Why I pay little attention to EV/S evaluation

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Why I pay little attention to EV/S evaluation?

Some weeks ago someone on the board asked me whether I was comfortable buying high valuation companies, and whether I paid a lot of attention to evaluation. I responded that: No, I usually hardly pay any attention to the EV/S type of evaluation. Some people were horrified by that. Recently Bear asked me about it off board, so I thought I should explain it to all of you.

I guess I feel that there are so many factors that go into a decision about investing in a company, that comparing companies on the basis of valuation just doesn’t make much sense to me. I think about:

What field the company is in (from building houses, to manufacturing, to hardware, to software, and business to business, to customer facing, etc)?
How many competitors it has or whether it has a field to itself for now?
Does it have recurring revenue or not?
Deferred revenue?
Rate of growth of revenue?
Are customers happy with what they are getting?
Is there a pathway to profitability?
Free cash flow?
Cash on hand?
Absence of debt?
Reliability of management?
Founder led?
Not reliant on one or two big customers? (think Skyworks)
etc.
etc.

That all adds up to: Where is the company going in the future? How can I choose between two companies and say “I’ll pick this one rather than that one simply because it has a lower EV/S basis”???

Think how different Shopify is from Nutanix, or Okta, or MongoDB, or Zscaler, — on who they deal with, what they do, who their competition is, what their issues are? They are in different worlds. How can you decide between them on the basis of valuation? Bert sold out of Shopify at about $93 on the basis of valuation. He bought back in at $150 or so. The same with Square, which he sold out of at about $35 based on valuation. He’s now changed his thoughts about evaluation on hypergrowth, recurring revenue, companies.

There are just so many things about an EV/S ratio:

Are those sales in the S-part of the ratio recurring revenue or are they hardware that has to be sold again and again? Wouldn’t you have to give a MUCH higher valuation to a company whose revenue is mostly recurring?

Or consider the gross margins. Some of our companies have 85% or 90% gross margins. That means that each dollar of gross revenue in that S in the EV/S ratio brings in MANY more dollars to the company than a dollar of sales brings in to a company with a 40% or 50% gross margin (or less).

Is the rate of revenue growth rising so fast that that Sales in the EV/S ratio are likely to be so much larger in three or four years as to be almost unrecognizable? (Think Shopify, which went from $24 million to $395 million in four years, and to $673 million in five. And this year over a billion! Think of that! From $24 million to over a billion dollars, over $1,000 million, in six years!

Say that six years ago you passed on an investment you wanted to make in Shopify because its EV/S valuation was too high? (Yes, I know it wasn’t public then, this is just a hypothetical). How would you feel now that its sales have gone from $24 million to over a billion dollars? How irrelevant would you consider that EV/S evaluation from six years ago?

I figure that if a stock has a high valuation it means that the market, and the people who invest in the stock, thinks it’s a great company with a great future. I figure that my job is investigate and learn about the company and decide whether I also think it’s a great company with a great future. If I do, I’ll take my chances on valuation.

I hope this helps explain it.

Saul

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Hi Saul,
I see all the things you mentioned as things that need to be taken into account when looking at EV/S. For example when I evaluated Zuo http://discussion.fool.com/zuora-a-review-and-analysis-33099873… my take away was that you had other companies with better revenue growth, cash flow and margins that were “valued” similarly hence why I didn’t take a position in Zuo. Similarly I posted recently that AYX was a good buy at 31 because its EV/S had dropped considerably but the rest of the stuff we were talking had done well. Some may have considered ayx to not be such an amazing deal because just 6 short weeks before that it was at a similar price, but it’s ev/s was higher back then because we didn’t have the benefit of their latest quarterly report.

I think you rightly point out that EV/S can’t be used in a vacuum, and you very nicely pointed out all many of the things we should be considering when we look at EV/S. I also very much agree with your point about why investing in high EV/S companies can be very profitable for us.

thanks,
e

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Valuation matters. Of course, it does. If you go to the store to buy a pair of pants then you look at the price. What is that pair worth? If the price tag says $30 then you might think it’s worth it. Is it worth $300 or $500? Personally, I have paid $300 for a pair of pants but I wouldn’t pay it for any pair of pants. Would I pay $900 for a pair of pants? Never. It’s just not worth it. The point is you need to look at price and compare that to the value.

How does one value what a stock is worth? Well, one traditional way is to look at the P/E. But this only tells half or less of the story. The value is also dependent on the growth of E. We used to look a lot at the 1 year PEG which is the P/E divided by the growth in E. We used to compare stock using this metric and from that determine if a stock was a good value. Growth matters but growth at a good value is a clear determining factor on whether to actually make the investment. To ignore valuation is simply foolish.

Now that Saul is invested in rapidly growing companies that have essentially no earnings, P/E and the 1 year PEG no longer work. Therefore, we need another metric to value these companies. EV/sales (enterprise value divided by sales) is the start but it is like P/E. It only provides half of the consideration. So, Saul is correct that EV/sales or P/S cannot be looked at without considering the other factors like revenue growth, gross margin, operating expense as a percent of revenue, as well as other factors including the change in these other factors. But to ignore valuation is like blindly buying based on growth. How do you know if you are buying the shoes for $900 or $30??

I start with P/S together with the 1 year revenue growth rate. This is just the start. I also consider GM, customer growth, cashflow, and other factors which are more intangible like competitive advantage. There are a lot of consideration when I decide whether I like company A compared to company B. And which company I prefer can change as their relative stock prices change. I often make adjustments to my allocations based on valuation, remembering that P/S is a factor that needs to be adjusted for things like growth rate, GM, and several other factors.

Chris

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Saul, surely the element missing here is risk. You may not pay any attention to P/S multiples but here’s the key point: the market doesn’t either. Your assumptions, carrying a shedload of risk for novice, concentrated and less agile investors, is an immutable ratio, a sure prospect and a rosy outlook.

I’m short of time but here’s an example and I hope the figures are right!

Company X has sales of $500m. and is on a multiple of sales of 20. Cap. is $10B. The end of toytown money comes and a few months later, owing to macro events, recession. After a while, there is not a single company in the market valued at a P/S of 10, let alone 20! Company X is lucky to be on an exceptionally high PS of 5 and now its cap. would be 2.5B except that… sales have come down. It’s that old double whammy, the falling sales (or earnings) and the falling multiple. The investor ruefully looks at a loss of capital of way over 75% and all those times he bought more on the way down…

It’s all about risk-adjusted returns, as O’Shaughnessy researched long ago in relation to PS in ‘What Works on Wall St.’. You are right: extremely ‘modified buy and hold’ is the order of the day. Dancing like Chuck Prince carries risk; the music stops one day. You are right until you are wrong. Play the game but keep your eye on the location of the exits from the ballroom.

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I should add that your post was so full of valuable notes about co. attributes you look for, in respect of what we do here, I printed it off.

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If you go to the store to buy a pair of pants then you look at the price. What is that pair worth? If the price tag says $30 then you might think it’s worth it. Is it worth $300 or $500? Personally, I have paid $300 for a pair of pants but I wouldn’t pay it for any pair of pants. Would I pay $900 for a pair of pants?
Please tell me you mean trousers!
A
:wink:

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If someone offered me $300 in ready money for a pair of pants, I would trouser it.

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Dancing like Chuck Prince carries risk; the music stops one day. You are right until you are wrong. Play the game but keep your eye on the location of the exits from the ballroom.

The music stops, but it starts back up in the not too distant future and the vast majority of companies go on to achieve new highs post downturn. Fear of loss is a powerful undercurrent in the stock market, and timeframe is ‘everything’.

conifer

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the vast majority of companies go on to achieve new highs post downturn. Yes but is that true of very highly priced no earnings stocks? The steep slope of the lazy S TALC curve takes place over a short period of time , if that is in a recession/bear market it may not be rewarded in stock price appreciation.
Aside from the oft quoted examples of 2000 ,does anybody have any hard data about the recovery rate of NPI/Saul type stocks compared to the bull peak before?
I don’t mean anecdotal, because I would really like to know. Is it the old favorites or new ones? Is full price recovery mostly found in consumer facing stocks like Amazon and Netflix? Or does it extend equally to B to B stocks?

Percentage wise it’s tough to make up for a 60% loss. We may never see another bull market like this one, still going strong (I think)after all this time.

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We may never see another bull market like this one, still going strong (I think)after all this time.

People keep talking about this “bull market” and how long it has been going. Do people not recall that the market dropped 60% in 2008-2009? If you take this drop into account the 2009-2018 period does not look so special. Look at the graph from 1982 through 2018. Draw a line from beginning to end for this time interval. There’s been a bull market with 2 big downturns. If global economic growth keeps progressing wouldn’t one expect the stock market to continue its march upward. Yes, there will be shocks and hiccups along the way but the period after these shocks should result in a steeper upward incline that the average over the entire period. Are we entering the 4th industrial revolution? Will AI, 5G, and technology acceleration juice economic growth in the coming years? We will see.

Chris

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1982 through 2018

36 years time span is beyond many investors. They die , or become unable to manage investments before then. And if the recession lasts longer than their cash they will have to eat into principal. Endowments can think 50 years ahead but most of the people who are old enough to have much money to invest can’t.

Look how long it took US markets to recover from 1929, NASDAQ from 2000, Japanese stock markets from their bubble.Though the odds are on your side that 3 or 4 years cash is enough for most bear markets it is not guaranteed.

Are we entering the 4th industrial revolution? Maybe it’s just a continuation of the last one. Perhaps awaiting wide use of AI and something to replace today’s silicon chips. TBD.

http://www.sepaforcorporates.com/thoughts/heck-fourth-indust…