Valuation and multiple expansion

Bear and Saul have recently written about multiple expansion and valuation:

Bear:
SHOP also now has 15% more shares outstanding than it did at the end of 2016. Other than accounting for that, Chris’s math is correct as far as I can see, but hopefully my addition here illuminates how this works in the real world. We have enjoyed such crazy gains the last two years, because in late 2016 and all through 2017, things were crazy underpriced. Things have changed.

Saul often says that he can’t time the market. I can’t either. So I’m not going to cash, because big a correction may not come. Sure we’ll have little corrections like we have all along, but who knows when? Our stocks may go up 30% from now before that happens. Or it may happen tomorrow. Either way, in the long run, stock appreciation will approximate each company’s revenue growth, adjusted for dilution. That’s still great…even comforting. The difference now is, we probably can’t expect multiple expansion on top of that.

Saul:
The huge, even enormous, relative number of gross profit dollars that our companies have, and will have in the future, for each current dollar of revenue, because of their growth rates and high gross margins, compared to the relatively small amount of gross profit that a conventional company has, and will have, for the same current dollar of revenue, is what gives our companies the much larger EV/S ratios. Simple as that!

And don’t bother telling me our companies are not making any profit. Any company with 75%, 85% or 95% gross margins can make a profit whenever they decide to! All they need to do is slow down their enormous S&M spending, whose purpose is to grab every new customer they can grab while the grabbing is good. Personally, I’d rather they keep grabbing all those customers now, because revenue will keep flowing from them for the indefinite future.

So this is an entirely different set of facts we are dealing with. That’s how I see it anyway. And I hope that I made it clear for you.

One thing is in agreement and a fact: EV/S multiples of most/all of the SaaS companies discussed on this board have increased. No dispute there. Bear and some others doubt that we can count on further multiple expansion from here. Saul, on the other hand, does not say whether multiples might expand further, contract, or stay the same. However, Saul spells out that past multiple expansion was highly deserved and he seems to suggest that additional multiple expansion may be warranted. Saul provided the reasons why the business model of SaaS deserves a higher valuation multiple than so called traditional companies. That argument is certainly compelling.

So one question is: were SaaS companies as a category severely undervalued 2 years ago or are the current multiples awarded to these companies an anomaly? It’s an important question because each of our answers will lead us to make position and allocation decisions. To say that simply because multiples have expanded over the past 2 years, SaaS must now be overvalued and no more multiple expansion is possible is not the right argument. The underlying premise to that argument is that SaaS companies were previously, roughly fairly valued which would make them overvalued now. Bear is of the opinion that generally the companies in his portfolio are not great bargains. The ~25 cash position and decision to trim supports that.

I have reached a different decision. I suspect, as Saul has pointed out, that the SaaS companies in general were very much undervalued 2 years ago. Will multiples expand, contract, or remain the same from here? I do not know. But I think it is possible for them to expand further. If I want the growth that these companies offer then I need to remain invested. I follow these companies closely and the business results continue to be very compelling. I think that we have chosen the very best publicly traded companies available. I don’t want to sit out and miss the upside. The revenue growth (assuming it continues) offers a large amount of protection because it leads to multiple contraction when the stock prices don’t move. If multiples remain constant we are looking at 60% annual returns. If we see a small contraction then we can still get very good returns when these companies growth revenue at 60%.

We have such good recent reports from CMF_muji, stocknovice, and Saul:

muji: https://discussion.fool.com/the-latest-in-earnings-34231103.aspx…
stocknovice: https://discussion.fool.com/stocknovice39s-june-portfolio-review…
Saul: https://discussion.fool.com/my-portfolio-at-the-end-of-june-2019…

These are all great write-ups and worth a read. There are some great explanations of the companies owned. Therefore, I’m not writing about the companies specifically.

Here is a summary of my portfolio through the first half of the year (for those of you who are interested):

2019 end of month returns (YTD):


Jan +26.9%
Feb +39.8%
Mar +49.4%
Apr +57.1%
May +53.2%
Jun +72.0%

Weekly Portfolio Performance Compared to S&P500(TR)


        GC Port	S&P500  Delta	
1/18/19	23.3%	 6.6%	16.7%
1/25/19	25.2%	 6.4%	18.8%
2/1/19	27.3%	 8.1%	19.2%
2/8/19	30.6%	 8.2%	22.4%
2/15/19	31.8%	11.0%	20.8%
2/22/19	38.6%	11.7%	26.8%
3/1/19	35.1%	12.3%	22.8%
3/8/19	30.2%	 9.9%	20.3%
3/15/19	44.0%	13.1%	30.9%
3/22/19	49.6%	12.3%	37.3%
3/29/19	49.4%	13.6%	35.7%
4/5/19	43.4%	16.0%	27.4%
4/12/19	49.2%	16.7%	32.5%
4/19/19	40.5%	16.6%	23.9%
4/26/19	54.4%	18.0%	36.4%
5/3/19	57.5%	18.3%	39.3%
5/10/19	54.0%	15.8%	38.2%
5/17/19	60.2%	15.0%	45.2%
5/24/19	54.8%	13.5%	41.4%
5/31/19	53.2%	10.7%	42.5%
6/7/19	73.6%	15.7%	58.0%
6/14/19	75.0%	16.3%	58.7%
6/21/19	79.9%	18.9%	61.1%
6/28/19	72.0%	18.5%	53.4%

Portfolio peak was reached on 6/20 at +84.5% YTD. The delta between the S&P500 and my portfolio has expanded fairly steadily throughout the first half of 2019. The high returns to some others with similar stocks can be explain by my use of options. Since the beginning of 2017, options have contributed about 25% of my total gains (including realized and unrealized).

ALLOCATIONS AS OF 6/30/19


	6/30	5/3	6/30 shares only  % gain per % move
AYX	21.7%	23.0%	21.7%	          1.0%
TWLO	19.0%	19.8%	14.8%	          1.4%
MDB	16.3%	14.1%	13.0%	          1.5%
ZS	11.4%	10.8%	10.4%	          1.3%
OKTA	 6.0%	 8.5%	 6.0%	          1.0%
ESTC	 5.8%	 4.6%	 5.4%	          1.9%
SQ	 5.3%	 7.2%	 5.3%	          1.0%
TTD	 5.1%	 7.6%	 4.0%	          1.6%
CRWD	 4.7%	 0.0%	 4.7%	          1.0%
SMAR	 3.6%	 1.9%	 3.6%	          1.0%
options			 8.7%	
cash	 2.6%	 2.7%	 2.6%	

Mostly my allocations are ordered from highest to lowest in a way that reflect my confidence in the business AND my thinking the stock company (and stock) will appreciate going forward. For example, SMAR is the smallest allocation because I do not have confidence that their offering to their customers is as sticky as the offerings of my other companies.

The column on the far right represents the number of call option equivalent shares I own for each actual share. My call options positions are the following:

ESTC Nov19 $80 calls
MDB Jan21 $70 calls
MDB Jan21 $85 calls
TTD Jan21 $130 calls
TWLO Jan20 $45 calls
TWLO Jan20 $65 calls
ZS Jan21 $65 calls

In aggregate, my options positions (long calls less the negative value of short puts) is 8.7% of my portfolio.

CHANGES IN MAY and JUNE

I made some changes to my portfolio since my last update on May 3, 2019:

  • After MDB and OKTA reported earnings, I sold some OKTA to buy more MDB.

  • After TTD and SMAR reported earnings, I sold some TTD to buy more SMAR.

  • I bought CRWD as a new position on the day of the IPO. I initially bought some at $65 and bought a bunch more at around $58 on the same day. To pay for these shares I sold some OKTA, ZS, and SQ. I also used some cash that I later replenished by trimming AYX.

  • I added a bunch to ESTC by selling more OKTA and trimming AYX.

Chris

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The revenue growth (assuming it continues) offers a large amount of protection because it leads to multiple contraction when the stock prices don’t move. If multiples remain constant we are looking at 60% annual returns. If we see a small contraction then we can still get very good returns when these companies growth revenue at 60%.

Chris, great post.

Can you explain the above for me? I can’t tell if I’m just not understanding it, or if you meant to write a number other than “60%” for one of these percentages.

thanks

Can you explain the above for me? I can’t tell if I’m just not understanding it, or if you meant to write a number other than “60%” for one of these percentages.

If a company has a EV/S of 30 and it grows by 60% then revenue is 60% higher in a year. This means that if the stock price does not move then the new multiple will be lower because S increased by 60%. EV/S should be 12 instead of the 30 from the previous year.

Chris

If a company has a EV/S of 30 and it grows by 60% then revenue is 60% higher in a year. This means that if the stock price does not move then the new multiple will be lower because S increased by 60%. EV/S should be 12 instead of the 30 from the previous year.

Got it! Thank you, Chris, for taking the time to explain.

Chris,I enjoy reading all your posts and those of others like Saul, Bear, Stocknovice etc explaining in details why the stocks discussed here are doing so well and how EV/S will go down in successive years due to expected high growth. So, I wanted to understand how you calculated the new EV/S as 12 with 60% growth rate and no change in EV.

Should it not be 18.75 being equal to 30/1.6? Please let me know why I am getting this different number, although your main point of diminishing EV/S in successive years is still valid.

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Should it not be 18.75 being equal to 30/1.6?

Alphab,

You have that correct. Just divide the current EV/S by the growth rate to get a forward EV/S.

AJ

So, I wanted to understand how you calculated the new EV/S as 12 with 60% growth rate and no change in EV.

Should it not be 18.75 being equal to 30/1.6? Please let me know why I am getting this different number, although your main point of diminishing EV/S in successive years is still valid.

Let’s use real numbers to confirm.

Before: EV=3000 and S=100 so EV/S=30

After S=160 and EV is still 3000 so now EV/S=18.75.

So yes, I make a calculation error and you are correct.

Chris

3 Likes

Chris you are correct w 18 and being forward looking. The issue is room for error and value left off the table for reasonable return.

So much of that comes from CAP. I am looking at Zscaler and it looks undervalued believe it or not. The reason for this is (1) great CAP (and of course we will stay vigilant in re) but also (2) it does not take 100% or 60% or even compounded 50% growth over 3 or 4 years to get actually textbook cheap. It gets there w “pedestrian” numbers over 3 or 4 years that it is likely to exceed. If it does not then we have misjudged the company or not seen its CAP clear enough.

Elastic of course looks dirt cheap in re, but we have no idea where Elastic will make its money as it dominates no specific vertical or niche as of yet. So more of a wildcard although “cheaper”. Still “overvalued” so has that going for it.

As for Zoom or Crowd or Work, I do not see where Crowd has the CAPNin a crowded market to give any confidence for 3 or 4 years at the growth needed. Zoom and Work I will hold back for now as both are transformative businesses, and not just another end point solution. Still, on their face, dang…hard to justify that type of multiple and still think any room for error over next 3 or 4 years. Particularly as the terminal multiple may remain at 10-15 (as Zscaler’s should) thus even w great execution that multiple we only be a third or quarter of itself in the end as it matures.

But future always hard to see. That is why we need room for error.

Why is crowd not just another end point solution that is presently just a little bit better?

Tinker

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I suspect, as Saul has pointed out, that the SaaS companies in general were very much undervalued 2 years ago. Will multiples expand, contract, or remain the same from here? I do not know. But I think it is possible for them to expand further.

Hi Chris,
Yes, I agree. In my End of June Summary I wrote (arithmetic corrected):

In 2017 let’s say that my average company grew revenue by 55%, and my portfolio grew with the revenue, but then there was 19% valuation increase (1.55 x 1.17 = 1.84, as people started to understand what I described above, and I ended up +84%.

And the same thing happened in 2018. We can estimate that average company revenue grew 55% and valuation increased 11%, giving me +71%.

In 2019, as we can see from the IPO’s of Zoom and Crowdstrike, the general public finally caught on to what we’ve been riding for the last two years.

Chris, I think that while we saw people just starting to catch on to what I described in my end of the month summary in 2017 and 2018, this is the year when the S-curve took off (witness Zoom and Crowdstrike). In the past two years it was just us, and gradually a few others, who saw the value in these companies, and we weren’t enough to move the needle much, but now the institutions and the general investing public all want a piece of these SaaS companies with rapid growth, high gross margins, subscription software, recurring revenue, high dollar-based retention rates, and the rest. That is moving and will further move the needle! You can see it for example in how Alteryx and Okta, and the rest just keep moving up. I suspect that when we finish 2019 we will look back on it as the year of the valuation catching up to where it should be, with perhaps a little asymptotic adding on in 2020 and 2021, but not much further addition to valuation.

But remember everyone, I could be completely wrong about all of this. Don’t take my musings as gospel.

Saul

23 Likes

Saul, most of the fast growing companies going public are in the SaaS space, but Beyond Meat is also at crazy high price ratios. It seems the market will take growth no matter where it will come from.

Uber and Lyft fell flat at their IPOs. I was actually looking forward to them but saw their most recent numbers and Uber is decelerating revenues very quickly to the mid-low 20s. I think that’s why their stock prices did not skyrocket on the first day of trading.

“Why is crowd not just another end point solution that is presently just a little bit better?”

I have been scratching my head over this one since I noticed members taking small positions. The SaaS model is nothing new in this space. Before the IPO, my organization’s endpoint product was already cloud-based and subscription-based with constant new feature development intended to expand after their landing. I’m sure CRWD is better, but as we’ve been talking about, these services are sticky so unless they will be competing on price I don’t see how that marginal betterness would lead to a switch for my organization.

There is also other great tech in this space from highly respected (for the tech at least) competitors such as Carbon Black, Cylance, and more.

CRWD essentially got great brand recognition from their work on the Democratic party hack and I’m sure they are a great company. I need to go back and read the posts of the members who wrote up their position choices on this one, but I passed as it seemed to have less of a competitive advantage than the other companies we follow.

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Reading that 80% of the market trading is now passive machine trading I can’t help but think that the market has very little to do with fundamentals and everything to do with chasing momentum now.

The market is pushing up valuations of any company that has momentum while passing on names that lose momentum, leaving them behind. Look at SQ and ESTC for example.

I think as long as the chase for performance by machines continues (seems like this has to end badly at some point) this new market reality isn’t going to end. You just need to make sure you are in the momentum names and not the ones that are thrown off this moving train.

4 Likes

I’m not ready to blame everything on algo trading. First off, all index funds use algorithmic trading. It’s possible that other positions within a fund with decisions made by a fund manager use algorithmic trading. You can’t blame 2000 on algorithms, nor the 1960s, 1920s, or Dutch Tulip Mania on algoritmic trading. They’re not necessary for bubbles or excessive prices to come about, and it’s not like this is some unusual thing for a bunch of growth companies to be priced high to the point you really have to wonder if prices are getting ahead of themselves. Aside from that for every algorithm that buys momentum, there’d probably be another that buys on weakness, that is, if these algorithm trading are nothing more than mechanical investing.

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