Thoughts on traditional EV/S, and why EV/S has little to do with our companies.
Some who are new to the board seem almost personally offended by the fact that our stocks usually have EV/S ratios which are very high by traditional EV/S standards.
I don’t have the answer to what is “overvalued,” but I know that traditional EV/S ratios have very little to do with our companies! Our companies are profoundly different than the companies that EV/S was traditionally used for. Why? Here are some reasons:
First of all, a company with 70% to 90% gross margins is worth a much higher EV/S ratio than a company with 30% or 40% gross margins because each million dollars of sales is worth so much more to the company in take home dollars.
Just think about this for a minute. If you have 85% gross margins, a million dollars in sales is worth $850,000 to you. If you have 42% gross margins (still quite acceptable), the same million dollars in sales only brings you $420,000. Now really think about that. How can you put the same million dollars in the denominator of EV/S and expect to get a sensible value? Our company with an 85% gross margin is naturally worth twice the EV/S of a normal company with a 42% gross margin, other things being equal.
And a company with a 28% gross margin (believe me, there are plenty of those too, in the real world) only keeps $280,000 out of that million in revenue. How can you put the same million dollars in revenue in the denominator of EV/S for all three of those companies??? Our company with 85% gross margin is naturally worth three times the EV/S sported by the 28% gross margin company, other things being equal… But… other things aren’t equal!!!
Secondly. For a company that is leasing software that becomes integrated into the core of the customer’s business, and with a subscription model that brings in recurring revenue, each million dollars of sales today is not just for this year. It’s for next year too, and the year after, and the year after that, and…. pretty much forever. No one, simply no one, is going to tear out a system that is core and essential to the smooth running of their business, and that would disrupt their entire business to pull out, to save a few dollars. It ain’t gonna happen folks.
Okay now, you have a million dollars of sales this year that will, for all practical purposes, be there next year, and the year after too, and new sales next year will be an extra bonus added on. When you put that million dollars into the denominator of the EV/S equation, what do you have to multiply that million dollars by to take into account all those future years of recurring revenue? By three? By four? By five? That sure brings down the real EV/S for our SaaS companies, doesn’t it?
Compare it to a clothing manufacturer (just for instance). It sells 100,000 coats this year, but has no idea if it will sell 100,000 coats next year, or even 50,000 (maybe another brand will be in fashion). Recurring revenue on a subscription sure beats the heck out of that, doesn’t it? At first glance that clothing company example may seem irrelevant. But no, the EV/S of maybe 3 or 4 that it carries, has helped to shape the idea in your head of what a EV/S normally is. But if the clothing company’s EV/S is 3, if one of our companies has the same revenue (the same S in the denominator), what should its EV/S be? Four times that? Six times that? Ten times that?
Thirdly. But wait! This year’s customers will spend more next year. Our companies have a dollar-based net retention rate maybe averaging 125% or so. That means that this year’s sale revenue isn’t just going to recur next year, but it will be 25% bigger next year, and bigger the year after that. Well of course a company with a 125% dollar-based net retention rate of recurring and growing revenue will have a higher EV/S ratio, than a normal company with the same revenue, the same S value, down there in the denominator, which may not even be there at all next year … (duh!)
Fourthly. And then there is growth rate! Well, of course a company that is consistently growing revenue at 50% to 80% is going to have very high EV/S ratios, because in just two years a consistent 60% growth rate means they will have more than two and a half times as much revenue as they have now. That’s in just two years! (And several of our companies have 90% to 130% growth!!!)
And in three years, that 60% growth will mean more than four times the revenue they have now!
And in four years, more than six and a half times the revenue they have now! That will sure bring that EV/S ratio down, won’t it? I won’t go beyond four years but that’s enough. (You won’t believe it but a fifth year will bring the revenue to more than ten times what you started with. Obviously they don’t need to keep a 60% growth rate to really push up their revenue! That S in the denominator is going to grow rapidly.)
Fifthly. And these companies are capital non-intensive. To double their revenue they don’t need to build a new factory, and buy new machinery, and hire new factory workers, etc or open new stores, or…whatever. They can just double their revenue in the cloud with pretty much the only expense being S&M to get the new customers. And then, as we wrote above, the customers are there almost forever. Just think what that does to traditional valuation.
Sixthly. And being non-capital intensive means that almost none of our companies have any debt. They have cash and equivalents. Inflation won’t mean they have to pay a lot of interest. It means they will make more interest on their cash.
Seventh, and finally, of course a company that is leasing a software solution that every enterprise on the planet needs, and that the vast majority don’t have yet, and that all those companies will keep indefinitely once they install it, will have a higher EV/S ratio than a company selling a product that anyone can put off getting a new model of, or stop buying for the duration of a recession, etc.
Here’s the key to this: You can live another year with your old cell phone, or computer, or car, or raincoat, or refrigerator, or kindle, or ski jacket, or your old factory, or whatever, without buying a new one next year, but once you lease this software, you keep leasing it indefinitely (no stopping for a year.) If you think about that and understand it, you’ve gotten the message!
And of course, of course, of course, companies that have ALL these features…
Leasing software, not a physical thing that requires capex to expand
70-90% gross margins AND
a subscription model with recurring revenue AND
125% net retention rates AND
growing revenue at 50% to 80%, AND
selling products that all enterprises need
low capital intensive
no debt and plenty of cash …
are going to have very high EV/S rates (…duh), and I don’t know what is high, but I will NEVER sell out just because the price has gone up, and because some people think the EV/S is too high. (Although I will trim if my position size has gotten too large). I just don’t know where these companies will ultimately end up.
My decision about my confidence in a company is based on gross margin, recurring revenue, growth rates, dollar-based net retention rates, necessity to their customers, dominance in their field, my confidence in management, and how all that looks to me for the future. Traditional EV/S enters very very little into the equation.