EV/S and exponential growth

Investment Analysis Clubs Saul’s Investing Discussions
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I think that the single most important factor in choosing a stock is it’s growth rate. There are, of course, other important factors but I will argue that the revenue growth rate is the most important. I think people can get caught up in valuation which can lead them to sell a stock because it’s too expensive. I think that we should look more at the growth rate as the primary decision driver. Looking back or looking only one year ahead can also lead us astray. It does not give us a sense for the importance of growth.

TOTAL REVENUE GIVEN A CONSTANT GROWTH RATE


growth	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
40%	100	140	196	 274	 384	 538
50%	100	150	225	 338	 506	 759
60%	100	160	256	 410	 655	1049
70%	100	170	289	 491	 835	1420
80%	100	180	324	 583	1050	1890
100%	100	200	400	 800	1600	3200
120%	100	220	484	1065	2343	5154

The above table can give a better sense for how much more valuable a higher growth rate is. A 40% growth rate compounded after 5 years gives almost a 440% gain after 5 years. If you double the growth rate to 80% then you get almost an 1800% gain after 5 years. If you triple the growth rate to 120% then you get more than a 5000% gain. So after 5 years doubling growth is more than 4x better and tripling growth is more than 12x better.

Now let’s consider how much EV/S would be reduced with the passing of each year and considering each of the growth rates:

REDUCTION OF EV/S AS A PERCENTAGE OF YEAR 0


growth	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
40%	0%	29%	49%	64%	74%	81%
50%	0%	33%	56%	70%	80%	87%
60%	0%	38%	61%	76%	85%	90%
70%	0%	41%	65%	80%	88%	93%
80%	0%	44%	69%	83%	90%	95%
100%	0%	50%	75%	88%	94%	97%
120%	0%	55%	79%	91%	96%	98%

When a company is growing at 100% then the EV/S comes down very fast. Take ZM as an example. We’ve heard a lot of people saying that the EV/S was just too high. It’s intolerable at 70x or 80x. Consider 2 years of growth at 100% and you will see an 80x EV/S drop to 20x. Rather than looking at the 80x and ruling the company out, one might be better served by asking “for how long can ZM’s 100% growth be maintained?”. If the answer is 2 years or longer then buy at 70-80x EV/S may still look like a bargain. It ZM could manage 100% growth for a third year then its EV/S drops from 80x to less than 10x.

Yes, there are many other things to consider in investing decisions: gross margin, operating margin going in the right direction, stock dilution, etc. But I think that the single most important factor with our SaaS companies is be the revenue growth rate and the duration of that growth rate. Think about why or why not will the growth slow.

Chris

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Zoom $331m in last full fiscal year, I believe.

100% growth 3 years in a row looks like:
$662m
$1334m
$2648m

Are there any examples of any companies growing like that, for 3+ years, starting at a base revenue of over $300m?

What was Zoom doing 2-3 years ago in revenue…were they viewed then as a disruptive threat? How possible is it that in 2-3 years (from now) Zoom is itself disrupted or threatened, as their main product is video conferencing, which is almost a commodity, imo? 2-3 years in tech can be a lifetime.

I don’t think there is a path to them getting to $2.6b in revenues in 3 years.
Can they eventually get to $2.6b? I guess, maybe…not sure the TAM of video conferencing justifies it. I don’t see a major moat/switching cost keeping large enterprises from going back to WebEx or Skype or a new company, if their Zoom bill starts zooming up too much.

So maybe they can get to $2.6b in 4 years.
331m - 2019
662m - 2020 w/ 100% growth
1.1b - 2021 w/ 75% growth (still better than about any other company Saul owns currently)
1.8b - 2022 w/ 60% growth
2.7b - 2023 w/ 50% growth

Seems a bit more likely, if still optimistic and aggressive.
So now you have a company with TTM revenues of $2.7b, likely increased/new competition as they have a firm bulls-eye on them at this point for a couple years. Is the market still handing out a P/S of 20 like candy to 50% y/y growers? Let’s say “yes”.

Mkt cap would be a whopping $54b (or about 6 companies of MDB’s current size), for a 21.23% CAGR on your stock investment over that time, which is less than I believe Saul averaged for a couple decades prior to this whole SaaS explosion when he was focused more on stocks with good P/E’s.

My goal in investing is really all about CAGR, or what you believe your return can/should be over X amount of time?

There is no question their metrics are off the charts/great. I just think there are much better potential CAGR choices than ZM from their current price.

Good news is, if ZM is given a $50b mkt cap prior to 2023, I think all hyper-growth software stocks will also be doing very very well.

Dreamer

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I like both Chris and Dreamer’s posts, as I believe this is the right way to look at it. Of course, we’re still guessing about what the growth rate going forward will be. I’m still waiting and watching ZM.

Like Dreamer said, all of the video conferencing companies are already targeting what ZM is doing, including new unknown startups, and we don’t know how long they’ve been targeting them. My sense is that the price of the product will come down, hurting revenues and margins. Can ZM continue growth in the face of that? I don’t know.

Enjoy,
Brian

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Zoom’s numbers from the earnings presentation from the 1Q 2020 Earnings Webinar:

https://investors.zoom.us/static-files/926ae36b-4256-48b2-bf…

QoQ YoY
Q1 2018 27
Q2 2018 33 22%
Q3 2018 41 24%
Q4 2018 51 24%
Q1 2019 60 18% 122%
Q2 2019 75 25% 127%
Q3 2019 90 20% 120%
Q4 2019 106 18% 108%
Q1 2020 122 15% 103%
Q2 2020 130 7% 73% Guidance

So, ignoring the guidance, it looks to be trending towards sub-100% growth rate soon. S&M expense is 53% of revenue … I wonder if that is an increase on previous quarters; I haven’t found any figures on that.

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Here’s a spreadsheet that produces a table of the reduction in EV/S given an initial EV/S number, here 80 for ZM.

Reduction in EV/S With Revenue Growth With Initial EV/S Value

Initial EV/S	80					
Revenue Growth	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
40%	80.0	57.1	40.8	29.2	20.8	14.9
50%	80.0	53.3	35.6	23.7	15.8	10.5
60%	80.0	50.0	31.3	19.5	12.2	7.6
70%	80.0	47.1	27.7	16.3	9.6	5.6
80%	80.0	44.4	24.7	13.7	7.6	4.2
100%	80.0	40.0	20.0	10.0	5.0	2.5
120%	80.0	36.4	16.5	7.5	3.4	1.6

Spreadsheet here:
https://docs.google.com/spreadsheets/d/1GIk17qKtaWqbSJY8AiMj…

Enjoy,
Brian

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So maybe they can get to $2.6b in 4 years.
331m - 2019
662m - 2020 w/ 100% growth
1.1b - 2021 w/ 75% growth (still better than about any other company Saul owns currently)
1.8b - 2022 w/ 60% growth
2.7b - 2023 w/ 50% growth

My post was not about ZM. It’s just that ZM (in the past) had one of the highest revenue growth rates out there. Our job as an analyst is to analyze companies and use the evidence and our own judgement to decide which companies will grow fast into the future. Which ones will grow for many years into the future? How confident are we that growth will be high for years? If we can figure that out, act on it and be right then we should do very well.

I decided that in spite of ZM’s fast growth in the past, I’m not confident enough about ZM’s future growth. Why not? My reason is that I’m not confident that ZM’s offering is as sticky and irreplaceable as the offerings of some of the alternative companies. That’s just my opinion. I passed on ZM. I did buy CRWD which has a similar growth rate to ZM but is more sticky and less replaceable IMO.

Chris

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DreamerDad asked:
100% growth 3 years in a row looks like:
$662m
$1334m
$2648m

Are there any examples of any companies growing like that, for 3+ years, starting at a base revenue of over $300m?

Tesla exceeded $300M in revenue in 2012. Here are yearly revenue figures since then:


2012: $  413.26M  +102.3%
2013: $ 2013.5M   +387.2%
2014: $ 3198.36M  + 58.8%
2015: $ 4046.03M  + 26.5%
2016: $ 7000.13M  + 73.0%
2017: $11758.75M  + 68.0%
2018: $21461.27M  + 82.5%

Sorry, not 100%. Only 93% compounding over six years starting at over $400M. And 2019Q1 continued up, with TTM revenue up 81.2% over the year previous.

https://www.statista.com/statistics/272120/revenue-of-tesla

Of course, Tesla isn’t a “Saul stock”, but you asked.

-IGU-

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Consider 2 years of growth at 100% and you will see an 80x EV/S drop to 20x.

When SHOP revenue was growing at 100% rates in late 2016, the PS ratio was around 10. If the PS had been 80, it would have been a $320 stock instead of a $40 stock at the time. Note that SHOP is a $302 stock today. So the stock would be down (even despite the recent run up).

If SHOP had had a PS ratio of 40 in late 2016, it still wouldn’t have even doubled, in 2.5 years, even after the recent run up.

SHOP also now has 15% more shares outstanding than it did at the end of 2016. Other than accounting for that, Chris’s math is correct as far as I can see, but hopefully my addition here illuminates how this works in the real world. We have enjoyed such crazy gains the last two years, because in late 2016 and all through 2017, things were crazy underpriced. Things have changed.

Saul often says that he can’t time the market. I can’t either. So I’m not going to cash, because big a correction may not come. Sure we’ll have little corrections like we have all along, but who knows when? Our stocks may go up 30% from now before that happens. Or it may happen tomorrow. Either way, in the long run, stock appreciation will approximate each company’s revenue growth, adjusted for dilution. That’s still great…even comforting. The difference now is, we probably can’t expect multiple expansion on top of that.

Bear

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Either way, in the long run, stock appreciation will approximate each company’s revenue growth, adjusted for dilution. That’s still great…even comforting. The difference now is, we probably can’t expect multiple expansion on top of that.

Amen, brother.

And that’s saying something, as I am an atheist.

One caveat might be, assuming GM and growth % and annual revenues are fairly equal, that the company with the largest multiple may (should?) bring in a lower return, over time, than the companies with lower multiples.

So if ZS, MDB, and ESTC all continue to crank out 60%ish growth, and since they have the same revenue base (roughly) odds favor ESTC stock appreciation rate from today’s prices over say the next 12-18 months. That is simplistic, as we want to weigh our subjective views on moats and TAM and all that, but it is how I look at it.

ZS is high right now, but I think you can argue they hit $1b in 3 years, and assuming little/no dilution, they would drop from a 34-35 multiple to 10 if the stock price never moved. I don’t see that happening. Will the market hand out 15 or 20 or still give them a multiple of 30 at that time?
I think 30 is unlikely but you could see the multiple drop to 20 over 3 years, while making 26% CAGR on your ZS stock along the way. Pretty good.

The CAGR gets higher for MDB and even higher for ESTC, provided they maintain strong growth too.

It took me a while to see this, but it seems sort of apparent that since about Feb 2018, the vast majority of market indices have been flat, and the legacy “value” stocks such as banks and high-dividend stocks and defensive stocks have languished a bit, largely under threat of rising rates and the Trade War. Software stocks with recurring revenues seemed immune and to your SHOP example, funds have poured into not just Saul stocks, but almost all SaaS 35-40%+ growers and even some others like VEEV or PAYC with lower rev growth but higher profit. “Enterprise stocks are recession-proof” we are told: https://news.crunchbase.com/news/are-enterprise-software-sto…
https://medium.com/@sammyabdullah/is-saas-recession-proof-cc…

Heck…this Forbes guy thought of this about 11 years ago with CRM and Concur (bought by SAP):
https://www.forbes.com/2008/01/17/saas-recession-concur-tech…

The IPOs of CRWD, WORK, ZM are essentially proving that nothing is sneaking by the market anymore in terms of high-growth SaaS. And it really is discriminate too, based on growth rate…SAIL and NTNX and CLDR and others are punished and have much lower multiples. So our stocks are on a short leash…if growth stumbles, the carpet gets pulled out and multiple will implode.

I don’t have any answers, let alone all the answers. I can only look at ZM and scratch my head and wonder if something has jumped the shark. The ramifications are if corrections on those recent IPOs will drag down entire SaaS group with it, or if market will remain discriminate.

So I fall back on what might be a buyout/acquisition cost floor. ESTC is at $5.5b for 60% growth, forecasting for $403m (and likely beating-and-raising along the way) this year. That seems a lot easier to acquire for a premium than ZM at $26b.

Dreamer

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Great write-up Chris! I also pounded the table about the value of the value of the compounding of high growth over just a few years in my last monthly review (and tied it to high gross margins as well). I think though that, instead of thinking about the EV/S coming down, it’s better to think of it in terms of how much more $100 in current revenue is worth in a company if it can compound growing at 50% per year. In four years will be up 406%. If you compare it to a company growing at 10%, which in four years will be up 44%, of course it is worth a much higher current market cap. And especially if it has twice the gross margin and thus keeps twice as much of that revenue, that doubles its worth again. (Not even thinking about a company growing at 60% or 70% or more.)
Best,
Saul

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One has to marry the purity of mathematics…

**TOTAL REVENUE GIVEN A CONSTANT GROWTH RATE**

growth	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
40%	100	140	196	 274	 384	 538
50%	100	150	225	 338	 506	 759
60%	100	160	256	 410	 655	1049
70%	100	170	289	 491	 835	1420
80%	100	180	324	 583	1050	1890
100%	100	200	400	 800	1600	3200
120%	100	220	484	1065	2343	5154

Author: GauchoChris

with the messiness of the real world…

Saul often says that he can’t time the market. I can’t either. So I’m not going to cash, because big a correction may not come. Sure we’ll have little corrections like we have all along, but who knows when? Our stocks may go up 30% from now before that happens. Or it may happen tomorrow. Either way, in the long run, stock appreciation will approximate each company’s revenue growth, adjusted for dilution. That’s still great…even comforting. The difference now is, we probably can’t expect multiple expansion on top of that.
Author: PaulWBryant

That marriage happens in the “S” curve which describes growth in the real world. 100% growth cannot go on forever. The limiting factor is market size. The “S” curve shows a slow initial uptake by technology aficionados followed by early adopters. Once market penetration reaches about 15% the pragmatist buyers come in and create “the curve in the hockey stick” that forms the bottom of the “S.” At this point we see the rapid growth illustrated by GauchoChris. That fantastic run has to end eventually which is PaulWBryant’s concern. The top of the “S” curve starts to set in with around 85% market penetration after which growth switches to a vegetative rate (replacement and new buyers).

But it’s not that clean either! During the middle of the “S” curve we often see 50% drops in share price that are not life threatening to the business. In cases like Apple there are successive “S” curves (iPod, iPad, iPhone, iWatch, iSomethingElse). Disruptive technology usually creates new markets making it hard if not impossible to estimate Total Accessible Market size. Or a fast grower gets disrupted and becomes obsolete (Nokia phones).

Another consideration is that the higher the growth rate the faster the market gets saturated and the shorter the time-line of the “S” curve. One trick pony companies will fade quickly. Most of our SaaS companies deal with data and, unlike material goods, there is no physical limitation to their potential growth. MongoDB will have increasing volumes of data to crunch with no visible limit but the number of people video-conferencing does have a real limit. Remember that continued growth depends on market size. If the market itself is not expanding the end arrives sooner.

One conclusion, love companies that crunch data, unending tsunamis of data.

Denny Schlesinger

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Rather than looking at the 80x and ruling the company out, one might be better served by asking “for how long can ZM’s 100% growth be maintained?”. If the answer is 2 years or longer then buy at 70-80x EV/S may still look like a bargain. It ZM could manage 100% growth for a third year then its EV/S drops from 80x to less than 10x.

Chris:

Thanks for your post. I posted a month ago about the revenue growth > 50% rule here:

https://discussion.fool.com/the-50-yoy-revenue-rule-34218545.asp…

Wasn’t well received as I recall…but these stocks are the ones that have been rewarded most in the past few years.

It turns out that these specific stocks are NOT that common at all…I track the tech stocks (mostly SaaS but others) that are the highest revenue growth…its easy to see why some people complain that there aren’t new stocks discussed here and elsewhere…because those same people do not appreciate that these are very rare breeds…very rare.

Go through the previous long lists of SaaS stocks from various articles the past few years…still very few (Saas or not) can claim >50% revenue growth repeatedly.

So where I would quibble with your conclusions rests on your above quote. IMO, when you enter a stock with an EV/S of 80…an investor is putting enormous pressure on continuing insane revenue growth for years AND that a high P/S will ALSO be maintained.

That is much riskier investing than buying TTD, SHOP, MDB, etc when they were much lower EV/S stocks (prior to their multiple expansions).

I would also suggest a walk down memory lane to previous hypervalued bubble-like investments like the Tulip mania or the Nifty 50…when these investments were bid to astronomical levels only to be decimated in few years to come.

For the exact same reason that revenue growth drives these stocks higher (and money chases fewer and fewer stocks that meet this criteria), any slip and those same stocks get killed.

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previous hypervalued bubble-like investments like the Tulip mania

Hi duma,
Tulip bulbs had no inherent value. That’s a hell of a big difference.
Saul

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So we want to own the companies that have high revenue growth AND can continue that growth for years.

The best companies have optionality to shift into different markets as they reach the top of the S curve on their first/main market to continue their growth.

Or, their market is so big, they can grow for a long time with out hitting the top of the S curve, like NFLX.

One thing that is different now, because of the internet and/or the cloud, a companies market used to be the US, or a certain area of the world. Now it’s the entire world. Technology has expanded the market for all companies, it’s just much easier to go worldwide.

Jim

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So we want to own the companies that have high revenue growth AND can continue that growth for years.

AND have high gross margins. Very important.
Saul

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"previous hypervalued bubble-like investments like the Tulip mania

Hi duma,
Tulip bulbs had no inherent value. That’s a hell of a big difference.’

Saul:

The tulips had a value for the people who liked the novelty of it, and to look at and smell it. The SaaS stocks have a different value but in some senses, it is the same thing. We are arguing how much this valuing has gone overboard.
One might think ‘inherently’ the value of a flower should be less than pieces of software that are being used to increase the efficiency of what an enterprise is doing. That could be so but that does not mean the tulip did not have any value. In both instances, we can become extreme about it.

tj

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Saul, ‘it’s better to think of it in terms of how much more $100 in current revenue is worth in a company if it can compound growing at 50% per year.’

Getting my head around the fact that these companies, growing rev’s at 50+%, are reinvesting these revenues into their continued growth and therefore compounding the worth of the revenue is difficult. Just writing that made me question its validity, in a good way.

Thanks,
Jason

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'“…it’s better to think of it in terms of how much more $100 in current revenue is worth in a company if it can compound growing at 50% per year. In four years will be up 406%. If you compare it to a company growing at 10%, which in four years will be up 44%, of course it is worth a much higher current market cap. And especially if it has twice the gross margin and thus keeps twice as much of that revenue, that doubles its worth again. (Not even thinking about a company growing at 60% or 70% or more.)…”

I can understand the math and the growth. What I can’t get past is what prevents someone else from coming in and doing the same thing?

My two random thoughts on the matter is:

  1. It has to make something physical, like AAXN. AAXN is shifting its business from hardware to SaaS. However, it still makes the police body cameras, stun guns, etc., which will work in unison with their SaaS. So making something physical puts a more understandable moat to their SaaS.
    and 2) All the internet stocks tanked in 2000. Who lives and who doesn’t?? Taking a page from Michael Murphy? (who had a Tech newsletter), R&D helps give a clue. It does not guarantee survival, but it does help the odds.

DoesMIWork

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So we want to own the companies that have high revenue growth AND can continue that growth for years.

That’s a darn good summary!

Denny Schlesinger

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What I can’t get past is what prevents someone else from coming in and doing the same thing?

If it’s a commodity product, you are right. But if it’s technology you need to understand “Path Dependence.”

https://www.google.com/search?client=safari&rls=en&q…

Denny Schlesinger

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