Much has been made about comparing / contrasting SaaS stocks to one another. What I am going to present is how I use the correlation between Manageable Cash Growth Rate (i.e., Gross Profit Growth Rate) and EV/S to inform how I draw boundaries into a business.
I will then discuss how I utilize this information to supplement, not dictate, my investment thesis. I draw conclusions and discuss three characteristics that I believe further justifying investment in companies that are “below the value line”.
I see a correlation: https://imgur.com/T8rC95O
Manageable Cash Growth Rate (MCGR)
Saul et. others pound the drum on High Revenue Growth + High Margins = Justified Investment Valuations. They aren’t wrong, let’s think about why and then evaluate the evidence.
Product Cost Margin Gross Profit
Year 1 $100 70% $70
Year 2 $150 70% $105
You’d think the Gross Profit Growth Rate = 105/70 = 50%
this is not the right measure because we want to think about the cash growth for management… i.e., how much more cash should management expect next quarter/year
Manageable Cash Growth Rate (MCGR)
Simply stated: How much increased growth will land in management’s lap to deploy as they see fit?
Revenue Growth (150/100 = 50%) * Gross Margins (70%) = 35%
This is representative of the actual cash growth management has that can flow to the bottom line or be reinvested. This number correlates to the EV/S
Correlating EV/S with Manageable Cash Growth Rate (MCGR)
As you can see from the link below, there is a strong correlation between a company’s EV/S and their MCGR (R^2 = ~70%)
The formula looks something like:
MCGR = 0.0148 * EV/S + 0.0999
or
EV/S = MCGR / 0.0148 – 6.75
When I felt like the approach worked: DDOG
When DDOG IPO’d, I took a quick look at the numbers
82% Revenue Growth; 71% margins = 61.6% MCGR
EV/S = .616 / 0.0148 – 6.75 = 34.9
ARR = $330M * 34.9 = $11.51B
$11.51 B / 290 MM Shares = $39.75
This kind of gave me an idea on where the market felt companies should land.
Why I track it, How I use it
Outside of the obvious benefit of tracking and paying attention to companies and the impact of FUD events, I’m able to cognitively tie together
- How much cash is flowing to companies whose CEOs I feel very strongly about
- Which stocks are performing at the highest levels
- The impact of margins on relatively ranking
- Providing a broad curve for price impact of a stock based on deceleration
Observed Caveats
-
TAM is a factor that is meaningful.
MITK has always been a “discounted” company. However, they have nearly saturated their TAM and aren’t moving as far as EV/S is concerned. -
Hidden growth stories stand out
ROKU stands out because of its Platform growth, which I track. Frankly, outside of paying attention to the qualitative discussion of how ROKU is doing becoming the standard SmartTV and (perhaps) SmartSpeaker OS for deploying connectedTV… I don’t care about hardware sales.
APPN, which can’t seem to shake its subscription to services growth rates, stays closer to the line. You simply don’t see the same traction, so you can determine the EV/S is fair at the rate. -
The market pays for optionality
OKTA and SHOP are both prime examples of companies that look “overvalued” according to this clustering. However, OKTA and SHOP are both rapidly working to expand their offerings. I think the market buys into that, especially where these companies are considered.
Me? I look at these and think to myself… why bet on potential new products when proven products in early TAM (AYX, ZS, MDB) look better.
My Portfolio
My Portfolio has become admittedly concentrated and agile over the past year. This board among others have contributed to that. This tool helps me in my conviction as a screener.
YTD +34%
AYX 20.5%
TWLO 13.6%
ZS 13.4%
TTD 11.3%
ESTC 10.9%
MDB 10.1%
OKTA 7.5%
PD 6.1%
ROKU 3.3%
SHOP 2.4%
EVBG 1.1%
A Bit About Each
AYX
High growing, highest margin, high guiding, moat of their own.
Recent acquisition of Tableau by Salesforce only reiterated EV/S
Performing so well it’s almost boring
TWLO
Strong guidance, even with the SEND acquisition included
Big fan of DevOps focused models, customers are printing the Sales and Marketing opportunities
Like others, Net Retention Revenue is the story of product success
Margins depress valuation
ZS
High margin, strong growth, sticky product
Completely reracking and stacking cybersecurity… longer sales… makes a lot of sense to me
Added 3% to this position and considering adding more
TTD
ConnectedTV & Advertisement, some exposure to MacroGrowth markets
Counter intuitively, just because Macro ad growth could slow down, targeted ad growth may accelerate
Quality, Leader, Visionary
ESTC & MDB
Not sure about the open source model, but I do like customers writing the Sales and Marketing
Products seem to continue to expand, ESTC is one of the strongest guides; MDB is a tad troublesome but large TAM
Left MDB after the AMZN FUD, taught me enough to stick with ESTC
OKTA
Sticky product, easy marketplace, always feels overvalued
OKTA numbers are good, but valuation feels based on optionality and guidance feels constrained
Top of my to trim list
PD
Has been a bad performer for me
I’m still invested because high margins, and DevOps focused company
Like EVBG (below), I’m not sure where this company’s TAM really exists
This is the most undervalued pure SaaS (excluding ROKU, MITK) of the cohort and has had the greatest EV/S compression
ROKU
ROKUs platform has me very excited
Quick runup, I think I can keep nibbling until it finds a bounce
This was my strategy until everything else compressed, now, looks like other opportunities as well
SHOP and EVBG
Capital Gains constraints
I don’t understand SHOPs continued growth, but it is there
EVBG just underwent a massive mgmt. change., I’ll be watching, but disappointed in expand products
Just a Fool