Deciphering Shopify's Price to Sales

I have no position in Shopify (SHOP) or the other stocks below.
I have no opinion whether Shopify or the other stocks below are good or bad investments.
My interest in Shopify and these other businesses is purely as an observer.

Before we get to Shopify, let’s first briefly look at two other SaaS companies – Paycom
Software (PAYC) and the modestly named Ultimate Software Group (ULTI). Both firms provide
payroll and human resource services on the cloud. Both are rivals to each other at times.

PAYC sports a Price-to-Sales ratio (P/S) of 13.9 versus a P/S of 8.9 for ULTI. So ULTI is
‘cheaper’ on a P/S basis. Looking at sales growth, ULTI has grown revenues 23% annualized
over the last four years, whereas PAYC has grown revenues 41% annualized over the same
period. So perhaps we’ve discovered the reason why ULTI is cheaper.

If you stop there, you’d be missing out on a good part of the story. That’s because the
primary driver of business value and stock price growth is earnings. The Price-to-Earnings
ratio (P/E) for ULTI is 312 versus a P/E of 87 for PAYC. In addition, PAYC has grown
earnings a whopping 67% annualized over the last four years versus ULTI’s 9% annualized
growth in earnings over the same period. From an earnings standpoint, PAYC is more valuable
and its stock is cheaper.

If you’re sharp-eyed, you’ll notice that PAYC has grown earnings much faster than sales
but ULTI has grown earnings much slower than sales. Why is that? Because of profit
margins. PAYC has a net profit margin close to 16% whereas ULTI’s margin is in the
neighborhood of 3%.

It turns out there is a relationship between P/S and P/E, and profit margin is the key
to that relationship. In fact, we can express the relationship in this formula:

P/E = P/S * (1/Profit Margin)

For ULTI, P/E = 8.78 * (1/.0281) = 312.
For PAYC, P/E = 13.87 * (1/.1585) = 87.

You can look these numbers up on Yahoo or Morningstar. They are trailing twelve month
(TTM) figures. You’ll find that Yahoo and Monringstar will have a slightly different
number from mine and from each other (because of differences in share counts and other
factors), but it’s ‘close enough’ to prove the relationship.

To sum up, the primary driver of company value is earnings growth. The drivers of earnings
growth are sales growth AND profit margin. Looking at P/S in isolation misses out on this
key part of the story.

What does this have to do with Shopify’s P/S? Shopify doesn’t have any positive earnings
or positive net profit margin.

The answer to this is expectations. What drives stock price is expectations about earnings
growth. As we have seen, that translates into expectations about not only sales growth but
also profit margin. Using the formula above we can see what market expectations are built
into Shopify’s current P/S of 21.8:

At 10% profit margin: P/E = 21.8 * (1/.10) = 218
At 20% profit margin: P/E = 21.8 * (1/.20) = 109
At 30% profit margin: P/E = 21.8 * (1/.30) = 73

The market currently has high expectations for Shopify for sales growth but also has high
expectations for its future profit margins. Looking at P/S in isolation misses this.



We could also see what kind of earnings Shopify would have if they plowed less of their revenue into growth. That’s something that makes them unusual - they’re not hapless, they’re choosing to forego current profit in the interest of more of it in the future.

Amazon has taken this to an extreme for decades now, where their profit barely comes from retail sales. They seem to only care about taking someone else’s retail sale, and their source of real profit is mostly an inadvertent byproduct of developing a cloud service for internal use.

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