I read your post with great interest. I am going to run it on some of my highest conviction holdings and see what it tells me. As you outline in your analysis, it appears to be an additional tool that works best when comparing to additional metrics such as P/S and revenue growth.
On a related note, I spent a number of years evaluating M&A targets of various free standing medical clinics in a 20 state region. We often used this metric to help prioritize our targeted acquisitions; where best to direct our limited resources (time & capital). Additionally, once acquired, we very often used this metric on which to negotiate and base the “earn out” with the practicing doctor group.
Revenue Growth is great because in some businesses, revenue growth can cure a lot of ills. However, in a medical practice, like many other businesses…what good is Revenue Growth if it is not profitable growth. Specialty medical practices could be doing tremendous volumes, but all of the downstream profit was walking out the door via doctor salaries, advertising, administrative support, opulent facilities = extremely high occupancy costs, etc.
I think you are definitely onto something and quite frankly, being familiar with the concept, I never considered applying it to my investment portfolio.
If you divide the P/GP ratio by the revenue growth then you have what would be similar to a PEG ratio. That would give you a number that you could compare between companies.
Bear, you are a man after my own heart! Here’s what I wrote in my June Portfolio Summary where I gave my explanation of why our stocks are so highly valued:
"And revenue which has very high gross margins is worth more per dollar of current revenue (in other words, it’s worth a higher EV/S) than lower gross margin, revenue. WHY? Let me explain it to you.
EV/S, which is traditionally used for evaluation, puts sales (revenue) as the denominator. But that’s silly! On $100 million of sales Alteryx, with gross margins of 90%, keeps $90 million, while a grocery chain, with gross margins of 10%, keeps $10 million on the same $100 million of sales. Revenue by itself doesn’t tell you much of anything. It’s the gross margin dollars which ought to go in the denominator, not total revenue."
I do something very similar, i.e. I calculate the terminal net margin to scale at the same ratio as gross margin. So, if we have 2 companies with 80% and 40% GMs and we assume the terminal net margin for the first one to be 24% the second one should be 12%. But lately I have been thinking that some companies may just have much higher operating costs and a really low COGS thus distorting the picture. It will be interesting to see the Net:gross profit margin ratio for a bunch of large software companies to see if they are indeed similar.
I do something very similar, i.e. I calculate the terminal net margin to scale at the same ratio as gross margin. So, if we have 2 companies with 80% and 40% GMs and we assume the terminal net margin for the first one to be 24% the second one should be 12%. But lately I have been thinking that some companies may just have much higher operating costs and a really low COGS thus distorting the picture. It will be interesting to see the Net:gross profit margin ratio for a bunch of large software companies to see if they are indeed similar.
So, yeah, Operating Expenses (OpEx) are the rest of the picture. Gross Profit minus OpEx = Net Income
So you could just look at Net Income, obviously. But I think how you get there tells you something. The P/GP tells you how potentially profitable a company could be if the OpEx is reasonable. So maybe looking at whether the OpEx is reasonable is a good next step. Last quarter here’s what they were as a percentage of GP:
Stitch Fix has a slower growth rate and lower margins, so it’s not exactly the same.
3.4 is correct. The fear, I would imagine, is that they will suffer the fate of so many other clothing companies, and margins will erode over time. (If the quality isn’t good enough, people won’t pay a premium for long. And quality clothes aren’t cheap to make. It’s just a hard business.)
Even American Eagle, which has been around since the 1970’s, only sports a P/GP of about 1.8. So maybe 3.4 is saying that the market believes in SFIX!
Yes OpEx as % of GP is a good next step. On Roku as the player rev % drops GM should rise into the 50%s. Also its Opex are likely to be lower than other software companies as you already note. So Roku despite its lower GM can be an outlier. Agreed, TWLO looks bad in this regard.
I think P/GP compares these companies’ valuations in a more interesting way than P/S. I have already incorporated this into the numbers I track. I’ll see what the response is here before I discuss it ad nauseum, but I think it’s at least worth considering along with P/S or EV/S.
IMO, this has little to no value.
Just a few of those reasons are:
The gross margins issue was already accounted for in the initial selection of the stocks…they all have very high gross margins (other than say TWLO and ROKU). It is easy to spot this without another calculation.
There is historical data on P/S in like-industries and against the actual stock itself…not the case with your P/GP. It can be very helpful to graph historical P/S over time for a given stock…that data is readily available.
There is very little logic IMO to compare unlike industries (SaaS or not) by their P/S or P/GP regardless. Just because TTD may have a lower P/GP doesn’t make it a buy over an MDB with a higher P/GP…different industry and different growth/risk prospects.
So for me, this number crunching machination doesn’t seem to be discerning for buys and sells. Not worth the effort IMO.
Bear,
Interesting take to get real numbers from companies not making much in the way of true earnings.
In one of the follow on posts you mention comparing these numbers versus revenue growth. That isn’t bad but it has a little apples and oranges feel. It seems like the better method and more logical follow through would be to then compare Gross Profit growth rates since this is the basis of the original ratio and includes the margin thought into the growth rate as well.
I apologize for not just calculating the numbers but I just dont have the time today and it would take a little effort to get the right numbers going back, but certainly does seem interesting.
Anyway, just a thought. No ratio is perfect because whatever you leave out (selling costs) can always swing the overall profit of a company and is important, but still, an interesting thought process…
I’m thinking the growth rates should be very similar. For instance, if you have 100 in Revenue and 50% GM then gross profit is 50. If you grow that revenue 100% to 200 then 100 falls to gross profit. So gross profit would also increase 100%.
Just quick back of the napkin math but it should be similar.
Interesting take to get real numbers from companies not making much in the way of true earnings.
It is my personal opinion that if we are able to establish another metric by which high growth companies can be evaluated, then we are one step closer to focusing in on the “best of the best” high growth companies. Putting the best of the best through these additional filters/ratios may allow some of us to make decisions about conviction and allocation.
Putting the best of the best through these additional filters/ratios may allow some of us to make decisions about conviction and allocation.
The flip side of which is that reliance on such metrics to make buy and sell decisions can result in us making as deep an analysis of the company, it’s business, and it’s market.
I think the ratio is useful as it is relatively simple to calculate and provides another data point.
There is an easy way to calculate this that gives a good approximation as long as gross margins don’t fluctuate much from quarter to quarter. Just take the P/S and divide by the gross margin the past quarter.
As an example, PS of 15 divided by 0.8 (80% GM) gives the approximate P/GP of 18.8.
I’m sure others have figured that out already, but it makes the calculation a bit easier though not perfect. Since GM doesn’t fluctuate to a great degree with SaaS companies (CRWD excepted), I think it can be useful.
The highest two I’ve seen thus far are SHOP and CRWD at 44.1 and SHOP at 42.7.
On a forward basis, CRWD is far more reasonably valued.
I haven’t analyzed ZOOM and would expect it to have similar characteristics as CRWD.
Here is what I show for P/GP for several companies. The growth rates are mine and are revenue growth which also assumes gross margins are relatively steady over the next 12 months.
