ZS at 100x? a thought experiment

Investment Analysis Clubs Saul’s Investing Discussions
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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.

Best,

Saul

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In a world where most people try to make investing sound so complicated to intimidate us into handing our money over to others and paying high fees for below average performance, Saul keeps things so simple.

Beautifully said Saul. Investing isn’t easy peasy, but keeping our approach simple and our mind clear certainly goes a long way towards making market-crushing returns achievable and simplish.

Saved your post in my eternal note database.

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Saul,
I would argue the hyper-growth SaaS stocks we tend to follow have created a new normal in P/S…not saying that is a good thing. Rather, we now look at a 20 P/S and think “cheap!” which is kind of crazy.

I get that these stocks are asset-light, not-hardware, and have recurring revenue…things that allow (arguably) for a higher valuation than say more traditional companies like an ANET.

My issue is I am started to get deja vu regarding stocks like ZS, from late 1999 and very early 2000, before the bubble burst. Back then I was all over the networking stocks like Cisco, Juniper, Redback Networks, etc… Everything just kept going up. There was a Saul-like board called Gorilla Game in which all the posters just seemed to blindly think “this time things are different” and as long as they could label something a gorilla or chimp or whatever other nonsense, they were shielded from anything ever going wrong in regards to valuation.

I think Juniper got up into the $50b or $70b range for market cap. I kept doing the napkin math and wondering how is this a legit valuation. Then the bubble burst, and JNPR and CSCO have yet to retrace those highs of 2000.

You mentioned in a post somewhere regarding your trading history that you followed your gut in 2000, I believe it was something about Yahoo going up an absurd amount in a few days, and you finally sold and got out before the collapse.

While ZS may not yet be at the Yahoo 2000-ish frenzy, I have also been wondering what is the mental cutoff for extreme valuations? Is it just one of those things you know when you see it? At what point can you declare a “win” and maybe move funds into another solid company that hasn’t quite skyrocketed as much?

I sold out of ZS recently. It was “overvalued” when I bought again in Jan, and it went up another 70% in about 2 months. It is growing it’s business 65% over an entire year. At some point, doesn’t a stock price have to reflect more in line with the growth of their business, however you choose to measure it? (revenue, earnings, billings, etc…)

This doesn’t mean I think ZS stopped being a great company, nor that I think it won’t be a bigger market cap in 2-3 years or 5-10 years. Pretty good bet it will be. But the next stop for ZS stock growth is a 40+ P/S which is usually reserved for speculative biotechs.

But if we are realistic when looking at your port or the concept of modified buy-and-hold, most of your stocks have not been owned by you for over 1 year, let alone 2 years. ZS just went public 12 months ago.

If the idea is to be in the best possible stocks for growth, in that moment in time, why would ZS be worth so much more than AYX, even though they have approx the same revenue run-rate and both have excellent growth rates? With the recent slide in ESTC, there is a similar argument there. If the market is pricing ZS rationally, then it follows it must be overlooking the value in AYX and ESTC, so wouldn’t funds be better allocated to the companies executing equally well that have lower valuations in their stock price?

I am not sure I have a real question in these ramblings, nor do I think there is a right or wrong answer. Holding a great company like ZS is not a bad thing long-term. If the 2000 bubble is too extreme a comparison, another poster brought up Splunk as an example of a company that had a very high P/S and then stock went sideways for 3-4 years, yet the company’s growth stayed strong and continues today. ZS at a $3b mkt cap seems a much different price appreciation oppty than ZS at almost $9b mkt cap.

I appreciate you responding to the ZS at 100x question…it had been on my mind too.

thanks,
Dreamer

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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

Thanks Saul,
I hear you and I also saved in my permanent file.

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I’m new to this board and want to know is there a website where I can look up the EV/S ratio of any company?

Thank you Saul for posting your thought experiment.

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I’m new to this board and want to know is there a website where I can look up the EV/S ratio of any company?

Marketscreener.com does this pretty well

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Very interesting Saul…one way to consider the question is to consider how long it will take for the EV/S to “catch up,” or “normalize.” Just throwing this out there for everyone…a spitball in the thought experiment world.

Back a ways, we thought that a PE ratio of 10/1 for a stable growing company was about right. That is, a wallet you buy for $10 today that will spit out $1 every year was reasonably priced. But pay $50 for that wallet, and maybe you won’t get your money back. It was/is a way to evaluate where the market is compared to a metric you could understand.

EV/S wasn’t considered years ago (part of why Amazon was ridiculously underpriced for what it has become). In the EV/S ratio world, we aren’t talking about generating earnings (yet). We are talking about expectations; that a hyper growth company will eventually grow up and have positive earnings and cash flow.

So how long until your “bet” that ZS will grow into your price will work out? Right now EV/S is about 35.

We can try to forecast positive earnings and cash flow, but those goalposts keep moving in growing companies. Let’s look at how long it would take, if you freeze the price, to come to a 1-to-1 EV/S ratio.

From last January with the prior 12 months at $242.9 M and the valuation above $8 billion, a frozen price from now, with a growth rate of 65% gets you back to 1/1 in 7 years:

0 $242.9
1 $401 M
2 $661
3 $1,091
…
7 $8,087

A 100 EV/S ($24 Billion?), frozen today, would take a while longer, but because of the amazing benefits of compounding, you would get there (roughly) in only two more years.

8 $13,344
9 $22,018

So the Devil (is very much) in the Details otherwise known as “it depends.”

If you know the market you are building into won’t allow growth to continue, then the math needs to fit the real world - “execution…and…how much of a market it has in front of it.” At some point we bump into real world limits. So it depends.

Anyway, the above is just FWIW and YMMV.

Cheers,

Bill

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Thanks Saul and Dreamer.

The question popped into my head of what would happen to the PS over time if the stock price stopped appreciating:

Year P/S
0 35.00
1 21.21
2 12.86
3 7.79
4 4.72
5 2.86
6 1.73
7 1.05
8 0.64
9 0.39
10 0.23

It takes about 5 years for P/S to get to around 3. For 30% price appreciation during that time:

	30%	Price appreciation
Year 	65%
0	35.00
1	27.58
2	21.73
3	17.12
4	13.49
5	10.63
6	8.37
7	6.60
8	5.20
9	4.09
10	3.23

So it takes 10 years to get to that point. My point is that with stocks growing this fast, we can get good price appreciation even if P/S is high and must decrease every year. And also a way to evaluate the effect of P/S normalization (given an expected rate of valuation grown) over time on the growth of the stock price.

Enjoy,
Brian

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Nice, Bill. We took different slants on the same basic idea.

Enjoy!
Brian

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Ha, thanks Brian, you too. I worry about us both! LOL. The math is very close - i think of the “frozen price” as “basis.” As (or if) the company grows, what was an expensive stock comes back to you, and becomes reasonable.

Cheers,

Bill

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My point is that with stocks growing this fast, we can get good price appreciation even if P/S is high and must decrease every year.

Yes. But…if rev is growing 65% per YEAR and stock grows 70% in 2 months, then the P/S continues to rise for ZS, as it has since January.

I find it perfectly reasonable to expect a stock price growth to match the company growth (whether you measure by earnings or rev, etc).

So if we forget about the previous 2 months and just start today, ZS stock could appreciate 65% and maintain their current P/S.

But since their P/S is higher than just about any other company, excluding biotechs/pot stocks, that are discussed here and at NPI, then I don’t think it is unreasonable for their P/S to shrink to be more in-line with other companies that have similar growth rates.

In your scenario of them “only” growing 30% y/y…the reality is if they started pumping out 30% growth the next few Q’s, I would wager the stock would plummet far faster than your model. I can’t think of too many stocks with a P/S over 17-to-20 that are growing “just” 30% y/y on my watchlist.

While I do think the valuation concerns are important, for this board this might be getting off-topic now, so last I will comment on it here.

Dreamer

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In your scenario of them “only” growing 30% y/y…the reality is if they started pumping out 30% growth the next few Q’s, I would wager the stock would plummet far faster than your model. I can’t think of too many stocks with a P/S over 17-to-20 that are growing “just” 30% y/y on my watchlist.

If you are referring to my scenario where I said:
For 30% price appreciation during that time

That 30% was for the stock price appreciation. I agree that the stock price percentage increase will likely lag the P/S percentage increase at some point over the next 5 years – unless the subscription growth rate goes up even faster than it has to offset that. I’m not counting on that.

As the P/S (or other such measure) gets higher, the likely return on the stock price gets lower, all else being equal. But that doesn’t necessarily mean it will plummet – but high growth stocks often do at some point, especially if they “get ahead of themselves” (what a mushy phrase).

Enjoy,
Brian

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Dreamer, A blast from the past.

“There was a Saul-like board called Gorilla Game in which all the posters just seemed to blindly think “this time things are different” and as long as they could label something a gorilla or chimp or whatever other nonsense, they were shielded from anything ever going wrong in regards to valuation.”

I was also on the board, as well as Denny S. It was an offshoot of the Gorilla Game by Geoffry Moore. As you remember the objective of the board was to try and identify an emerging Gorilla. I remember we identified one, QCOM.

Certainly the stock price got ahead of itself, reaching an inter-day high of $250, after splitting 4:1.

Tom

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There was a Saul-like board called Gorilla Game in which all the posters just seemed to blindly think “this time things are different” and as long as they could label something a gorilla or chimp or whatever other nonsense, they were shielded from anything ever going wrong in regards to valuation."

Sage observation Tom.

We have been through this very carefully on the NPI and explored all stocks that we could identify going back 20 years that had P/S>20 and what their subsequent stock returns were for 3 years.

These type of analysis have to acknowledge that there are always going to be an exception or two and I think Bert did a nice job in his recent article on ZS essentially stating that for an investor to buy ZS here, one has to believe that ZS takes over the industry…not just another player…truly a transformative event (paraphrasing).

But as a thought experiment, each of you might find it very interesting to identify other stocks that you say will do what ZS must do…maintain insane growth rates despite scaling above $1 Billion (no easy task), persistently high P/S in any market including recessions (never been done before that I am aware of), etc. What demands are you placing on this investment that have precedent?

One issue that I believe deserves some consideration on the positive side is that a company like ZS is in growth mode…not profit mode. At some point, it should be able to convert that revenue to earnings and at that moment, what would it do on a PE basis given its business model.

For example, at this moment, if it has profit margin of 35%, what is its PE (and could it reasonably produce that profit margin)?

A great example of this is VEEV that has a P/S of 21 but has a PE of 83 (margin of 27%). I would think ZS could substantially exceed that profit margin.

Best:
Duma

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https://discussion.fool.com/gorilla-game-viable-now-12113473.asp…
From March 3rd 2000. Hilarious or sad…maybe both?

Whole post sums up my fading belief in the GG fad.
But the sarcastic ending is great:
“Well, got to go…thinking about picking up some PALM at a P:E ratio of 1400…I know that’s a high ratio, but this COULD become a gorilla some day, after all. And the P:S ratio is ONLY 68. And if we start talking about the price:vision ratio, it’s a steal!!”

Bruce Brown would later wonder if exit strategies should be a thing:
https://discussion.fool.com/market-timing-thoughts-12205260.aspx…

Flash-forward 18 years, and Bruce amazingly thinks pretty highly of GG it seems:
https://discussion.fool.com/strength-of-old-gorillas-power-of-ad…
(he would later reply to me on that now dusty tumbleweed-strewn board)

While he pointed out some Gorillas that are still alive and kicking, I noticed no mention of Juniper or Redback Networks. :slight_smile:

I don’t mean to pick on him…seems like a great guy, and always put a lot of thought and research into most of his posts.

But the real game isn’t to pick the best companies that will last for 20+ years.
It is to buy the stock price at point A and sell it for a, hopefully, much higher (and near the forever ATH) point B.

If a company lasts 20 years, but point B occurs in year 2 or 3, then it doesn’t make sense as a LTBH, no matter if it is a Gorilla or a Chimp or a Baboon or whatever.

Dreamer

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Brian,

You do realize that if ZS grew revenue at 65% for 10 years, it would be generating revenue of $28 billion a year right?

I don’t know. Last time I started talking like this on Motley Fool message boards. Last time I made money in this short amount of time, we were pretty close to the peak of the tech bubble.

I just looked at the market cap of a few tech darlings of 1999. FFIV is at a $9 billion market cap. JNPR is too. The only thing they have to do with cloud stocks is they were the darlings of their time.

I’m sure this is way OT for this board, so I’ll just post this one message.

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Regarding this whole EV/S multiple discussion, I would like to point folks to the thread I made some months back over on the NPI board about a possible new valuation methodology that could perhaps guide what a “right”/“correct” multiple could be. The concept still needs further fleshing out, but the basis seems logical to me.
https://discussion.fool.com/work-in-progress-valuation-methodolo…

In listening (finally) to the beginning of Fish’s interview with Bert Hochfield over this past weekend, Bert mentioned plotting all (or at least a good number) of his companies on a graph by EV/S ratio. That sparked me to think back to the my prior thread. That particular discussion is at about the 20 minute mark in the linked Podcast below:
https://www.youtube.com/watch?v=VxlS0JIvGIU
Listen Notes:
https://www.listennotes.com/fr/podcasts/the-investing-city/e…

volfan84
who thinks that we can refine the proposed methodology from the link above to determine a “proper” valuation range even for “our” super fast growers

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For me, it doesn’t matter if ZS or anyone else grows in perpetuity at 70% a year or whatever. All that matters is that they grow enough to be worth my investment.

Let’s say I buy shares of Dreamer Co largely because they have a great CEO. Dreamer Co is growing at 70% a year. The also have gross profit of 70%. And their P/S is a gaudy 24.

Revenue - $10
Cost of share - $240

At a 70% growth rate, that P/S is going to come down relative to my purchase price very quickly.
At purchase - 24
In one year - 14.1
Year 2 - 8.3
See what I did there? I divided 1.7 (70% growth) into the P/S. Still not cheap compared to the P/S of more traditional companies, but as Saul has pointed out many times, companies that make blue jeans and doughnuts just can grow like this. So SaaS companies are worth more. And again, all I care about is how it relates to what I paid for it. Time is my biggest ally in investing.

Second, to acquire a customer, it costs SaaS companies the equivalent of about 12-18 months of sales. Once that period is over it becomes almost all profit (slight exaggeration). So we want our companies to grow very, very quickly. It’s a land grab. When they do this they are going to lose a bunch of money, at least in the beginning. That is OK, because the more money they lose when they are starting, the more profitable they will become once they have covered the cost of customer acquisition. It’s a sling shot effect and counter intuitive when compared to traditional companies.

SaaS companies have gross profits that traditional companies cannot even think about reaching. Let’s take Dreamer Co again. 70% gross profit, let’s assume that at some point that can be 35% net. If that was happening today (35% profit on $10 of revenue is $3.50 into a $240 stub price) Dreamer Co would have a PE of 68.5. That’s not bad, for a company growing that fast and sporting that sort of profit.

Let’s factor this out based on what I paid for the stock, not what it is trading for in the future.
Year two PE becomes - 40.3
Year three - 23.7

Obviously things are not going to progress in a linear fashion like this, but for what it is worth, that is how I do my thought experiment.

Jeb

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I was also on the board, as well as Denny S.

Guilty as charged but not quite. Relevant dates:

11/29/1999 - Denny posts Bulls, Bears and Chickens to the Gilder Forum. This is a bubble alert. https://softwaretimes.com/files/bulls,%20bears%20and%20chick…

12/30/1999 - Analyst Sets a $1,000 Target for QCOM: https://www.wsj.com/articles/SB946504678184913770

01/03/2000 - QCOM hits 1000

7/10/2001 - Denny’s first post at TMF, at the NPI board: https://discussion.fool.com/hi-paul-yes-i-read-all-four-of-moore…

1/25/2002 - Denny’s first post at the Gorilla Game board, about browsers: https://discussion.fool.com/bruce-sent-via-internet-explorer-5-w…

After 20 years memories become fuzzy. There was a lot to learn from The Gorilla Game that is as valid today as it was then. The dot com bubble really stated around 1995 culminating in 2000. Today there is nothing like it: https://invest.kleinnet.com/bmw1/stats40/^IXIC.html

It would seem like SaaS stocks are in bubble territory but in truth GAAP accounting for SaaS is not comparable to traditional companies. When you built a steel mill the cost of the mill went into the Asset side of the Balance Sheet with only a small part going to expenses each year via Depreciation. With software the cost of developing the software does not go to Asset side of the Balance Sheet, it is expensed as it happens. With SaaS the cost of acquiring long term customers does not go to the Asset side of the Balance Sheet, it is expensed as it happens. If R&D and S&M were to go on the Balance Sheet SaaS would show a profit much sooner.

I highly recommend studying David Skok’s explanation of SaaS finances:

David Skok of Matrix Partners: Driving SaaS Success Using Key Metrics

https://www.youtube.com/watch?v=bCBccKfG9U0

For SaaS to reach profitability Revenue, actually Gross Margin, needs to grow vigorously for LTM to exceed CAC and a slow down in Revenue or an undue rise in S&M are the red flags to watch for.

So no, SaaS valuation is not bubble valuation, neither from the price chart nor from the GAAP (CRAP) accounting points of view. You might argue that Price to Sales (P/S) takes care of these GAAP anomalies and P/S are also sky high compared to traditional business. Again there are notable cost differences between steel mills and SaaS.

  • SaaS is asset light, not capital intensive
  • Open Source reduces the cost of developing software
  • Gross Margin is much higher in SaaS
  • Paying for talent via stock options shifts the burden from the company to the shareholders offset by stock buybacks which are optional – payrolls are not optional.

My point is that the metrics that Graham and Dodd used in Security Analysis have changed radically. Do watch David Skok.

Denny Schlesinger

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They are not all going to grow at 70% a year for 5 years. In fact none of them will much past $1 billion in revs, w Elastic most likely to be the next SHOP in regard.

If one is over valued they all are. One won’t lose less money in 12x holding than a 20x holding. All are worth it or none are.

The market has already made some harsh discriminations cutting out Pure Pivotal Talend Cloudera Nutanix. Pure has great fundamentals and growth but the market gives it 2x and yet Pure performs far worse than any overvalued stock.

In the end this all becomes gibberish. Look at marketcap to opportunity vs risk of obtaining opportunity. If too much of the marketcap is eaten up to make the plausible returns worthwhile then sell and move on.

Multiples are meaningless. Valuation is what counts. Valuation is risk reward of future returns adjusted for risk. If too much of the valuation is already consumed to adjust for risk then sell.

The rest is jibber jabber.

Tinker

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