT. After all, I’m not really discussing a particular growth company. But I’m reasonably confident that my recent thoughts along these lines are not unique. So maybe the discussion is helpful to others. I hope so.

I’ll wrap up by saying I’m more in a quandary than putting out a call to action. I appreciate reading the thoughts of others. It has helped me chill somewhat. I always thought I’d be able to emotionally weather a strong downdraft, I guess I was a bit too sanguine about that. It’s easier to feel that way when one’s portfolio is increasing in value. Market activity since late July has been a rude awakening.

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there may be no such thing as a “typical” recession any more than there is a “typical” number that comes up on a roulette wheel. The same is true for declines of any individual stock during a recession /bear market.

I’m still up for the year do that for enough years and you will have a very comfortable retirement. We have been the beneficiaries of spotting a major trend many months ahead of the masses and even most of the pros.That is exceptional, and we won’t be able to do it every year.

able to emotionally weather a strong downdraft it gets better with enough practice. But the base emotions are always there it’s part of being human. That’s a good thing ,otherwise the computers would have made humans obsolete in markets and there would not be any room for the Sauls of this world.

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Excellent post, Bear! +1!

Question for you:

What I do is compare all the companies I own, or am considering owning, on a daily basis. Usually things stay within ranges I find reasonable, and so I don’t adjust anything based on relative valuations. But recently Zscaler had a PS ratio 50% higher (maybe more) than other somewhat similar companies. It was fair to ask why. I didn’t know why, so I reduced my position. Now that ZS is back in a reasonable range, I’ve added back. I’ve done the same with CRWD and OKTA.

Could you share some of this information with us? Specifically, what companies did you consider as similar companies to ZS, CRWD, and OKTA and what were the PS of all.

Just curious.

Jeb

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We can’t expect the market to be reasonable. The market is over-correction personified, and stocks are wild stallions.

It wasn’t that long ago that some on this board were complaining that Mr Market had caught on to SaaS businesses, and as a result it was going to be harder and harder to find such businesses at a low/reasonable valuation.

It seems their complaints have been acted upon.

Growth stocks - like the ones discussed here - need to grow into their valuations to be worth what we paid - and would still pay today - for them. The question will remain for a few years whether what we have experienced the past couple years was a bubble, or whether what we’re in today is a buying opportunity, or maybe just the first leg of an overdue correction, etc.

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Usually things stay within ranges I find reasonable, and so I don’t adjust anything based on relative valuations. But recently Zscaler had a PS ratio 50% higher (maybe more) than other somewhat similar companies. It was fair to ask why. I didn’t know why, so I reduced my position. Now that ZS is back in a reasonable range, I’ve added back. I’ve done the same with CRWD and OKTA.

OKTA is 27% off it’s all time high. At one point did OKTA become “unreasonable” and at what point did it become “reasonable” again? OKTA is now trading back where it was in May.

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I admit, that’s a click-bait title. But hear me out.

Unfortunately, I can’t get over the misuse of the word “worth.”

One valid use of “worth” is current Market Capitalization. In that sense, Amazon will always be worth more than ZScaler, and probably worth more than any of our SaaS companies ever will. The value of the grand-daddy of SaaS companies, Salesforce, is around #75 by Market Cap (https://www.corporateinformation.com/Top-100.aspx?topcase=b ). Amazon is consistently in the top 3 or 4 consistently.

My take on #2: of course valuation matters. Why is Amazon worth more than Zscaler? If valuation doesn’t matter, there is no reason.

This is confusing “worth” with “valuation.” And more confusingly, “total value” is not “valuation.” Welome to the English language. I admit these words do not have precise meanings on their own, but typically when “valuation” is used as Bear used it, it refers not to the total sum of stock price times quantity (market cap), but instead to the “multiple” of the stock price, typically in relation to profits (P/E ratio), or sales (P/S ratio).

As we constantly discuss here, the real issue for us is growth. In this regard and in percentage terms, it’s not unlikely that Zscaler could grow much faster than Amazon. And so while Zscaler as a company is not (and will not be) worth more than Amazon, the multiple Mr. Market is willing to pay for ZS shares could easily be higher than the multiple on AMZN shares.

And this is where the phrase “grow into their valuation” comes from. A company with a high valuation (expressed as multiple, not as total value), is expected to grow faster than a company with a low valuation - total market cap doesn’t matter.

I’ve repeatedly said that in order to make money on stocks you have to predict the future better than Mr. Market. And valuation is a big part of this prediction equation.

What’s less obvious is that while we all know that human emotions and sentiment play a role, one aspect that is very consistent is that most people tend to place a mental limit on how much or as quickly something will grow. This is why some people sell at doubles or triples, or after big run-ups in price.

I believe most of our investments on this board are based on recognizing that a company will not just grow, but grow faster and/or longer than Mr. Market expects. When Mr. Market catches on, many of us sell. Take Shopify, for instance, we had a great run but two things happened: One, growth slowed (note SHOP was/is still growing, just the rate of growth was/is declining). Two, Mr. Market recognized that SHOP is/was a great business and bid up the multiple they were willing to pay for that growth. In other words, even though Shopify wasn’t growing as fast as before, Mr. Market was willing to pay more for that growth than they had back when growth was faster. As a result, SHOP continued to increase in price after many here sold. The bottom still could fall out, and SHOP suffered like many other SaaS business model companies stock did this past week. So while the stock did continue to rise, selling was a justified move - hard to predict what Mr. Market’s sentiment will be (again as we saw this past week).

Now, it might be worth realizing there are rare instances where Mr. Market behaves differently. Back in 1998 Henry Blodget predicted that Amazon would trade over $400 (it was about $240). AMZN proceeded to climb above $400 within a month, some thinking mostly because of the prediction. Today AMZN trades about at about $1800, in large part because it grew a ton in eCommerce and then invented and grew to become the dominant player in large TAM Cloud Hosting as a service. So even with the dot com bust, AMZN eventually grew into its valuation and then some.

Which brings us back to whether valuation matters. While a common MF Rule Breaker and sometimes this board’s mantra is that “valuation doesn’t matter,” what is really being said is that as high as the valuation Mr. Market has put on this company today, we believe it’s going to grow faster and/or longer than Mr. Market gives it credit for.

So when you see a company with a high P/E ratio, check its growth rate. If that company is growing quickly enough, that seemingly high P/E might actually be underestimating its future! And human behavior is that we don’t expect companies to grow as quickly and/or as long as some will, and so what looks at first blush to be a high valuation is actually a lower valuation than the company deserves.

And, to me, that’s what many of our discussions are about. The standard metrics for P/E, P/S or whatever literally don’t apply. The old YPEG discussed here years ago was one measure, but that limited us to profitable companies. The companies with the most growth potential today often utilize a subscription model for service, and the key to growth there is to invest all cash flow into expanding the business - acquiring more customers and getting existing customers to buy more services. I don’t know what metric(s) we can come up with to measure that, but if possible that would be really valuable for us.

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" … What might be more scary is that the market seems to have re-priced the set point on the kind of stocks we own. We don’t know that there’s a floor there. Actually, there isn’t in any literal sense. The market could decide these amazing companies are only worth a PS ratio of 10, or less! …"

I don’t know how Mr. Market does the reprice computation, but at some point he does the recomputation and repricing, and shocks you with his decision. Not the first pullback, or the second. But one of them, the repricing of expectations seems to get baked in to “only 30% yoy” instead of “100% yoy”.

Good examples are Intel, Cisco, Ericson, Nokia and Lucent. All those were crazy growth names for several years in the 90’s, and with good reason. Their yoy growths were over 100%. They were the dominant players in industries expected to grow to the moon. Then Mr. Market decided that the expected growth was not sustainable, and those companies hit the later step of Saul’s sigmoid growth curve and their prices crashed on short notice.

TXN and BRCM, they did come back, but took a long time. Intel and Cisco still have not reclaimed their old highs, despite being the #1 players in their respective industries. Their growth slowed down to more “normal” levels, but only after the prices crashed.

I don’t know enough about SaaS to opine on when the stocks of this board would slow down. Those who understand that industry better will have a better guess. Saul mentioned this concept somewhere. Something about losing interest in companies only expected to double or so.

Good luck to all.

Specifically, what companies did you consider as similar companies to ZS, CRWD, and OKTA and what were the PS of all.

Jeb,

Just total back of napkin stuff. For example, if the situation is:


Company   PS     RevGrowthRate
ESTC      22          60%
OKTA      25          50%
ZS        28          55%
CRWD      42          95%

…then I probably rationalize that these are in “within ranges” relative to their growth that nothing is too out of whack. Obviously ESTC looks cheap in this example, but that’s about all I can glean.

If the situation is:


Company   PS     RevGrowthRate
ESTC      22          60%
OKTA      25          50%
ZS        42          55%
CRWD      65          95%

…then I would probably be trimming ZS and CRWD. It’s hard to make the call with CRWD because it’s growing so fast, but ZS looks like a clear outlier. In this example I either have to convince myself that ZS is roughly twice as attractive as ESTC and OKTA, or I should trim or sell ZS.

Bear

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The companies with the most growth potential today often utilize a subscription model for service, and the key to growth there is to invest all cash flow into expanding the business - acquiring more customers and getting existing customers to buy more services. I don’t know what metric(s) we can come up with to measure that, but if possible that would be really valuable for us.

I would have thought it was the LTV/CAC metric.

https://www.profitwell.com/blog/youre-calculating-cac-wrong

[You can find any number of articles disucssing the above.]

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Good feedback Bear.

I’ve heard it said that the value of a corporate stock is what someone is willing to pay for it. There are no magic numbers, despite the best efforts of many great fund managers and investors over decades to define the best entry and exit points. It’s a marketplace where stocks trade hands based on supply and demand. Analysis, and reams of research, information and knowledge stimulate pricing to an extent, which we see at work in various trends such as the SaaS trend, but there are many other factors to stock price movements. Perhaps the most often overlooked factor is emotions, and specifically how emotions affect buying and selling on the stock market. We see what happens when fear grips the market and red flows all over the charts. We may be less prone to recognize when over exuberance lifts shares to silly levels.

Great investors with long track records and experience, like Buffett, make their biggest and boldest moves in the contrarian tradition. When fear motivates investors to panic sell, great companies get sold off for no good reason, and Buffett scoops them up. When euphoria takes over and everyone is piling in at nosebleed levels, Buffett looks for the exit, loading up dry powder for the next panic attack.

It takes courage to sell a mega winner, and perhaps even more courage to buy a steep selloff, but what better epitomizes the mantra of “Buy Low, Sell High”?

@Najdorf,
Interesting article. I take issue with what the author asserts to be mistake number 2 in that he includes some one time expenses such as “web site design.” This is not a cost that recurs month to month, rather is done once and may not be revisited for years. While I don’t deny that they should be considered CAC, it would make more sense if costs of this nature were depreciated over the expected life of item that incurred the cost. Maybe that’s a niggle, but the author’s entire argument revolves around accuracy in the CAC calculation. Why introduce errors?

I also am puzzled about how one acquires some of the numbers used in the calculation of LTV/CAC. For example, where does churn come from? Where does website design come from? Most companies don’t explicitly report costs. How are they derived? Or is it just given? The author uses 5% churn in all three examples. If it’s a constant across all enterprises, why bother incorporating it? It will have the same influence for all companies and therefore adds nothing to the calculation. Of course, it’s not a constant. Companies like Square and Shop would be expected to have high churn. Companies like Zscaler would be expected to have near zero churn. Maybe that’s why his examples were all hypothetical rather than actual companies.

Seems to me, while CAC/LTV is conceptually interesting, calculation requires a lot of guesswork, thereby making the ratio considerably less valuable then the author asserts. Same as always GIGO.

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Many, if not most companies, explicitly share their churn rate and cost of acqusition. The overall point was to do the work to figure it out and not rely on guesswork.