A recent post recently got me thinking about the role of valuation in our companies. “How can Zscaler and Crowdstrike be trading at such different multiples if they have relatively similar growth rates?” the poster asked.
Truth is, I used to ask myself these sort of questions all the time. While I was confident that traditional methods of valuation did not matter for our companies [1], I still sought to find “value” within our companies. My thoughts have substantially evolved since then – and I think it might be helpful to some to explain why.
Let’s use the two companies raised by the poster for an example. Previously, this is how I would compare Zscaler and Crowdstrike:
Revenue Growth GrossMargins OpIncome EV/NTMR
ZScaler 62% 81% $21M 42x
Crowdstrike 64% 76% $51M 26x
“Wow!” I would think to myself. “Surely the market is underappreciating Crowdstrike’s results!!! It’s growing faster than ZScaler, has similar gross margins, is producing more than double the operating income – and is trading substantially cheaper! What an incredible buying opportunity!” I would use a bunch of different valuation techniques, such as the “oomph factor” [2] to prove to myself that Crowdstrike was indeed underappreciated – and I would load up on shares.
But something wasn’t quite right. How did I know? Well, I kept holding onto companies after it was “too late,” and continuously got punished by the market for doing so. The most evident (and painful) one was Zoom, which I saw no reason to exit after its 369% revenue growth reported in Q1’2020 despite many of the board leaders doing so. Needless to say, my exit price after Q2’2020 was far from ideal, and I wrote about it here [3].
So how do I compare Zscaler and Crowdstrike NOW?
Revenue growth was 62% for Zscaler. Wow, that means ZScaler has accelerated its revenue growth in 6 of the last 7 quarters. For Crowdstrike, 64% means a fifth consecutive quarter of deceleration. But wait, let’s look at quarterly growth rates too. Aha, Crowdstrike grew at 12.6% from 11.5% last quarter, that’s better. What about Zscaler? Wait a minute, they went from 11.7% to 17.0%!!! OK, let’s now annualize these quarterly numbers. Annualizing Crowdstrike’s 12.6% = 61%, so they’re operating at a similar level to their YoY growth. Annualizing Zscaler’s 17.0% = 87%!!! If that doesn’t scream tailwinds, I don’t know what does.
Let’s try to dig deeper at these tailwinds by looking at other metrics. Crowdstrike’s RPO grew at 81%, slightly down from last year’s 86%, and still incredibly impressive. But Zscaler? They grew RPO at 97%!!! That is up from the 56% RPO growth they reported last year. And what about revenue retention? Crowdstrike once again remained at a fantastic 120%. But you guessed it, Zscaler went from 122% last year to around 130%. [4]
Lastly, we see that customers are continuing to flock to Crowdstrike at an impressive 75%. Let’s look at quarterly figures though – 12.3% QoQ is slightly down from last quarter’s 14.5%, which is slightly down from the previous quarter’s 15.4%, which is slightly down from the previous quarter’s 17.6%. Meanwhile, Zscaler decided to start publishing these figures lately, and while we don’t have an extensive track record, we know that they grew customers spending $1M+ ARR at 87% and enterprise customers ($100k+) at 53%. So, which company do you think am I willing to load up on now?
Let’s get back to the point about valuation. Do I think that Zscaler and Crowdstrike merit such different “valuations”? Previously, I would have said “No way, and that’s why I would load up Crowdstrike!” Now, after looking through the picture through a different lens (as described above), ZScaler’s premium may seem somewhat justified.
But that’s besides the point! Fundamentally, I think we can at least somewhat agree that stock price movements are driven by the extent that a company is able to “surprise” the market. The more a company’s performance can surprise market participants (through its quarterly results, product releases, key metrics, etc.) the more the market rewards or punishes its stock price.
So at the end of the day, what does valuation tell us? The expression that “in the short term, the market is a voting machine” is not new, but the nuance in my interpretation is that valuation is like a “bet” that the market is making about the extent of “surprise” that a company will yield.
Why are Cloudflare and Snowflake the two most expensive software companies (by traditional valuation metrics)? At least to some degree, investors may be making a bet that Cloudflare maintains it’s growth durability for many years to come because of some of the reasons outlined by Saul here [5]. Similarly, investors may be making a bet that Snowflake doubles its revenue again next year and then continuous surprising with its powerful network effects for years to come.
And so, which company do you think investors think that might have a better chance at surprising the market in the coming years? And therein lays one of the key pillars of this board’s edge – making “bets” on companies’ outperformance before the wider market does. Not market timing, not momentum investing, no hypothetical gambles – just a relentless focus on execution.
-RMTZP
Please read this before posting https://discussion.fool.com/we-are-having-a-board-emergency-3492… and visit https://discussion.fool.com/rules-of-the-board-revised-edition-3… to maximize your learning of the board
PS: I realize this can be a contentious topic, so please try to limit responses before we dive into an off-topic tangent 
[1] https://discussion.fool.com/why-my-investing-criteria-have-chang…
[2] https://discussion.fool.com/the-oomph-factor-34182263.aspx
[3] https://discussion.fool.com/clearly-the-market-has-voted-in-favo…
[4] “Net retention rate was above 125% in the quarter and higher than the 128% we reported last quarter” https://ir.zscaler.com/static-files/e4ffaa39-4f58-4066-b657-…
[5] https://discussion.fool.com/cloudflare-here39s-what-we-were-miss…