My thoughts about the valuation of our companies
I was curious about what your thoughts were to the maximum limits of your valuation stock price being irrelevant. Using SHOP at 19.9 p/s, many people say this is an extremely high valuation, including myself. Does this valuation give you any hesitation when building out a position? If not at what level would you begin to hesitate due to valuation of this type of growth company, or do you use different valuation metrics entirely?
Maraj asked a good question here. I know I’ve answered it before, but I’ll take another few swings at it.
First: A shameful admission. I don’t really look at P/S ratios and couldn’t tell you the P/S ratio’s of any of my companies. Why? Consider a supermarket company that has a maybe 3% margin and a software company that has a 95% margin. That means $100 million in sales is worth $3 million to the supermarket company and $95 million to the software company. How do you compare bare P/S ratios in any meaningful way?
Second: Growth matters. Our companies are growing VERY fast. A company compounding sales growth of 60% for just three years (hard to do, I grant), would have over four times current sales and cut that P/S by a factor of four. In other words that $100 million in revenue we were talking about would grow to $410 million in just three years at that pace.
While it’s hard to do it can be done. For example, Shopify compounded 100% growth for four years, and then this last year it “slowed down” to 73%. That was $24 million, $50 million, $105 million, $205 million, $389 million, $673 million. Take a good look at those numbers! Revenue has grown 28 times in five years. That’s not 28%, or 280%! It’s 28 TIMES, a 28-bagger (that’s the power of compounding), in just five years.
Third: Our new SaaS companies are a new breed, and the accounting and evaluation metrics haven’t caught up with them yet. Look, if your company manufactures cell phones, washing machines, dishwashers, refrigerators, railroad engines, or microchips, you sell one this year and next year you have go out and sell a new one, with no great guarantee that you will, or that your customer will need a new one. If you have $100 million in revenue this year, who knows what your revenue will be next year? On the other hand, when our SaaS company signs up a new customer, for all practical purposes, it’s forever! We only see one quarter’s revenue, but the customer is leasing a program that becomes so intertwined with their business that it becomes more and more difficult to extract it and switch to another provider.
Fourth: In fact, most customers will sign up for new services next year, so most of our SaaS companies have dollar based retention rates of 120% to 130%. That means that that $100 revenue becomes $120 or $130 million next year, just from existing clients, before they even sign up any new clients. That’s a 20% to 30% growth rate “guaranteed,” before the first new client signs up!
Fifth: Then there is deferred revenue. This is money paid for a year (or two years) in advance, but which can only be recognized quarter by quarter. It doesn’t mean any additional revenue in the long run, but having the money in the bank, and resultant positive cash flow, means the SaaS company won’t have to go out and raise more money unless it wants to. It also means that those customers really are signed up forever if they are willing to pay in advance to get a slightly reduced lease rate.
Sixth: Let’s look at sales and marketing expense. If you sell a refrigerator, a bicycle, a railroad car, an oil drilling rig, your sales and marketing expense, with its salaries and commissions, goes into more or less the same quarter where you recognize your sales revenue, and it makes total sense. That enables you to see how well your company is doing.
But you remember that I said, when talking about SaaS companies, that the accounting and evaluation metrics haven’t caught up with them yet. As I understand it, when a SaaS company makes a sale, the sales and marketing expense, with its salaries and commissions, goes into the quarter when the sale is made, but only one-fortieth of the revenue that will come from that sale over the next 10 years with very little further S&M expense, is recognized in that quarter. (One quarter’s worth out of forty quarters).
Probably a lot less than one-fortieth actually, as the customers usually spend more each year (see dollar based retention rates above), maybe one-one hundredth, but we can be conservative and think of it as one-fortieth.
Seven: So guess what? Duh…! The S&M expenses dwarf the revenue at first, and the SaaS companies show big “losses” according to current accounting. How could they not if all the sales expenses are counted, but only 1% to 2% of the total revenue from the sale is counted.
As opposed to the companies selling bicycles or oil rigs, current accounting does NOT give you an idea of how well your company is doing. As I’ve heard more than one SaaS company CEO say something like, “We’d be crazy not to spend every penny we can of S&M to sign up new customers now, before anyone else signs them up, because they will be our customers forever.”
So when people make snarky remarks about our “loss-making” companies, remember that they may not entirely understand what is going on.
I hope that this helps.
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