I have been looking into valuation metrics for a few months now and have had great difficulty finding one that I works for my purposes.
When my stocks are given a richer valuation than they deserve, I want to:
- Be aware that it is happening
- Quantify the degree of the over-valuation
- Make an informed decision about whether I will trim a little
- Identify a viable trim price-point
- Identify an attractive add-more price-point
We are not in 2020 anymore, Toto….when we could buy every dip and ride these stocks up to the clouds. The market will continue to be volatile with fast and furious ups and downs. As an investor, I want to juice my portfolio returns by raising cash when markets are up and putting that cash back to work when the markets slide lower.
After evaluating a variety of valuation metrics, I am leaning towards using this metric
Enterprise Value (EV) / Annual Gross Profit (GP)
EV = Market cap + Total debt - Total cash
GP = (Total quarterly revenues - Total quarterly cost of revenues) * 4
See some sample calculations here: https://bit.ly/3xmC7Kk
What I like about this valuation metric:
- It seems to be more sensitive than EV/NTM…NTM is next 12 months revenue. As per the table above, CRWD, DDOG and S could be more over-valued than we think they are.
- Debt and cash in the numerator ensures that we do not ignore these two original sins that have led many high-fliers to the dumpster.
- Gross profit reflects operating efficiency, market share growth trends and pricing power, which we want to see at healthy levels in our companies.
Since many of our favorite growth companies are not yet profitable, we cannot use net income, earnings, free cash flows or even EBITDA consistently across the cohort….see the invalid negative numbers above.
One might argue that EV/GP is backward looking, meaning it ignores future growth potential. Why not use EV/NTM?..Because, imo, the macro conditions have changed significantly and I need to adjust my investing lenses accordingly. NTM would be based on company forward revenue guidance or analyst estimates…these are predictions that may not come to fruition. I do not want to ignore the potential of slower economic growth and its impact to the revenue pipelines of these stocks. EV/GP helps me take a more conservative valuation stance in this regard.
It will take a few earnings cycles to identify appropriate over-bought and over-sold thresholds e.g. Is 40 and above the time to trim? Perhaps 20 and below is best for adding back? Maybe the trigger levels for SaaS companies are different than those for semiconductor companies.