In search of a better valuation metric

Investment Analysis Clubs Saul’s Investing Discussions
1

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:

  1. Be aware that it is happening
  2. Quantify the degree of the over-valuation
  3. Make an informed decision about whether I will trim a little
  4. Identify a viable trim price-point
  5. 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:

  1. 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.
  2. 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.
  3. 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.

Beachman twitter.com/Iwannabeontheb2

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2

Because not all growth/hypergrowth/tech companies have a positive net income or even a positive EBIT/EBITA. Many do not have positive cash flows, so that does not work either.

See the sample data using the link above. Negative valuation metrics are not valid.

3

Hey Beachman,

If one could easily identify “overvalued” vs “undervalued”, this whole business of stock picking would be a whole lot simpler.

Here’s how I see it:

In isolation, EV/Gross Profit doesn’t give a great picture of revenue growth and its subsequent impact on operating leverage.

In isolation, EV/Gross Profit doesn’t provide a precise comparison between a company growing top line revenues at 30% with 20% operating margin and a company growing 30% with 60% operating margin. (The differences, over time, will be dramatic).

EV/Gross Profit doesn’t have anything to say about free cash flow.

When looking at a high growth company, a large part of the valuation comes with the recognition that these companies are growing fast and compounding. Looking backwards won’t give an accurate picture, IMO.
Is EV/Gross Profit a valuable metric? Yes. But in my humble experience, these multiples have to be considered holistically - not in isolation - and as part of a broader, more quantitative analysis.

My opinion, open to others!

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Very true, Peter…when I am trimming because I think a stock is overvalued, someone else is buying because they think they are getting it at a good price. Thats what makes a market…differences of opinions between two parties that come together to make a trade. Value/valuation is in the eye of the beholder.

And its just one aspect of a stock to consider. I wrote about other business metrics that I track here: https://discussion.fool.com/getting-ready-for-earnings-season-35…
One has to consider a company wholistically before making a decision.

e.g. even though DDOG might seem over-valued by EV/GP, I am not inclined to trim it because it is doing so well as a business and perhaps deserves its slightly richer price level. On the other hand, S might need a little shave off the top because it is on the complete opposite end of the spectrum in terms of business health.

As investors, we need to develop a framework that works for our portfolio and use it consistently.

Cheers
Beachman

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Hi Beachman, I’m sorry, but obsessing over different obscure valuation methods, instead of how the company’s business is doing, is really, really, REALLY, OFF-TOPIC for OUR board. Please take this discussion to a value investing board.

Thanks for your cooperation

Saul

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