Sharing some thoughts about valuation

[BobbyBe]

While the typical investor might look at our stocks and say they are way overvalued, with a p/s ration of say 22 (outrageous! they would say), we know better. We know that our stock’s 22 P/S ratio comes with revenue growth that is upwards of 50% and may very well be accelerating.

So assuming no price change and no acceleration in growth, my sleepy math figures the p/s of our company growing at 50% becomes…

16.5 in one year
which becomes 12 in two years
which becomes 9 in three years
Which becomes 6 in four years
Which becomes 4 in five years.

Now, we are seeing these companies as having up to a decade or more of exponential growth. Some of them have accelerating growth closer to 100%. A P/S ratio of 22 for a company like this is a downright bargain!

So two questions come up…at what point would such a company become overvalued? Would you pay 66 p/s for a company you think will grow revenue at 50% annually for a decade? What’s your limit?

Second, how do you determine if costs will continue to exponentially increase inline with sales? Our companies are mostly not profitable, but the idea is that they will be profitable at scale. But what if that doesn’t happen? Does anyone factor this into their analysis? What tools do you use? This is why I stay away from the CRM space and companies like Salesforce and Hubspot. It seems to me as if CRM is so competitive that companies will always be spending to outdo each other. But I don’t know how to research this to come up with a definitive conclusion. This has been an argument that people have made against growth companies for ages, eg amazon. But it looks like the bear thesis is wrong here and Amazon’s profits are set to start moving in the next few years. So when might the bear thesis be right? Any thoughts?

[captainccs]

So two questions come up…at what point would such a company become overvalued? Would you pay 66 p/s for a company you think will grow revenue at 50% annually for a decade? What’s your limit?

Q 1 Part one, at what point would such a company become overvalued?

When everyone has one and there is no one left to sell to. That’s what that the “S” curve is about. When market penetration approaches 85%, growth start slowing and multiples start contracting. A company can have multiple overlapping “S” curves: iPod, iPad, iPhone, iWatch, iWhatever or newer versions.

Q 1 Part two, each industry has typical multiples, it’s not one fits all.

“S” curve https://www.google.com/search?q=S+curve&num=50&newwi…

Second, how do you determine if costs will continue to exponentially increase inline with sales?

In the Profit & Loss Statement look at the margins, Gross, Operating, and Net.

Denny Schlesinger

[PaulWBryant]

Would you pay 66 p/s for a company you think will grow revenue at 50% annually for a decade? What’s your limit?

This question is so key. The market has struggled to answer it. For example, in 2016 when Shopify was growing 100% YoY, it was valued at a PS of 10 or so. Now even though they say growth will be below 50% soon, the PS is more like 20. The market has increased its answer to your question. No one thinks SHOP or any of our companies will grow at 50% for a decade. But if one did…

Imagine company XYZ had $500m of revenue last year. If their P/S ratio was 66, it would mean their market cap is $33 billion. After 10 years of revenue growing at 50% annually, revenue would be $29 billion. Even a PS of 6 (not 66) would mean the market cap would be $173 billion. So you would have better than a 5 bagger in 10 years.

If growth was only 40%, (at a PS of 6) you’d still have almost a 3 bagger. (A PS of 7 would give you more than a 3 bagger.)

If growth was 30%, (at a PS of 6) you would still be up from $33b to $41b in market cap.

Sure, it’s hard to know which companies will do this. But as we’ve seen, and as I’ve hopefully shown here, it’s even harder to value such companies! Your “66 p/s” might have been hyperbole, but I think you’ve illustrated the challenge in valuing these companies highly enough!

Bear

[ghonkaba]

<<< So assuming no price change and no acceleration in growth, my sleepy math figures the p/s of our company growing at 50% becomes…

16.5 in one year
which becomes 12 in two years
which becomes 9 in three years
Which becomes 6 in four years
Which becomes 4 in five years. >>>

A P/S 22 stock that doesn’t increase the P for 1-5 years? I like to look at forward 12 months P/S, or better forward EV/S, but past that seems pretty meaningless if no stock price change. Not too many people in these high PS stocks if they stop appreciating!

These future PS numbers would be more interesting using various stock growth rates, like 15%, 20%, 25% etc.

[GauchoRico]

So two questions come up…at what point would such a company become overvalued? Would you pay 66 p/s for a company you think will grow revenue at 50% annually for a decade? What’s your limit?

Here’s how I would answer that question: it depends on several things…

1. what are my alternative investments? There are other companies in a similar space (i.e. SaaS companies also growing at a similar rate) and I would tend the one that is valued the lowest with all other factors being equal. What are these these other factors? See #2.

2. other factors: these include gross margins for a company growing revenue at 50% with 90% margins is much better than a company growing revenue at 50% with only 70% margins. Has the company demonstrated that it is dominating its target markets? How much of the TAM has it captured or more importantly how much is still available to capture (green field being better than share already possessed by competitors)? What is the growth rate of the target market? What are the barriers to entry? What is the competitive advantage of the company (i.e. how well will it compete and how will it prevent others from entering its turf?)? How long do I think it will retain its competitive advantage? Will it be able to maintain pricing or will competition drive down price and margins? Are operating expenses as a percentage of revenue decreasing as the quarters and years go by? What is the cost to acquire a new customer (e.g. SQ acquires them very easily at low cost because most self onboard and cross selling is another opportunity for expansion of customer spending once they have one)? There are other factors and the point is that the answers determine a few things that make it easier to make investment and allocation decisions: what is my confidence in the company’s business model, what is my confidence that the company will continue its rapid growth, what is my confidence that massive profits will flow in the future? The higher my confidence that higher my allocation.

So #1 and #2 are both important, but without a strong opinion of the important factors in #2, a good relative valuation is probably not enough for me to invest. Conversely, if the relative valuation is much higher than other companies that also have good “other” factors then I probably won’t invest much.

Hope that helps.

Chris

[Tamhas]

It seems to me that one of the difficult issues around this kind of valuation of this kind of company is that while one can justify a high valuation looking out far enough years of future growth, that it is also likely that, as the company becomes more mature (farther up the S curve, as Denny keeps reminding us), that the multiples are likely to decline, as is the rate of growth. So, projecting out 5 or 10 years is mostly meaningless. This doesn’t mean that one can’t ride the wave for 2 or 3 years before this starts to happen, but it does mean that one can’t just buy and forget, one needs to keep paying attention.

[SaulR80683]

Perhaps a way of thinking about it that is a bit easier to grasp.

If a company can increase revenue by an average of 50% for just four years, just four, they will quintuple their revenue. (Not as impossible as you would think. Shopify did 100% compounded for four years which gave them 16 times their starting revenue. The next year they slowed down to 73% growth, which gave them about 28 times their starting revenue in five years. (Those numbers really pile up, power of compounding, you know. If they just tack on 50% the next year they’d have 42 times what they started with. That makes a “high” P/S revenue rather laughable, doesn’t it.)

But you don’t need 100% growth. I pointed out that if a company can increase revenue by an average of 50% for just four years, just four, they will quintuple their revenue. If they can do it for just one more year, they will have seven and a half times the revenue they started with, in five years.

And if they reach six years it will be 11.5 times what they started with. Remember, a number of our companies are well over 50%, or even over 60%, currently, which gives them a cushion for a final year below 50%.

Hope this helps,

Saul

[zx6158]

Hi all,

Thanks for the great questions and wonderful discussions!

I have followed this board for some time now and learned a ton from some great investors here. I am truly amazed by the results produced by you, esp. within the past two years. And slowly, I started to modify my way of investing. I added some SAAS companies to my portfolio, but still keep some of the stalwarts I have had for years. I just feel more comfortable this way.

Hope the following is not too OT.

To me, all the favorite, high growth companies we follow here, they are not profitable, at least from GAAP standpoint, except for few. So the question that I should ask myself is that, without strong, consistent fcf and sometimes dividend to protect the downside, if the inevitable stock price drop comes, 70%, 80%, even 90%, multiple times with a period of a decade, let’s say, just look at Amazon, for example, will I have the stomach to hold tight? given that the company’s growth slows down quite a bit but is still growing (much) better than most others at that time(relative speaking, because the standard changes with time) and I still believe in the bright(er) future of the company.

I am not sure what my answer will be, I hope I will be able to do so.

What do you guys think?

Zangwei

[captainccs]

… will I have the stomach to hold tight?

The sixty-four million dollar question! What counts is neither the present nor the past but the future. One must have faith in the future to hold. What do you use for a crystal ball? Use the wrong metrics and you’ll get the wrong answer.

I believe the two most important metrics are the business model and market penetration. Business model is a complex issue but one should look for “the” leader in fast growth, asset light, one take most, increasing returns industries. Three examples for me are NVDA, MDB, and ALGN and possibly V. The other metric is market penetration, the fastest growth happens between 15% and 85% (give or take) market penetration. As 85% market penetration is approached ratios contract, the stock morphs from growth to cash cow value.

Denny Schlesinger

[Texmex]

“Would you pay 66 p/s for a company you think will grow revenue at 50% annually for a decade?”

To answer your question it will be useful to see how fast some of the best companies have grown in the past.

30% over 10y - 14x in revenue quite possible. AMZN and NFLX, 2 fast growing stocks. They have grown 13x and 10x between 2006-16 (that is oldest data I have access to). AMZN may have grown faster earlier.

40% over 10y - 29x I would like to know if anyone companies have attained this level of revenue growth

50% over 10y - 58x I really doubt any company has grown this fast assuming we are starting at say $200M/y

[Melancholia2]

One thing to keep in mind is that as companies grow and mature, they most likely will not support these high multiples of sales. At some point they should start making money, so the metrics for valuation change. Companies of the sort that are given a lot of attention on this board are young companies in growth mode. The hope is that these companies conquer substantial market share, thus substantially reducing (maybe eliminating) the cost of customer acquisition. “Land and expand” mode gives way to cash cow status.

The case of Amazon brings up another salient factor. Amazon is a substantially different company now than it was 10 years ago, which was substantially different from 10 years prior to that. Initially, Amazon sold books followed thereafter by forays into seemingly everything retail. Much of the run-up in valuation in the past 5+ years is due to AWS. Ten years ago there probably wasn’t much of a compelling case to own Amazon. And this brings up my point. These companies may or may not be substantially similar in the future compared to what they are now. The key, as is often emphasized and reiterated on this board, is to be diligent and vigilant as to whether financial results, stories, and strategy execution remain on track or go off the rails.

[cleverbear1]

Good afternoon everyone,

I thought I would cut and paste a response from Bert to a question I posed about using EV/Sales and P/S ratios to evaluate Shopify. I hope that some members of the board will find his comments helpful. They are interesting both as a reflection on the importance he gives to these metrics and as an overview of the future prospects of this company. I struggle with how to use these ratios when trying to decide whether to buy or sell. The question originated from a RBC report put out immediately after the company reported its Q3 results. If I understood the analysis correctly, they used an EV/S ratio of 9 in arriving at a target price of 159.00 US at the end of 2019. The denominator was 1.9 billion which includes forward earnings to the end of 2020. I substituted a higher figure for sales and came up with a price of 170.00. Bert’s remarks are enclosed within quotation marks;

"Any time that I have to write about valuation, I always start with the comment that valuation is a fraught exercise. I hate to give price targets, simply because I do not think that doing so benefits anyone. I had my share of troubles as an analyst when I attempted not to provide price targets in written form. I was told the SEC requires them.
That said, you are a subscriber, so I will undertake the exercise. When analysts do EV/S projections, they cannot simply use the next year or two of growth. The models do not work that way. The current consensus for growth next year is 40%. That seems unreasonable to me-it will almost certainly be greater than that. So, let’s try 45% for the next couple of years, That suggests to me, that the run rate revenues by the end of 2020 are going to be around $2 billion in the last quarter, adjusted for seasonality. But at that point, in order to derive a share valuation, you need to have some expectations in place regarding 2021 and 2022 growth. Otherwise, you are simply … in the wind with no chance of success. But now the problem is comes down to this…not only is SHOP remaking itself but the company will have new initiatives of some major importance that you do not know about in place to generate growth in 2021 and 2022.

Shopify in particular is on the way to remaking itself quite considerably. It is not just about attracting small merchants to the platform building web sites. It is very much about SHOP+ which is quite a different offering focused on a different potential customer set, coupled with Pay and Shipments, the applications on the platform and international expansion.

But the thing I harp on-we do not know what Tobi and the folks in Ottawa have in mind. Not really. Look how fast research and development is rising. 70% last quarter. Tobi background is in computer science. You may know the man is a genius-he was programming when he was 10 and had a job as a programmer when he was in 10th grade. Now he wears that silly cap and of course he speaks with a German accent as he was born there. But you are betting on him and his colleagues. And you simply can’t encapsulate that in an EV/S. If you can, I don’t know the Rosetta Stone for valuation any more than the next person. You are writing me on a morning in which there are 3 mergers to discuss, and one of them is at an EVS of something like 20X.

Can anyone realistically tell me that Tobi would turn down an offer at 20X EV/S? I own a small amount of SHOP in the model portfolio. I might own more if I hadn’t alternatives that I like as well. But I would not be terribly concerned about price targets of $159 or $170. Spend your cycles trying to decide if you think SHOP’s initiatives will produce hyper growth beyond next year. If you do, the shares will work. And if not, not.

I realize that is not a satisfactory answer to your question. But I honestly do not focus m y attention on a valuation number for a company like SHOP which is run by a genius and which is spending hugely to develop new solutions that we do not know about."

Just to be clear, I did receive his permission to copy and paste his reply to this board. I also can’t help but put in a plug in for his Ticker Target Investment website. The subscription is worth every penny. I emailed my question to him last night and had a response by mid-morning.

All the best!