# The Oomph Factor

Ok, so Twilio growing sales at 77% YoY has an EV/S ratio of 23 whereas Zscaler growing sales at “only” 65% has a higher EV/S ratio of 33. Does this mean that ZS is outrageously expensive compared to TWLO? The answer is no. Because, among other things, Zscaler’s gross profit margin is 79%, whereas Twilio’s is only 53%.

Put another way, for every \$100 of sales, ZS generates \$79 of gross profit, compared to \$53 of gross profit for Twilio. So the higher EV/S ratio for ZS is justified, given similar revenue growth rates for the two companies.

That got me to thinking. Can we compare these SaaS companies against each other in a more apples-to-apples way than just looking at their EV/S ratios? We need to adjust these ratios by a factor that includes both revenue growth rates and gross margins.

In the rest of this post, I’ll introduce what I call the Oomph Factor, and use it to measure the relative attractiveness of the companies discussed here. When adjusted for Oomph, the valuation of Twilio looks quite similar to Zscaler - they’re certainly not as far apart as their EV/S ratios indicate. Using the Oomph Factor, as described below, I’m inclined to put new money now into buying more of AYX and TTD and not put any more into OKTA, ZS or TWLO (which are already very large positions for me).

The Oomph Factor
I’m constructing this factor by first calculating the square of the YoY revenue growth rate, written as a multiplier. I then multiply that by the company’s Gross Profit Margin (GPM).

``````Oomph = GPM*(1 + %Sales Growth YoY)^2
``````

For example, if a company is growing sales 50% YoY, the multiplier is 1.5, and 1.5 squared is 2.25. If this company has a GPM of 60%, then the Oomph factor is 2.25*0.6 = 1.35.

The reason I’m squaring the sales growth rate is because a) I want to give it a higher weight than the profit margin and b) the sales growth in the 2nd year, if the same as the first, would result in an amount that is the square of the incremental revenue (i.e., compounded positive sales growth is an exponentially increasing number).

The companies that have Oomph values greater than 2.0 are truly exceptional, as shown in the table below. Not only are they hitting it out of the park in annual sales growth, they’re doing it with high gross margins as well.

``````
Gross   YoY Sales
Symbol  Margin  Growth     Oomph    EV/S    EV/S/Oomph
======  ======  =========  =====    ====    ==========
AYX       91%     55%      2.18     20.5     **9.4**
ZS        79%     65%      2.16     32.6     15.1
ESTC      74%     70%      2.15     23.1     10.7
MDB       74%     70%      2.13     28.5     13.4
SMAR      81%     58%      2.04     22.8     11.2
TTD       76%     56%      1.86     18.1     **9.7**
TWLO      53%     77%      1.66     23.4     14.1
OKTA      73%     50%      1.64     26.0     15.9
SQ        41%     51%      0.93      9.5     10.2

``````

The last column on the right shows the EV/S to Oomph (EVSO) ratios of each company. Just like P/E ratios, the lower the EVSO ratio, the more attractive its value. You’ll see that ZS, OKTA and MDB have relatively high EVSO ratios, in the mid-teens. But AYX and TTD have EVSO ratios below 10. ESTC, with a EVSO ratio below 11, also looks attractive, by this measure.

Is the EVSO ratio a perfect valuation metric? Of course not. There are many other factors that influence stock prices, especially in the short term. But it’s the ratio I’m using, in between earnings calls, to decide what positions I should add to, and what I should trim.

Ron

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That’s interesting for me Ron - for 2 reasons.

From everything I have seen I have been thinking that Twilio and AYX are probably the best value of the bunch from a relative EV/S/Growth perspective but adding in the Oomph factor from GM - finally there is something to differentiate AYX from TWLO. On the other hand I have been struggling how to consider Square as an outlier from on an EV/S basis but bringing in GM into the equation reconciles that disparity.

It does also confirm that OKTA is probably the most relatively extended already and that’s leaving aside potential deterioration in growth rates.

I’d be interested to see what happens to Shopify. Is YoY growth latest Q or TTM?

Thanks for sharing.
A

3 Likes

BTW on Shopify…

If I take the latest Quarter YoY growth rate rather than TTM which is the more conservative/lower of the two then I get to:

SHOP:-
GM 56%
YoY Growth 54%
Oomph 1.32
EV/S 20.41
EV/S/Oomph = 15.4

If we take TTM growth then:
GM 56%
YoY Growth 59%
Oomph 1.42
EV/S 20.41
EV/S/Oomph = 14.4

NB I have used latest full year/TTM GM and not latest Q - latest Q was 54% but I assume we aren’t taking quarterly data points for that.

Cheers
Ant

4 Likes

Yes, margins are an extremely important factor. A couple months ago another user made the calculations for our stocks and came to a similar conclusion that AYX and TTD seem to be the best bargains.

https://discussion.fool.com/relative-valuations-of-our-saas-stoc…

The thing is that the market also prices expected changes in margins in and AYX has announced a couple of times that they don’t expect to post margins over 90% for long.

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Zoom’s Oomph

GM: 81%
Rev Growth: 118%
Oomph: 3.85
EV/S (at \$32/sh, top of IPO range): 24.9
EV/S/O: 6.5

Eric

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The companies that have Oomph values greater than 2.0 are truly exceptional, as shown in the table below. Not only are they hitting it out of the park in annual sales growth, they’re doing it with high gross margins as well.

Hi Ron, for what it’s worth, Square’s revenue rate increase was 61% not 51%, and their adjusted gross margins are much, much, higher than 41%. I’m not sure where you got those numbers, but perhaps you are not familiar with the company and thus used total revenue which includes a large amount of pass-through revenue to Visa and Mastercharge, which Square collects and just passes through so no one, including the company, pays any attention to total revenue. It’s adjusted revenue that counts (it’s a lot smaller).

Saul

11 Likes

The problem with these type of ratios is that it always makes you feel clever and, more dangerously, confident in your decision making (if it works for an extended period of time, you might even believe it to be invincible and start to shift your risk tolerance further) but then investor expectations shift and you end up reacting a bit too late to the change. One of the reasons Saul dropped P/E as a consideration is because it started to fail to work for the highest opportunity cost investments in the market (i.e. SAAS industry). A variety of factors also goes into the market’s valuation of SAAS companies which you don’t pick up, such as total addressable market (a reason AYX looks cheaper compared to ZS or MDB or even TWLO).

It’s good to have something as a reference point, but I would warn of putting a lot of your weighting to any single metric when making investment decisions

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Square as an outlier from on an EV/S basis but bringing in GM into the equation reconciles that disparity.

For this analysis, SQ should really be split into 2 separate business lines which should be evaluated individually then blended. SQ’s subscription and services business comprise 42% of revenue, have 71% GM, and are growing at 134%. The transaction based revenue has GM of 37%, comprised 58% of revenue, and a 1 year growth rate of 29%.

Chris

16 Likes

Interesting exercise. But,in a way it reminds me of the esoteric sort of analysis used by “professionals” to scare off folks who think they are able to invest without professional help.

I’m pretty adept with numbers. It’s not the math that gives me pause, rather I’m not at all confident that the meaning that you have imbued them with is valid with respect to any realistic longitudinal experience. I won’t nitpick, but it seems that some of the formula is purely arbitrary rather than being based on thoughtful evaluation and testing with real world experience. You’ve provided a single snapshot, do you feel that’s sufficient in order to make investment decisions? Color me skeptical.

I have no idea how you might validate this tool. If we reserve our focus to XaaS, subscription based product offerings, I’m not sure there’s enough history with the companies that are in this domain to provide a useful historical study, but at least some back testing might be illuminating.

7 Likes

I thought this was interesting (very new to board here) as I do a lot of stats work so I thought I would run some simple analyses.

I did a correlation between EV/S and your new factor and they correlate at .71, suggesting a pretty strong correlation. Since you add the square term, you aren’t just getting a linear combination of the old variables, but I’m still not sure what you are adding. I also correlated you EVSO measure and oomph and those correlate at .04, so almost orthogonal to the original measure. I then regressed oomph on EV/S, and EV/S is statistically significant predictor of oomph. The R-Square of the model, which shows how much variation of oomph explained my EV/S and its .52. This means that EV/S account for at least 50% of the outcome.

This is not to say this new measure is bad, we’d need a lot more data to do a better analysis since there are not too many cases, but I think these simple analyses help us understand what new measures are giving us. Ideally, we’d have lots of different measure and do a factor analysis to try to get a sense how multiple measures load on the same factor and which ones don’t.

My initial take is that this new measure doesn’t offer much in terms of additional explanatory power, but may be faster to look at then comparing multiple measures at the same time, but the jury is still out.

B

24 Likes

Yea I think there is a bit of let’s come up with formulas to help justify our investments, instead of more critical thinking.

It starts with hey let’s drop the p/e that doesn’t work, how about p/s. Then hey let’s make a p/s of above 30 seem logical.

Great investments the last couple of years, and glad to be in many of them, but been cutting back lately and raising cash.

I think all these IPOs coming is exposing the group while also competing with investing dollars and the selloff has already started and will continue. Not a bad thing longer term.

I’d be very careful though and very patient here.

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Then hey let’s make a p/s of above 30 seem logical.

Where are you seeing that? In this analysis the company with the largest P(EV)/S ranks second to worst.

1 Like

In response to some great feedback from Gaucho Chris and Saul, I’ll explain how I calculated a gross margin of 41% for Square (SQ). From Square’s 2018 Earnings Report,

"Transaction-based revenue was \$668 million in the fourth quarter of 2018, up 27% year over year, and transaction-based profit was \$247 million, up 29% year over year. For the full year of 2018, transaction-based revenue was \$2.5 billion, up 29% year over year, and transaction-based profit was \$913 million, up 32% year over year.

Subscription and services-based revenue was \$194 million in the fourth quarter of 2018, up 144% year over year, and \$592 million for the full year of 2018, up 134% year over year. "

https://s21.q4cdn.com/114365585/files/doc_financials/2018/Q4…

So that means that total 2018 net revenue was \$2.5B + \$592M = \$3.1B. The transaction based business, at \$2.5B, is a whopping 81% of the total business. The subscription business was still only 19% of the business in 2018, although it grew 134%.

Since SQ’s total gross profit last year was \$1.3B, its gross margin was 1.3 / 3.1 = 41.9%

Saul, I realize that the growth numbers look more impressive if I use their adjusted revenue rather than their net revenue. But the numbers on sites like Yahoo are using the net revenue to report EV/S, so I wanted to be consistent.

Ron

6 Likes

Saul, I realize that the growth numbers look more impressive if I use their adjusted revenue rather than their net revenue. But the numbers on sites like Yahoo are using the net revenue to report EV/S, so I wanted to be consistent.

Hi rdutt, I’m sorry to sound really critical, but there is no point in being “consistent” if you are using the wrong numbers. No one, but no one, who follows Square, including the company itself, pays any attention to total revenue. And just because Yahoo’s robo-computer picked it up doesn’t mean that it has ANY relevance to the actual business. It has NONE, NADA, ZERO, relevance. It’s just plain WRONG! Square’s revenue is its adjusted revenue, which is less than its total revenue.

Here’s why! When Square processes credit card transactions for its small merchants it takes its own small fee out directly (1% or something like that). That’s its own revenue. But as a convenience for these little merchants it also takes out the credit card company’s fee (Visa or MasterCard), and passes it on directly and totally to Visa or MasterCard. It’s just a pass through. It never belonged to Square. It’s not revenue for Square. They are just passing it on for the little merchant. It has 0% margin for Square. It’s simply NOT Square’s revenue!!!

The problem is that a bizarre vagary of GAAP computing says that that has to be counted as revenue. That makes Squares total revenue look grotesquely greater than it actually is, with a lot of 0% revenue, and if you count all that extra revenue with no gross margin as revenue, of course gross margins and operating margins would look artificially low, WHICH IS WHY NO ONE CONSIDERS IT AS PART OF SQUARE’S ACTUAL REVENUE, and to do so is JUST PLAIN WRONG!!! Of course counting that extra stuff as revenue makes gross margins look way smaller than they are.

That’s why I wrote in the Knowledgebase the following:

Get the information yourself. I suggest that you don’t get earnings (or other information that’s important to you), off Yahoo, or eTrade, etc, but get earnings off the company’s earnings press releases, which you can always find on their Investor Relations site. You just don’t know what Yahoo’s computer is grabbing.”

Geez!!!

Saul

22 Likes

No one, but no one, who follows Square, including the company itself, pays any attention to total revenue.

That may be true, but investors are certainly paying attention to it. Square’s Q4 shareholder letter mentions “total net revenue” 25 times, so they clearly think the number is important. The \$3.1 billion total net revenue figure for 2018 that I gave earlier came directly from Square’s 4Q shareholder letter, and not from Yahoo.

… as a convenience for these little merchants it also takes out the credit card company’s fee (Visa or MasterCard), and passes it on directly and totally to Visa or MasterCard. It’s just a pass through. It never belonged to Square.

Here’s Square’s Q4 shareholder letter in which they explain total revenue versus adjusted revenue: https://s21.q4cdn.com/114365585/files/doc_financials/2018/Q4…

Page 16 of the letter says

"Adjusted Revenue is a non-GAAP financial measure that we define as our total net revenue less transaction-based costs and bitcoin costs, and we add back the impact of the acquired deferred revenue adjustment, which was written down to fair value in purchase accounting. We believe it is useful to subtract transaction-based costs and bitcoin costs from total net revenue to derive Adjusted Revenue as this is a primary metric used by management to measure our business performance, and it affords greater comparability to other payments solution providers. Substantially all of the transaction-based costs are interchange and assessment fees, processing fees, and bank settlement fees paid to third-party payment processors and financial institutions. While some payments solution providers present their revenue in a similar fashion to us, others present their revenue net of transaction-based costs because, unlike us, they pass through these costs directly to their sellers and are not deemed the principal in these arrangements. Under our standard pricing model, we do not pass through these costs directly to our sellers.

Adjusted Revenue has limitations as a financial measure, should be considered as supplemental in nature, and is not meant as a substitute for the related financial information prepared in accordance with GAAP."

So it’s not as simple an adjustment as just accounting for pass-through revenue.

And the Consolidated Statement on page 17 of the report shows that for Q4 2018, there was \$380 million of gross profit against total net revenue of \$932 million, which again gives a gross profit margin of 41%.

Anyway, I don’t mean to prolong this. We can agree to disagree.

5 Likes

Rdutt,

I really think you should listen to Saul on this one.

The part that you highlighted in your quote about deferred revenue adjustments - I know you highlighted it to show that adjusted revenue is not just adjusting for pass-through revenue for third parties - is only a tiny fraction of the adjustment. You can see that from the way it‘s formulated: First they mention transaction based cost (that’s Third party pass-through; the vast majority of the adjustment), then comes bitcoin (a tiny adjustment compared to pass-through) and then comes the sentence you highlighted, which to me sounds like accounting jargon for a miniscule adjustment (I‘m not even sure what it means, are you?).

The point is, from an economical standpoint it makes no sense to look at total revenue, and no one following the stock seriously does so - regardless of some disclaimers the accounting or legal department might add to their statements (who cares for these things anyways? They have a totally different purpose than informing investors on what to look at).

Saul is trying to teach you a valuable lesson here which you should take to heart in my opinion: Look beyond the headline numbers and dig deeper to get a better understanding of your investments. It will improve your returns. It has improved mine.

Best
Niki

19 Likes

First they mention transaction based cost (that’s Third party pass-through; the vast majority of the adjustment), then comes bitcoin (a tiny adjustment compared to pass-through) and then comes the sentence you highlighted, … accounting jargon for a miniscule adjustment…The point is, from an economical standpoint it makes no sense to look at total revenue, and no one following the stock seriously does so - regardless of some disclaimers the accounting or legal department might add to their statements (who cares for these things anyways? They have a totally different purpose than informing investors on what to look at).

Saul is trying to teach you a valuable lesson here which you should take to heart in my opinion: Look beyond the headline numbers and dig deeper to get a better understanding of your investments. It will improve your returns. It has improved mine. - Niki

Thanks Niki (Diablito), for explaining it so clearly. I shouldn’t let myself get so frustrated.

Would any company adjust their revenue to make it smaller, a little less than half as big, unless it really was smaller???

Can you imagine the outcry if Square tried to pass off their total revenue as their real revenue? …The analysts would all be shouting … “That’s not your real revenue, you are counting all that pass through revenue that belongs to the credit card companies! Your real revenue is only half that!”

Even Bert, who is a real purist about adjusted figures and stock-based compensation, only talks about Square’s adjusted revenue and doesn’t even mention total revenue. For example from his September write-up:

Based on that new guidance, the current First Call consensus for revenues this year has reached \$1.54 billion, representing growth of 57%.

Adjusted revenue came in at \$1.59 billion for the year. So Bert, and First Call, and the analysts, whose recommendations make up the First Call consensus, don’t even mention or consider total revenue (about \$3.33 billion, as I remember), because it’s an irrelevant number.

Thanks again, Niki,

Saul

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While it should be obvious, it might be worth noting that the reason that official statements about finances include Total Revenue, the reason for that is that it is mandated by GAAP. There are a number of things mandated by GAAP which investors think are nonsense … not the least of which is subtracting stock based compensation as an expense … so investors adjust these figures before making their comparisons.

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Thanks, everyone for your comments. For those of us who are long Square, the more important question is, what does the future hold? Why has the stock languished for the past 3 months while Paypal has gone up 20%?

In my original post, I made the case that companies with an Oomph factor greater than 2.0 are truly exceptional. (Oomph is the square of the YoY revenue growth, in multiplier form, multiplied by the gross margin.) SQ didn’t look like it was in this exceptional league, using GAAP revenue and margin. But 2018 Adjusted Revenue, net of transaction costs, was only \$1.6B, not \$3.1B. This gives SQ an EV/S ratio of 18.7, which is right up there with the likes of TTD and AYX. Compare that to Paypal’s EV/S ratio of 7.8, and there is a case to be made that the market thinks SQ is overvalued. Maybe that’s why SQ has been flat for the past 3 months, digesting its gains.

But now let’s look at Square’s Oomph using it’s Gross Profit as a percentage of its adjusted revenue. This is a harder number to calculate precisely. The Q4 Shareholder report shows a Gross Profit of \$380M out of a reported adjusted revenue of \$464M, which implies a gross margin of 81.9%. (This seems awfully high to me - would appreciate if someone could double check.)

Assuming that is, indeed, the correct adjusted gross margin, Square’s Oomph shoots up to 2.2, and catapults it to 1st place in the list of exceptional companies that we analyzed. Here’s that updated list below:

``````
Gross   YoY Sales
Symbol  Margin  Growth     Oomph    EV/S    EV/S/Oomph
======  ======  =========  =====    ====    ==========
SQ        82%     64%      2.20     18.7     8.5
AYX       91%     55%      2.18     20.5     9.4
ZS        79%     65%      2.16     32.6     15.1
ESTC      74%     70%      2.15     24.4     11.3
MDB       74%     70%      2.13     28.5     13.4
SMAR      81%     58%      2.04     23.7     11.6
TTD       76%     56%      1.86     19.4     10.4
TWLO      53%     77%      1.66     25.2     15.1
OKTA      73%     50%      1.64     28.2     17.2

``````

The EV/S/Oomph ratios have crept up a bit since my last post, but SQ now looks like the most attractive value of the bunch. It will be interesting to see what happens after they announce earnings next week Wednesday.

Good luck to all,
Ron

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Ron,

I am very late to this thread, but I like this Oomph factor and think it could be a nice piece to comparing different companies. Obviously it could be fool-hardy to start to think it could rapidly become a singular be-all/end-all valuation methodology, but folks in this thread who have espoused that are simply building a straw man.

It shares some of the same key aspects as my yet-to-be-fleshed out idea in this thread from months ago over on the NPI board.
https://discussion.fool.com/work-in-progress-valuation-methodolo…

Similarly, I am a fan of it having a keen focus on EV rather than market cap, which has been something I have felt strongly about for almost 15 months now.
https://discussion.fool.com/evfcf-ratioa-superior-valuation-metr…

If I ever get around to doing some actual comparisons with my R40 to EV/S ratio valuation methodology, it would be interesting to compare those results to some “Oomph Factor” results.

volfan84

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