Here's why I like the Oomph Factor

[SaulR80683]

Here is why I like the Oomph Factor. First of all, a big thanks to Ron for inventing it and bringing it to the board!!! And also a thanks to Nilvest who has been working on a very similar method.

In the past, when we discussed valuing companies for investment by EV/S, I pooh-poohed using EV/S, saying that “Of course subscription companies, with nearly all recurring revenue, extremely rapid growth, high dollar-based net retention rates, and high gross margins, would have higher EV/S values than had previously been considered reasonable back in the days when people were looking at companies growing at 10% or 20% per year, most with no recurring revenue, and no net retention rates, and thus no ability to see future revenue”. (or something like that).

Then Ron came along with the Oomph factor, which doesn’t just look at bare EV/S ratios and compare them, but takes Growth Rate and Gross Margin into account… well duh! Why weren’t we doing that before???

Well, we were, but in a very impressionistic way in our heads (see the way I was thinking about it above). What the Oomph factor does is it gives you a multiplier for the bare EV/S value to make it fit better with what’s going on with the company.

I did my own EV/S/O scores on all my companies and a few more, and I found them quite useful. One suggestion though that I will make is that, in addition to growth rate and gross margin, the Oomph factor should take into account whether the revenue is almost all recurring subscription revenue (which gives a lot of revenue security), or whether it is not recurring.

We’ve been applying Oomph pretty much to all SaaS type companies so far, all of which have had a lot of recurring revenue and high dollar-based retention rates, so it hasn’t mattered. But if we start to compare against other companies out in the general public of investing, it will matter.

I feel that the Oomph factor should get a 10% boost if all of a company’s revenue is recurring subscription revenue. Having all of this year’s revenue assured for next year (at least) is certainly worth a 10% boost. For those not mathematically inclined, that means multiplying the Oomph factor by 1.10 before dividing it into the EV/S. Okay, but most companies don’t have 100% recurring revenue. Usually it’s 80% to 90%, with some service revenue tacked in there. Okay, I’ll boost by 9% for 90% recurring revenue (multiply by 1.09), and 8% for 80% recurring revenue, etc. That’s just how I plan to do it.

But remember that the Oomph factor is simply a non-intelligent tool, an attempt to quantify our qualitative impressions, and it’s neither rigid, nor some piece of magic. It doesn’t even take into account dollar-based net retention rate. It’s not perfect. And it will require some subjective decisions, and each of you can use it, or not, or modify it as you like. And some companies with high final values will do well, and some with low final values will do poorly. You still have to use your brain and your intuition.

Best,

Saul

[JAFbrblev]

While Net Revenue Retention rate is important and a great SaaS indicator, it’s incredibly important to also consider if customers are growing.

PVTL, for instance, has a world renown Net Revenue Retention rate of 149%, yet, they have almost no growth in new customers.

I have great concern and caution if all Net Revenue Retention is coming from the same pool…eventually you will overfish the pond.

However, where we see growth in both (AYX, TWLO, etc) I see great execution and potential.

Fully endorse the use of EV to gross profit growth rate as a relative measure.

Just a Fool

[nilvest]

Thanks for sharing your thoughts Saul.

The square of growth rate * gross margin has that magic effect to get comparison to near reality we have seen.

There are VCs who have promoted “rule of 40” - where they look at sum of growth rate + ebitda (or cash flow) to decide what qualifies high growth for them… but it doesnt really match up to what we see in the market.

I agree one could account for recurring revenue, founder manager and such factors to Oomph factor.

Yes I have been trying to hone similar method for few years and it has certainly showed me relative overvaluation vs under valuation across many high growth companies.

I try to frame potential valuation range (upside and downside) with such formula that accounts for recurring revenue, customer switching cost etc. and apply them quantitatively.

I maintain a spreadsheet of 30+ stocks keeping it up to date.
Will be happy to share with any one interested in access to it can send me private message by
Checking “E-mail this Reply to the Author”
AND
Unchecking “Post this Reply to the Boards”

Nilvest

[rdutt]

Glad you found the Oomph factor to be a useful metric, Saul. And, yes, I view this factor as a “blunt instrument”, not a “precision tool” for evaluating SaaS companies. It’s just one of many factors that should be taken into consideration when deciding whether or not to buy (more) shares.

And I also like your idea of giving the Oomph factor a boost proportional to how much of the revenue is recurring subscription revenue. Investors are willing to pay a premium for the certainty of the revenue in future years.

My day job in IT keeps me very busy, but I do intend to do some research into historical valuations of older SaaS companies like Salesforce, Service Now and Splunk to see if EV/S/Oomph ratios were lower 5 years ago, and how useful this type of ratio was back then. I would also welcome posts from others about the current EV/S/O ratios of companies like Shopify and Zoom.

Thanks again for the shout out, and we are all extremely fortunate that this board exists.

Ron

[tchalla]

I like the concept of the oomph factor, and have also been using a modified version

My modification is to substitute the last Q growth rate squared with

Last Q growth rate x NTM estimated growth rate

In many cases the value may be as near similar to the original as to be unimportant, but if rev growth is accelerating / decelerating it captures some of that.

I use my own estimates for the NTM growth rate, based on historical data, billings where available, ER call sentiment, and the official company ER guidance (which is often sandbagged)

The false precision runs the risk of being misleading if used as a blunt instrument, I fully accept.

[doppelg36]

I found it helpful as well. I have been tracking a similar idea.

One suggestion that I like to mix in that I think Saul might like is instead of a squaring the growth rate, putting a little bit of opinion into the future growth direction. Start with last quarter’s growth and use your prediction for next year’s growth.

For example:
if you think SHOP is declining, it might be ( 1.49 * 1.40 )
if you think ZS has improved growth in its future use ( 1.65 * 1.68 )
if you don’t have a specific opinion, keep it the same ( growth squared )

As far as something like subscription revenue goes, I prefer to keep a separate value for things that are harder to fit into formulas. Keep a “quality” score derived from a checklist, number of stars, etc., and use the oomph and quality in concert to inform your choices.

So if you get a screaming buy on oomph for MU, your quality score tells you not to bet the farm on it.

[brittlerock]

Thanks for your insight on this Saul. I will probably give the Oomph Factor a bit more weight than I had previously considered.

I was somewhat skeptical for the same reason I am somewhat skeptical about all strictly numerical analysis of a companies performance and future potential; that reason being that it carries the risk of making the investment decision process a mechanical exercise. Plug the numbers in one end and the answer comes out the other. Of course, you recognize this hazard and commented about it.

I don’t mean to imply that numerical analysis is not valid, of course it’s not just valid, it’s invaluable. But it’s not the whole story. IMO maybe the greatest intangible related to investment decisions is the quality of management. I have never seen a satisfactory quantitative measure for this, yet it remains as a critical (if not the critical) factor in a company’s success.

For me, the numerical indicators are a powerful filter used to reduce the enormous field of investment opportunities to a few viable candidates. But the decision to buy and just as importantly, sell stock in a given company requires a lot of thought about intangibles and what if scenarios. It would not be easy to document the thought process involved as it takes a different shape for virtually every company under consideration.

[nilvest]

While Net Revenue Retention rate is important and a great SaaS indicator, it’s incredibly important to also consider if customers are growing.

JAF…

Saul and others also mentioned few more points e.g should “$based net expansion rate” be applied in the Oomph equation.

To me the real important idea is to get a “good” estimate of a range of valuation a company can achieve say 4 quarters to 12 quarters from now… both low end of the range and high end of the range…
So what I like to do is to use factors like net expansion rate, last 4 quarters revenue growth rate, growth rate of subscription services etc. to project potential revenue for multiple quarters out in time. Its on that number I apply a formula similar to Oomph factor to get to potential upper range of valuation… i take a simpler, pessimistic view to get to lower range… add stock dilution in line with last 4 quarters and now I have very simple upper and lower price range that can tell me what upside and downside is from here.

This method covers a lot of ground, but like many others pointed out, it is not fool proof and does not (MUST NOT) replace your qualitative analysis and understanding of the businesses.

Yes, this is a lot of work… but as Saul has demonstrated here and as Charlie Munger says - investing is hard work, it is not supposed to be easy. This is my additional piece of hard work that helps me make better decisions.