ZS at 100x? a thought experiment

Investment Analysis Clubs Saul’s Investing Discussions
#14

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

9 Likes
#15

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

19 Likes
#16

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.

5 Likes
#17

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

2 Likes
#18

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

19 Likes
#19

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

38 Likes
#20

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

7 Likes
#21

Saved your post in my eternal note database.

Austin

Will you make the DB publicly available? :blush:

This is my first post on this board so I hope this is a small contribution. This is a snippet from a post GKesarios on Jun 28, 2014 which speaks to owning high P/S stocks. As context, I own many of the SaaS stocks here, but I find this interesting to remember.

<I?When investors buy stocks with high P/S ratios, those stocks need to grow revenue at least 30%-40% on a yearly basis for many years into the future. This is because investors are paying a big premium today for growth that is expected to happen in the future. But, with any deviation from future growth expectations, the premium paid today may no longer be deserved. As a result, and because an irrationally high P/S ratio cannot be maintained by an increase in revenue growth, the stock is likely to collapse.

2 Likes
#22

When I bought SHOP I could have bought it for 35x sales and I would still have 5x on it.

Was it overvalued?

The multiple was meaningless tripe at the time. So why is it meaningful now?

Tinker

#23

Why doesn’t MF have an edit feature. Doh!

The post again…

Saved your post in my eternal note database.

Austin

Will you make the DB publicly available? :blush:

This is my first post on this board so I hope this is a small contribution. This is a snippet from a post GKesarios on Jun 28, 2014 which speaks to owning high P/S stocks. As context, I own many of the SaaS stocks here, but I find this interesting to remember.

When investors buy stocks with high P/S ratios, those stocks need to grow revenue at least 30%-40% on a yearly basis for many years into the future. This is because investors are paying a big premium today for growth that is expected to happen in the future. But, with any deviation from future growth expectations, the premium paid today may no longer be deserved. As a result, and because an irrationally high P/S ratio cannot be maintained by an increase in revenue growth, the stock is likely to collapse.

To finish my post, I think ZS’s expectations could be too high to hurdle at 100 x’s P/S. Nothing wrong with 100 P/S but market expectations could smash the price.

Mark

#24

If the business model is so compelling for saas companies, why haven’t they shown up in Salesforce yet at $13 billion in revenue?

1 Like
#25

There was a lot to learn from The Gorilla Game that is as valid today as it was then.

In particular, there was and is a lot to be learned from Moore’s books. The Gorilla Game itself is a bit of an aberration in which he somehow got talked into or talked himself into applying his perception to investing … and did so right at a time when a really abnormal investing environment made just about any theory likely to step in a hole. It is possible that feeling that a company was a Gorilla helped people to ignore all valuation discussions, but people seemed very good back then at ignoring valuation discussions for companies that couldn’t possibly be considered gorillas since they had yet to develop a business plan that even made money.

This is really a very, very, very different environment than we have today. The companies which are interesting us have real revenue growing at dramatic rates … a context which is likely to push the boundaries of traditional valuation metrics which are derived from companies with far, far less dramatic growth.

2 Likes
#26

It is because at its present marketcap it has eaten up a relatively large chunk of its opportunity and will never hyper grow again.

At the same time it is likely to grow at 20% a year for years to come and some day churn out tons in dividends when it stops growing, which may be years from now.

Compare that to CRM at $3 billion marketcap w hyper growth. Willing to pay a much higher multiple? We sure did for SHOP.

These multiples just are not cross comparable. It comes down to what your willing to pay for forward business adjusted for risk and that differs substantially by business and maturity of business.

Tinker

1 Like
#27

What I am reading on here is saas is a goldmine business model that leads to substantial profit margins for sellers of saas. Yes software companies always have high gp. But the biggest saas company out there does not have substantial net profit. So I have concern over paying huge numbers in hopes the Zscalers out there are going to have 20% net profit some day. It’s not working that way for crm.

1 Like
#28

12x,

Yes software companies always have high gp. But the biggest saas company out there does not have substantial net profit. So I have concern over paying huge numbers in hopes the Zscalers out there are going to have 20% net profit some day.

I think this is a really good point worth considering. Let me state that it is one of the reasons I like Arista (ANET) even though not a SaaS company. Net profit after taxes that goes to the bottom line is 30% of revenue. Operating Margins are typically around 37%. There are very few companies who are operating at that level.

I, too, have reservations about net profit levels upon maturing. I think that is key to understand, or try to glean, as well. That is, what businesses will exhibit exceptional margins down the road. One that does seem like a great candidate is Zscaler…hence the current valuation I guess.

A.J.

#29

SaaS is a superior business model with increasing returns as more volume increases utilization of the hardware and software necessary to handle it and thus why an Amazon and a Microsoft are now virtually unstoppable because no one can match their scale.

Look at Zscaler. The more customers they get the lower their fixed unit costs. Hardware is such that new customers may have practically zero marginal cost until such time as you fill up the node and then need to fill that up.

The value of each new customer is so great that it would be malpractice to not spend money to capture them all. With Zscaler, that has so little churn, such high switching costs, and such high lifetime value per customer they are doing something with economics that probably has not been seen since Microsoft. Certainly better than Palo Alto.

No, Zscaler is not another Microsoft but its economics of customer value per cost is very comparable. Thus Zscaler making a profit is a result of management underfunding sales and the market over demanding their product. They should scour the Earth and disrupt the market as it will better every businesses’s business and lock them in to Zscaler (I mean, not impossibly, but practically).

Salesforce is the same way. You get in the Salesforce CRM system you are not going to leave. In fact Salesforce looks undervalued here. So does Elastic (but yes, Elastic’s market cap is ~20% greater than Yahoo! lists. There should be 85 million shares counted is $7.225 billion, but at $5.5 billion market cap (as Yahoo! lists) that stock release fear appears to be a real thing.

Tinker

5 Likes
#30

“My point is that the metrics that Graham and Dodd used in Security Analysis have changed radically.“

On the end, the value of a business has to relate to the value it provides and will be providing. One would value a given business potential from what s/he can see now and ahead. SaaS will not be valued like a Nucor or a consumer business. Different kind of businesses will be valued differently. That is nothing new. The attractiveness of the SaaS business model does not mean it cannot be overvalued.

How would you valuate a ZS or ESTC or AYX or any such high growths? What would you look at if the high P/S or EV/S doesn’t tell you much or anything? Or not as much as one might think? I guess that at the initial stages of high growth, these simply cannot be valuated especially when they come off from relatively small bases. They have to reach some more stable periods in their growth to really see if there is a flywheel that can last or not. We should distinguish momentum with genuine epochal growth.

It is hard to call that value when most of these could get cut by more than half in a very short period of time. Or could that be a mistake from the market? It could be in the long run. In the shorter run, who really knows?

tj

1 Like
#31

Hey guys, this has gone into 30 posts in the thread, and everyone has said what they have to say about it three times at least, and then explained it another time or two. No one has to have the last word! Let’s just let it go and stop kicking a dead horse.
Thanks for your cooperation,
Saul

15 Likes
#32

“This time it is different” is a notoriously bad way to think … but, it is also obvious that one kind of business and another kind of business are not appropriately evaluated by the same metric and standards and one of the things about SaaS businesses is that it is in some ways a new business model with which we have as yet somewhat limited experience.

Clearly, selling hardware and software are very different businesses because one has to manufacture each unit of the hardware while much of the expense of the software is upfront. I say much since enterprise level software … as opposed to something shrink wrapped … can often include some enhancement as a part of each sale. Back when I was first selling my ERP software I could make some money on the hardware as well since the medium sized companies I was selling to had limited IT departments and one needed something mini-computer-like to support many companies. Now, the same number of users can be comfortably supported with better performance on a PC running Linux.

The genius of SaaS is that while one forgoes the big paycheck at time of sale, each sale turns into substantial recurring revenue for a significant period of time. Moreover, it is attractive to the customer because it eliminates the big up front cash outlay to purchase the license and often eliminates the cost and hazards of managing one’s own hosting (SaaS licensing can be used for on prem installations, but most often is not).

SaaS does not eliminate the need for customer-specific modifications, but it provides a huge incentive for the software company to think about better design. Pre-SaaS, many software providers were either “over the transom”, i.e., the customer was responsible for all customization or, if the provider did the customization, that was often done at minimal cost to create a unique implementation for that one customer unless the feature was one that was a good candidate for inclusion in core product. With SaaS, there is a strong motivation for the software provider to think in terms of a unified implementation with “switches” to invoke different behaviors for different users so that a single unified product was providing as much of the functionality as possible for all customers.

Which said, done right the SaaS business model enables extremely rapid company growth … as we have seen for some of the companies we discuss here. As we have seen, this strains our valuation models. I would like to suggest that this is exactly because of the rate of growth. We have seen that some traditional valuation metrics are invalidated by different business models, e.g., the Amazon keep investing the potential profits in growth so that P/E remains low despite enormous success. The inherent problem of an extremely high growth company is that a huge part of the “valuation” that the market provides is based on expectation, not performance. So, when those expectations are met, then the expectations continue to grow, but if the expectations are not met, even by a little, there can be a huge … technically disproportionate … contraction of expectations and thus of price.

At times, we have talked about the silliness of quarterly earnings reports and their impact, especially since analyst’s expectations are often based on little real knowledge. But, with these companies we would almost wish for monthly updates so that we could more rapidly adjust our expectations. And yet, even then, much of the reaction would be lacking in understanding of what was actually happening with the company.

10 Likes
#33

tl;dr