Per Jefferies "Software Stocks are Overvalu

This article goes along with all the discussion on valuation that has been going on here.…

Key points:
Historically, software companies have traded within a band from a two-times to 12-times enterprise value to revenue multiple, per Jefferies research. While the lower end of this band has remained steady for software stocks, the higher end has pushed to a 20-times enterprise to revenue multiple.

“Even historic terminal M&A takeout multiples do not support these valuations (CRM acquired MULE for 16x EV/NTM revs., CRM acquired DATA for 11x, and SAP acquired for Qualtrics for 17x). As such, we believe current valuation multiples for the high growth names are unsustainable and we expect that the correction will continue,” writes Jefferies.
The way to play software in Jefferies mind? Stay clear of momentum, and dive into a solid grower that pays a dividend such as Microsoft.

The thing I find most useful about the article is the chart comparing EV/S ratio on the vertical axis shown on the left side of the chart, and growth rates showing horizontally left to right marked under the chart.

A statitian will say this scattergram has a very high r^2. That is, there is a direct correlation between low growth rates and low EV/S and high growth rates and high EV/S.

So I’m not sure how far back Jeffries’ “historical research” went. If it was the last 15 years or so, as several have pointed out, this sudden influx of high growth companies is a new phenomenon. There simply weren’t nearly as many companies growing at 50, 60, 70% a year, let alone hold that growth rate for several years on end. I can EXPECT the current valuations be higher than historic. As I had mentioned earlier, MSFT opened at 20x Earnings on it’s IPO, not 20x sales, but earnings. Which would have been what, maybe 4x sales? If that? If anything less? So what then is normal? An IPO coming out growing revenue at 74% a year at 4x sales, or that same company as a mature juggernaut at 8x sales?

Will we EVER get such a fast growing software company to IPO at 4x sales again? My thought is no.

I went back like a year ago to try and gauge a trend of what P/S ratios new IPOs were coming out at. MDB AYX, SHOP and the like opened at anywhere from 8-12x sales. These companies IPOed before the stocks really started skyrocketing in price. Only recently did they start IPOing at 40-50x sales then just keep going up. It was clear to me that the new IPOs already had a lot of the price expansion baked in from the start. Another red flag for me was CRWD was valued at $3 billion the year before it went private, then here it was valued at $22 billion as an IPO just a year later.

I didn’t buy any of these stocks, but it didn’t stop me from losing money as MDB, ZS, ROKU, and finally AYX all started going down. So all that “caution” I displayed didn’t do me any good.

But back to that scattergram, we can see that ZM is priced the highest, and also growing the fastest. It was my opinion that as ZM and CRWD’s very high growth rates were unsustainable, and the market was simply looking at nothing other than current growth rates when valuing these companies at 50x sales. It wasn’t even considering that within the next year, both of these companies are more likely to be growing at 80% or less. At which point, price multiples would contract.

This is one of the reasons I have avoided ESTC over the past year, as revenue growth slowed, causing the price multiple to come down, causing the stock price to stagnate. It is clear now that just the lockup expiration was not holding the stock back.

GauchoChris wanted to investigate historical P/S ratios of software companies and was apparently working on a project. This website makes it relatively easy:…

It’s kind of hard to determine what the “right” or even “historical” P/S ratio really is, since the metric tends to be all over the place over time, and will vary from company to company. ORCL I believe fits more in line with the profit margins we can expect some of these SaaS companies to finally mature at, which is around 25% net profit margin. Looking at ORCL, it tended to spend a lot of time around 8-10x sales from 2006 to 2019. Even only going back to 2006 is probably misleading, when we hear about the software companies in the 1980s trading at around 10-20x earnings, not sales.

But at the end of the day, 1) I am not going to buy stocks at sky high valuations just because they are currently growing fast, especially when that current growth rate is slowing, and 2) I have no problem buying MDB at 19x sales if the “historic” valuations for a typical slow growth software company growing at 1/4 the rate of MDB, is half the valuation MDB is currently.

One thing I believe though, is we are out of the “bubble” territory and it’s no longer a worry for me.

What I will NOT do is take Jeffries’ advice is to completely abandon my methodology and start playing timing games or just stop being a growth investor and buy Microsoft.