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.