It is never too late to learn new things

If a newsletter is bad, that is something we should know. I don’t see the problem with that post.

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Hi, @rmtzp , you may not have come across this before, but it is relevant to your 10 P/S comment about ZS. One of the more famous CEOs of the dotcom era was Scott McNealy,
of Sun Microsystems, which peaked at about a market cap of about $200B (they later sold to Oracle, 96% off that top). In this Bloomberg interview in 2002, A Talk with Scott McNealy - Bloomberg , he said

At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

It is a terrible valuation; it is insane. There was a brief period of disruption where this worked, but it’s over. The strategy is gone, the losses are unlikely to be recouped. So many of us tried to warn the people on Saul’s board. It’s really sad.

For the most part an equity is worth its future cash flows discounted by a risk-free rate. At 10 * P/S or EV/S, even with 20% net margins it would be 50 p/e (or earning yield of 2%). And ZS has net margins of -24% based on a quick search.

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Hi all,
Thanks for all the informative comments on this thread. I’ve recently started to value companies via a simple DCF/ reverse DCF and I am quickly seeing the value in doing this exercise. Does anyone here builds those kind of models and is willing to work together on valuing stocks in this manner. My idea is to learn together and from each other’s viewpoints.

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And that assumes… I… maintain the current run rate. Do you realize how ridiculous those… assumptions are?

Really, Scott McNealy, did you plan for zero revenue growth rate for the next ten years? Then 10x revenues would be ridiculous. We made a couple of tries to see what EV/S could/should be for DDOG. The key unknowable is the growth rate for the next… 4 years. Model some efficiencies of scale for SG&A. Move R%D to cost of goods sold because as McNealy implied, you gotta keep pumping out innovation to keep growing at the assumed growth rate. Could you ever get to a p/e of… 25? What market cap does that imply? How does that compare to XYZ?

Beats heck out of me.

KC

Hi KC,

Could you please explain a bit for me, if you don’t mind…

I am assuming your are meaning to say that…DDOG can become a stock with P/E of 25? What has to happen for that? and how does it get to there from its current unprofitable metrics…

I had 200 shares with a cost basis of 160…and then rode it all the ay down to 60s…I did not buy any after that but neither sold…But then when it went back to 88 or so after the latest ER , I sold…and then the damn thing decides to run even more.

I was very convinced on that as long as the analysts had kept a high price target…but then those folks rerated it, and that’s when I lost it…

Thanks,
Charlie

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Hoping ANDY sees this but I guess any of you folks may also be able to answer this.

In the past, I had got killed by my very erroneous thinking…I bought XYZ at $350 just a year back…it felll to $300 after one ER…I would buy thinking well people wer buying at 350, and so it should be a good deal at $300…and I would think that those who are selling now were just day traders who just were not willing to hold long term…and the damn thing would fall to $250…and now I would panic and say…well, no choice but DCA so that I can get out even when it eventually rises…HOW STUPID WAS I - I know now!!!

I saw Andy’s comments on SNOWFLAKE…and I guess he is referring excatly to this

So, how does one correlate with what P/S is appropriate for what revenue growth?

I am guessing using such metrics is the way to decide if something is cheap or not…Thinking that stock A at 150 is 50% cheap compared to its prior 1 year price of 300 is, well, heights of stupidity - And that was me !!

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Hi Charlie, Do not think that I know anymore than you do or anyone else. I will give you my thoughts on this but take them for what they are worth and let’s just all keep learning. Snow is a great company, but I think because of Slootman they have always been over priced. They have good FCF margins but right now they are growing Revenue at 48 percent down from over 100 percent just about a year and a half ago. They are guiding for growth in the high 30 percent next quarter.

Now what you are willing to pay for a company Charlie is always very subjective. Some people will buy at any price but Snow has gone from a P/S of 18.58 to 206.25. It has always been a little scary for me because of how it was valued. But if a company is growing Revenue at around 30 percent, isn’t profitable, but has a FCF margin of around 27 percent. No debt and around 4 billion in cash, well I would be willing to buy it around a P/S of 10. Now that might be to high for other people also but for me that is where I would buy it. But when it gets there, if it does, I will not go all in. I expect that when this down turn is over that Snow will start accelerating it’s Revenue growth.

In a downturn Charlie, everything can get much cheaper than anyone would think. Maybe we have seen the lows and maybe we haven’t. But if you can buy a company, that you believe is a great company, at a much cheaper price, buy a little, hold and see if it goes lower so you can buy more. Just make sure the company you are buying can come out the other end without declaring bankruptcy. So companies with no debt, cash, at least FCF positive.

Hope that helps. But realize this is just my thoughts. Maybe someone else has a better idea.

Andy

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Thanks Andy, that certainly helps!

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Since most people use a price/sales ratio of 1, that says a lot. See below.

The appropriate price-to-sales (P/S) ratio to pay for a company will depend on a variety of factors, including the company’s growth prospects, profitability, industry trends, and market conditions. Generally, a lower P/S ratio indicates a company is undervalued relative to its sales, while a higher P/S ratio indicates a company is overvalued.

However, it’s important to note that there is no one-size-fits-all answer to this question, as what constitutes a “good” P/S ratio will depend on the specific circumstances of the company in question.

Some investors may use a P/S ratio of 1 as a rough benchmark for valuing a company, but it’s important to consider other factors such as the company’s growth potential, profitability, and competitive position.

For example, a company with strong growth prospects and high profit margins may justify a higher P/S ratio than a company with lower growth and lower margins. Additionally, different industries may have different average P/S ratios, so it’s important to consider the industry context when evaluating a company’s P/S ratio.

In summary, while the P/S ratio can be a useful tool for evaluating a company’s valuation, there is no single “good” P/S ratio that applies to all situations. Investors should consider a variety of factors when evaluating a company’s valuation, including growth prospects, profitability, industry trends, and market conditions.

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If they got there and had dividend with a payout ratio of 100%, they’d be paying the same as a 5 year treasury.

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P/S is a really bad metric. Retail has low margins and low P/S multiples as a rule. Software has higher margins and higher P/S. But that says nothing about which sector is a better investment or how you can compare companies within sectors.

Let’s say we four magical companies that can pay out 100% of profit and still grow, and both have $100M in revenue right now. Let’s assume a discount rate of 4% and no dilution. Let keep it simple and use the DCF formula here Discounted Cash Flow (DCF) Explained With Formula and Examples

Company 1 has 10% margins, 10% growth. Company 2 has 10% margins, 20% growth. Company 3 has 20% margins, 10% growth. Company 4 has 20% margins, 20% growth. The net present value over a 10 year window, discounted by 4% of them looks like this

Company 1
10 11 12.1 13.31 14.641 16.1051 17.71561 19.487171 21.4358881 23.57947691
1 1.04 1.0816 1.124864 1.16985856 1.216652902 1.265319018 1.315931779 1.36856905 1.423311812
10 10.57692308 11.18713018 11.83254153 12.51518816 13.23721825 14.00090392 14.80864837 15.66299347 16.56662771 130.3881747
Company 2
10 12 14.4 17.28 20.736 24.8832 29.85984 35.831808 42.9981696 51.59780352
1 1.04 1.0816 1.124864 1.16985856 1.216652902 1.265319018 1.315931779 1.36856905 1.423311812
10 11.53846154 13.31360947 15.36185708 17.72521971 20.45217658 23.59866529 27.22922918 31.41834136 36.25193234 206.8894925
Company 3
20 22 24.2 26.62 29.282 32.2102 35.43122 38.974342 42.8717762 47.15895382
1 1.04 1.0816 1.124864 1.16985856 1.216652902 1.265319018 1.315931779 1.36856905 1.423311812
10 21.15384615 22.37426036 23.66508307 25.03037632 26.47443649 28.00180783 29.61729674 31.32598694 33.13325542 250.7763493
Company 4
20 24 28.8 34.56 41.472 49.7664 59.71968 71.663616 85.9963392 103.195607
1 1.04 1.0816 1.124864 1.16985856 1.216652902 1.265319018 1.315931779 1.36856905 1.423311812
20 23.07692308 26.62721893 30.72371416 35.45043941 40.90435317 47.19733058 54.45845836 62.83668272 72.50386468 413.7789851

If each has 1M shares, and ignoring taxes, you’d pay $130, $206, $250, and $413 per share for those cash flows today which implies P/S of 1.3, 2.1, 2.5, and 4.1. P/S is just a reflection of assumptions about growth and margins on current valuation.

In the real world, you’d use a higher discount rate, maybe a longer window for your net present value calculation, you’d take into account taxes (yours and theirs), company margins would change over time, and you’d have to account for future dilution. But you see how a company with 20% net margins, 20% growth, and zero dilution only has a P/S around 4. It’s really hard to justify a P/S of 10 under extended periods under real world circumstances.

I am just a hack at this, I’m sure lots of people know this better. But this is a fundamental way of doing a valuation, it is inescapable over the long term, Some people just forget it periodically when markets get too exuberant.

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This is excellent, thanks a lot Ajm101!

Had a query, if you don’t mind - So,

Those prices you calculated, aren’t they what is expected AFTER 10 years, assuming they maintain the same growth and margin for those 10 years?

So, as investors, are we typically paying for what a stock would be worth 10 years from now?

Thanks again,
Charlie

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No, that’s what they are worth today. It sounds trite, but in 10 years, they are worth the NPV of the next 10 years of cash flows at the discount rate at that time.

You model what you think the stock will do in the future, and you figure out what it is worth under those assumptions in the present. If you guess poorly, you will overpay. Every year (or quarter, or day) things might change to alter your assumptions, and you would update your model accordingly.

What I posted was was the summation of

profit in year 1 * (growth rate)^N / (1 + risk free rate)^N

for N = 0-9.

For a Saul stock, you’d probably say “well, we’re losing money, but we’re making money faster than we’re spending it… we’ll saturate the addressable market space in 5 years, so we’ll grow expenses at 30% for years 0-4 and revenue at 50% for years 0-4, then after that level off to 5% expense growth and 10% revenue growth”. Since you are buying shares in a company and not whole companies, you probably going to want to divide those future profits by the expected number of share at that point in the future, to account for dilution from stock based compensation. I’m not saying I endorse that, but that is how you might model that kind of growth in a presently unprofitable but fast growing company.

You can also try what I did with a risk free rate of 1%, and then change it to 5% to see how sensitive they are to interest rate changes. Doing long term forecasting with very low interest rates was pricing for perfection, and not safe.

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Thanks so much Ajm101!!! It is beginning to make sense now.
And wow, I dread to see how the interest rate changes will affect the price… I always wondered why the market is this worked up by interest rates increase…Surely, a 2% increase can not result in a 30% drop…What a fool I was…All along there was some means to actually make sense of the mayhem!!!

Thanks again!

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My pleasure, I’m barely decent at this, hopefully some more knowledgeable people can correct my mistakes. I’m certainly oversimplifying things. But what you said about “make sense of the mayhem” is why Ben Graham’s Intelligent Investor has an evergreen quality to it.

For just one example, many companies don’t pay out dividends. They reinvest the profits in future growth, and invest it in profitable new projects. A company’s competence at doing this (ROE) gets important in models. Best luck with your investing, and thanks for the exchange.

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DCF models work very well for companies that are predictable but for growth companies they are pretty much worthless. If you want to see what I mean just go over Aswath Damodaran’s Dcf on Tsla.

Andy

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I don’t follow Damodaran. Do you mean this? Musings on Markets: A Do-it-yourself (DIY) Valuation of Tesla: Of Investment Regrets and Disagreements!

I don’t think that’s an indictment of DCF. Tesla is just a pretty unique company in a lot of ways. It looks like Damodaran sold at a split adjusted price around $43? I bet he wishes he held, but sometimes one makes mistakes. What is Buffett’s #1 rule, though?

As a counterpoint, lets look at Upstart, and My Portfolio at the End of Aug 2021 - maybe a DCF analysis wouldn’t have helped here, but UPST is down almost 90% from that post. We are trying to predict the future when investing, and that is intrinsically risky to the downside and upside.

DCF is a tool, not a strategy, and I disagree with you that they are worthless for high growth companies. Models are models, and GIGO applies. Let me extend my example from earlier. Say we have “company 5”, that sits around doing R&D for 5 years, then releases a blockbuster that creates a $500M annual profit invention that grows 10% annually after it debuts to the world. What is that worth?

DCF says:

Company 5
0 0 0 0 0 500 550 605 665.5 732.05
1 1.04 1.0816 1.124864 1.16985856 1.216652902 1.265319018 1.315931779 1.36856905 1.423311812
0 0 0 0 0 410.9635534 434.6729892 459.750277 486.2743314 514.3286198 2305.989771

$2306 per share.

What if that company instead enjoys 2 years of success of that product, but in year 7 there is a disaster of some kind, and profit drops by 60% - but bounces back by $50M annual after that - and the discount rate goes to 1%?

Company 5
0 0 0 0 0 500 550 100 150 200
1 1.04 1.0816 1.124864 1.16985856 1.216652902 1.265319018 1.277972209 1.290751931 1.30365945
0 0 0 0 0 410.9635534 434.6729892 78.24896294 116.2113311 153.4142985 1193.511135

$1193.

The company doesn’t disappear after 10 years, so many one wants to pay more. Maybe someone really likes a company and wants to pay a 20% premium.

What various net present value financial models give you is a framework to discuss a value quantitatively. If someone says a company should command a 10x revenue multiple, you ask them what there TAM is, what their terminal net margin rate is, and you can see if that valuation holds water at all. It doesn’t matter if the company is a transformational SaaS or sells tin buckets.

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No. Sorry for my cryptical post. I am very prone to use 4 sentences to cover an 8 paragraph issue. I was taking a great leap to say that a stock’s p/e “should” be the inverse of the treasury 10-year yield. The yield today is 3.77% . The inverse is 26.5. The value investor would want a discount to that. Graham wanted what, a 1/3 safety factor?

So the idea was exactly what you asked, “What has to happen for that?”. There are other theories (of course) on what a “correct” p/e is. I did a quick search and (of course) did not write down the links. There was a MF article that mentioned (did not advocate for) a “correct” p/e of 1. A more common benchmark is a p/e equal to earnings growth rate (rearview mirror approach). That never made sense to me as it seems to give no value to current earnings. The PEG uses a forward looking earnings (forecasted). Saul’s approach was to use a rearview approach with the apparent assumption that earnings growth would maintain the fairly recent growth trajectory–his 1yrPEG. That worked splendidly, until it didn’t. I didn’t because it got discovered and there weren’t any sub-1 1yrPEG’s. Ironically, this was a valuation based investment system which no longer worked because there weren’t any undervalued stocks.

So then came profitless hypergrowth and EV/S, which worked–until it didn’t. And for the same reason. No more 100% revenue growth with EV/S of… 4, 5, 6? And then the metric was to compare peers, the way Bert still operates. The cohort of 60% growers average an EV/S of… 27 and XYZ’s is 20–and tweak for some flavor of cash flow. That stopped working when all the cohort had unreasonable EV/S. Cheaper than ridiculous isn’t necessarily cheap.

A proposed evaluation method was to look at fast growers. Not hypergrowth. More mature growth like Sales Force, Service Now, maybe Palo Alto Networks. What EV/S do they have? (Still can be “cheaper than ridiculous”, of course). 20 or 25% growth is still exceptional from a broad market perspective. Would you take a 25% CAGR? Now you run into the same problem as the DCF approach. Fraught with predictions of future performance and future tech advances and future competitors and present competitors which evolve to eat your lunch by moving into adjacent verticals, etc. It is a fragile model. Highly dependent on at least two factors: 1) The predicted revenue growth trajectory, and 2) Mr. Market’s mental state. "“Mood changes, or swings, refer to abrupt shifts in your mood or emotional state, and may be a normal response to stress or hormonal shifts . However, they can also signify a mental health disorder like borderline personality disorder or bipolar disorder, which is characterized by extremely high and low moods.” Never a shortage of stress in the world and certainly not now. We witnessed and to an extent participated in extraordinary stock investment returns. It is difficult to get weaned from those highs. Perhaps the real question is whether we should be investing in tech growth at all, or to what extent. And if so, pick individual stocks or a broader basket or ETF’s? What basis do I have in choosing between internet security and e-commerce sectors . Between companies, ZS and OKTA. S or CRWD? GLBE or SHOP? Central bank responses to G20 fiscal “policy” has so distorted price discovery that maybe nothing works. Unprecedented actions just grossly inflated asset prices. That’s the reality and we are having to deal with inflation of real goods and deflation of financial assets–and derivatives of financial assets in particular, I believe. For those who are building wealth, I would put maybe 15% into a basket of high growth. 40% into small cap ETF. 45% into midcap value. Something like that. Every month. Would I do that? Probably not, but do as I say, not as I did/would do.
Dreamer has outlined his target, at least time-wise. Dreamer, you are taking on risk in order to protect your capital (shorting and buying puts). In your situation, I would consider very short term treasuries that are yielding 5.5% to 6% right now. I don’t know how easy that is to do. The treasury that I have was issued 10/15/2020. I purchased on 9/23/22. Maturity is 10/15/23, so it was 13 months out. Coupon yield is… drum roll… 0.12%. Current 3 year is 4.23% so that is a reference to the disruption the market has endured. 33 times increase in yield. Poor SVB, eh? (I paid only $95.90 so I didn’t invest for 0.12% yield). Here we have a wealth builder, a close-to-retirement guy who wants/needs “just a little bit more”, and an old guy 20+ years into retirement who needs the wealth to last another 19 years (28 for DW). And each owning, or willing to own at “right price”, DDOG. And, I suggest, all not qualified to determine “right price”, which quite probably is not knowable anyway.

What has to happen for DDOG to get to p/e of 25? Maintain a 10% per year reduction in revenue growth rate from its rate 6 months ago while maintaining GM and reducing SG&A to % of revenue to those of the mature growers. Dreamer modeled a much more rapid decline in revenue growth rate than I did. He is waiting for a correspondingly much lower price. I have 5.4% of port in DDOG, up 20% on the position established December, January, February and March.

Throwing rocks at the moon, folks.

KC

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Thanks a lot KC, Ajm and Andy! Very insightful!!

In every DCF model, don’t you need a terminal growth rate at the end of the growth trajectory? Say, year 11 to infinity.

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