Musicali asked last week whether there is a limit to valuation excess and if, for example Zscaler was in a bubble and was at 100 times EV/S, what would you do? Tinker immediately said that he would sell, and I said I guess I would reduce my position greatly.
However, I did a little thought experiment and decided “The Devil is in the Details”. The question is: When do you sell? You don’t just wake up and see the price at 100 times EV.
For example, a year ago ”everyone” felt that Zscaler was very overvalued. I don’t remember exactly but I think it had an EV/S ratio of 25 or so. At any rate I know for sure that it closed a year ago today at $26.60.
At yesterday’s close it was at almost $71.03 and an EV/S of 34.9 (let’s say 35x for simplicity). So the stock price is 2.67 TIMES the price it was at a year ago.
So, if you sold a year ago because it was obviously ridiculously overvalued, you would have missed a 167% rise in the stock price.
But should you sell today at a 35x EV/S ratio? That is the question!
Okay, let’s look forward now, and continue our thought experiment. Revenue last quarter was up 65% and accelerating (last four quarters were 49%, 54%, 59% and 65% growth). Let’s assume it stops accelerating and just rises at 65% for the year.
And let’s say the EV/S a year from now is 50x (on it’s way to 100x, remember!). The stock price will be $167.42. Now 50x is obviously ridiculous, but as I pointed out before, a stock doesn’t get to 100x instantaneously. It grows. When do you sell? It isn’t an easy question. If you sold today you would have missed another 136% rise by a year from now.
And we were only at 50x. To get to 100X, the EV/S ratio would have to go through 55x, 60x, 65x, 70x……. on the way to $100, and sales would be growing too. At what point did you sell out? And how much of the rise did you miss?
Damn, it’s not as easy a question as it seemed when Musicali asked it.
My solution is:
Don’t let any position get too big (certainly not significantly over 20%)
Consider how well the company is executing and how much of a market it has in front of it.
Consider your confidence level.
And if the valuation level makes you uncomfortable, reduce your position until you are more comfortable.