I had hoped to generate some discussion with my explanation of why our companies have had such a valuation expansion, but with all the 174 recs on my end of the month summary, the explanation seems to have gotten lost, so I’ll try it again. Agreement, disagreement, or just comments are all welcome. Here it is again.
Saul
Some investors are very questioning of the valuation of our stocks, which are very high-valued in EV/S terms compared to conventional stocks. I’m sure that some of you have wondered how and why our companies are valued so much higher than conventional companies. I therefore thought that I should give you a more detailed explanation about why our companies have had such a valuation expansion, which has occurred as other investors (and the market) have gradually realized what I will be explaining below. I’ve gone over and over and over my explanation many times to make it as clear as possible, and I hope that it is understandable to you and makes good sense…
It’s not that this “time” is different, it’s what we are investing in that’s different. What we are investing in never existed before. Look, ten years ago I searched for companies growing at 15% or 20% a year. And 25% was a dream come true. Now I wouldn’t even bother looking at a company with 20% or 25% revenue growth.
We are investing in a new model of enterprise. Our companies have very high revenue growth year after year. I’m talking about 40% to 65% per year for most of them, but some even higher. These are very high gross margin companies (70% to 92% for the most part). Their revenue is almost all recurring and thus largely locked in, and their dollar-based net retention rates are generally considerably greater than a very respectable 115-120%, meaning that last year’s customers buy a lot more this year than they bought last year, instead of having an attrition rate, or even, forbid-the-thought, companies which have customers making one time purchases, and thus which don’t even have any revenue guaranteed next year at all. I’ve never seen companies like ours before. Have you?
Now of course a company growing revenue 50% per year, with 95% recurring revenue, 92% gross margins, and a 130% dollar-based net retention rate is worth a much, much, higher EV/S than the old model of company, with fairly low revenue growth, low gross margins, and with little or no visibility into revenue for the next year and beyond!
And of course companies without security of revenue had to show a profit (PE) before we’d invest in them. Of course we pay more for a company where revenue is recurring.
And, of course rapidly growing revenue which has very high gross margins is worth more per dollar of present revenue (in other words, it has a higher EV/S) than slower growing, and lower gross margin, revenue. WHY? Let me explain it to you.
Look at it this way. Let’s consider an extreme example for clarity of understanding: I’ll take hypothetical conventional or traditional company and compare it with an equally imaginary one of our SaaS companies:
Let’s say that our conventional company has a 23% gross margin. That means it keeps $23 out of every $100 of revenue to cover operating expenses and profit. And let’s say our SaaS company has a 92% gross margin. That means that it keeps $92 out of that same $100 of revenue. (I said it would be an extreme example, but Alteryx had a 92% gross margin last year, and a 55% rate of revenue growth).
Almost by definition, the SaaS company is worth four times as much as the conventional company for every dollar of revenue, because it keeps four times as much of every dollar of that revenue as gross profit….
Thus, it would be totally normal for the SaaS company to have an EV/S ratio four times as high as the conventional company, even if they were growing at the same rate. The high margin company should have an EV/S ratio four times as high! (And, for example, if you were comparing it to a conventional company whose gross margins were 31%, our SaaS company should have an EV/S three times as high, etc.)
Note that that is WITHOUT even taking into account the higher rate of growth, which compounds, and without taking into account the recurring revenue.
“Okay, so tell me:”… WHY is the rate of growth important for comparing EV/S? There’s a heck of a good reason! Next year our company growing at 50% with high margins will have $150 of revenue instead of $100, and with its 92% gross profit margin, it will keep $138 toward covering operating expenses.
Let’s say our conventional company is growing at a nice steady respectable 10% per year. Next year, it will have just $110 of revenue, and with its 23% margins it will keep just $25 towards operating expenses. So now we have $138 versus $25… one year later! The difference in compounding is enormous and grows each year…
It’s astounding in a way, but if we go just one additional year later our SaaS company will have $225 in revenue and will keep $207… while the conventional company will have revenue of $121 and keeps $28.
Look at that again! The two companies both started two years ago with revenue of $100. Now our company is taking home $207 in gross profit , while the conventional company is taking home $28!!! Just two years later!
I won’t trouble you with the calculation for the third year, but our SaaS company growing at 50% will keep $310 in gross profit, which is ten times the $31 the conventional company will keep in gross profit. That gives you an idea of the enormous power of the combination of high growth and high gross margins that our companies are blessed with.
And for those who will maintain that companies can’t maintain 50% revenue growth for three years, Zscaler was over 50% the last two years, and at 59% and 65% the first two quarters of this fiscal year. Twilio was 66%, 44% and 63% for the last three years, Alteryx has been 59%, 53% and 55%, etc, etc, etc.
If the conventional company is trading at an enterprise value of let’s say, four times its revenue, isn’t our SaaS company worth 15 times revenue, or 20 times… or 25 times!
Remember that in two years the SaaS company will be taking home 7.4 times as many dollars in gross profit as the conventional company, and 7.4 times an EV/S of 4 gives you an EV/S of about 30. That’s what many people simply don’t get. You don’t even have to look at that 10x three-year example, which would justify an EV/S of 40.
You can argue that the rate of growth for the conventional company should be 13% instead of 10%, or that it should have a gross margin of 28%, or 35%, instead of 23%, and that will change the numbers slightly, but it won’t change the story at all.
And in our defense, my example used 50% revenue growth, but Okta was the only stock in my portfolio with revenue growth that low last quarter. All the others were above it. In fact, the percent rates of growth of revenue for my companies last quarter were 50%, 51%, 56%, 58%, 59%, 65%, 71%, 81%, and 108%. Thus you see that using 50% for our SaaS companies in the calculation was no exaggeration. In fact, it was actually being quite conservative. And five of my nine companies had gross margins over 80%, and two others were over 75%.
Now let’s consider that our company has almost all recurring revenue, and a dollar based net retention rate of 130%, which means that it is enormously more certain that our SaaS company will have increased revenue next year than that the conventional company will even have the same revenue next year. How much is that worth in increased EV/S? Is that security of our revenue worth another 30% tacked on? Or 20%, or 40%. I don’t know. But it becomes clear that, by simple arithmatic, the reason that our SaaS companies are exploding in EV/S is that the market is starting to do the same arithmatic that I just did.
To summarize
We have Factor One – that a company with a higher percentage of gross profit, takes home more dollars out of each $100 of revenue, and thus, by definition, is worth a higher EV/S, even without considering the higher rate of growth.
Then Factor Two, which is perhaps even more important, that companies with high rates of growth of revenue will compound that revenue enormously in just two or three years, and that, combined with the high gross profit margins, will produce hugely more gross profit margin dollars than a conventional slower growing company that started with the same revenue.
That our companies have an even greater EV/S (EV divided by current sales), flows by definition from that, when compared to a conventional company with the same revenue!
Finally Factor Three, which is perhaps less easy to quantify, but a large percentage of recurring revenue and a high dollar based net retention rate gives much more security to the revenue, and to its potential increase, and thus would warrant an even further increase to the EV/S in some investors’ eyes (like mine).
To summarize the summary,
What we are talking about is that the huge, even enormous, present and future relative number of gross profit margin dollars that our companies have, and will have in the future, for each current dollar of revenue, because of their growth rates and high gross margins, compared to the relatively small amount of gross margin profit that a traditional company has, and will have, for the same current dollar of revenue, is what gives our companies the much larger EV/S ratios. Simple as that!
And don’t bother telling me our companies are not making any profit. Any company with 75%, 85% or 95% gross margins can make a profit whenever they decide to! All they need to do is slow down their enormous S&M spending, whose purpose is to grab every new customer they can grab while the grabbing is good. Personally, I’d rather they keep grabbing all those customers now, because revenue will keep flowing from them for the indefinite future.
So YES, this is a different set of facts we are dealing with. And yes, it is different this time. That’s how I see it anyway. And I hope that I made it clear for you.
