Valuing Our High P/S Co's 3 years out

Given all the talk about valuations and P/S, I thought I would work out some numbers today to estimate possible results of declining P/S’s for our high growth companies as well as declining revenue growth rates and see what I come up with.

First I took our high growth companies and laid out their current market cap, revenue (both trailing 12 months, as well as annualizing the latest quarter), and the current P/S (again P/S based on trailing 12, and P/S from annualizing the latest quarter):


	 market cap 	trail 12mo rev     Latest Q annualized     P/S trailing   P/S annualized  YTD rev growth%	Last Q ended
									
MDB	 4,760,000,000 	    214,738,000 	 259,940,000 		 22.2 	     18.3		56%	           Q3
ZS	 5,090,000,000 	    213,611,000 	 253,192,000 		 23.8 	     20.1		59%	           Q1
NEWR	 4,930,000,000 	    413,392,000 	 459,584,000 		 11.9 	     10.7		35%	           Q2
AYX	 3,830,000,000 	    182,384,000 	 216,716,000 		 21.0 	     17.7		55%	           Q3
OKTA	 7,390,000,000 	    361,533,000 	 422,304,000 		 20.4 	     17.5		53%	           Q3
TTD	 6,150,000,000 	    419,474,000 	 475,300,000 		 14.7 	     12.9		54%	           Q3
TWLO	 9,350,000,000 	    561,001,000 	 675,580,000 		 16.7 	     13.8		57%	           Q3

Then I applied a rate of decline on both the P/S ratio and Revenue growth rate for each of the next three years. Here I show using a 10% annual decline in P/S ratio and 10% annual decline in growth rate. To be conservative, everything is based off the trailing 12 month revenue (not annualizing the latest quarter):


	 Year1 P/S  Year2 P/S  Year3 P/S   Year1 Rev%      Year1 $   Year2 Rev%     Year2 $    Year3 Rev%   Year3 $ 
										
MDB	 19.9          18.0 	   16.2        50%	 322,965,952 	45%	 469,463,308 	41%      661,117,009
ZS	 21.4 	       19.3 	   17.4        53%	 327,038,441 	48%	 483,330,112 	43%	 691,215,226 
NEWR	 10.7 	        9.7 	    8.7        32%	 543,610,480 	28%	 697,724,051 	26%	 875,748,343 
AYX	 18.9 	       17.0 	   15.3        50%	 272,664,080 	45%	 394,135,928 	40%	 552,164,728 
OKTA	 18.4 	       16.6 	   14.9        48%	 533,984,241 	43%	 763,223,676 	39%	 1,058,110,407 
TTD	 13.2 	       11.9 	   10.7        49%	 623,338,364 	44%	 895,986,564 	39%	 1,248,700,635 
TWLO	 15.0 	       13.5 	   12.1        51%	 848,794,513 	46%    1,240,682,940 	42%	 1,756,223,922 

And these are the resulting market cap valuations three years from now:

Scenario 1 -10%


	Year 3 P/S   Year 3 Revenue   Market cap year 3      Cumu 3yr MC inc   Compound Annual %
							
MDB	 16.2 	    661,117,009 	10,683,262,695 		124.4%	             30.9%
ZS	 17.4 	    691,215,226 	12,007,013,362 		135.9%	             33.1%
NEWR	 8.7 	    875,748,343 	7,613,628,883 		54.4%	             15.6%
AYX	 15.3 	    552,164,728 	8,452,948,568 		120.7%	             30.2%
OKTA	 14.9 	  1,058,110,407        15,767,215,657 		113.4%	             28.7%
TTD	 10.7 	  1,248,700,635        13,346,147,779 		117.0%	             29.5%
TWLO	 12.1 	  1,756,223,922        21,338,082,611 		128.2%	             31.7%

So what does this tell us? Even with “sky high” (as some would say) Price/Sales ratios today, and assuming that those ratios contract over the next three years, and assuming that their current revenue growth rates slow, this would still show most of our companies valuations more than doubling three years from now. 30%+ compounded for three years…I’ll take that all day long.

Of course, many other factors will impact how these companies are valued in the future, including their ability to control margins, opex, cash flow, competition, and potential remaining TAM. Also, a big one for growing companies like ours will be the impact of stock dilution which admittedly isn’t factored in above.

“But mekong, you’re only forecasting a drop of 10% per year on P/S and rev growth %…that’s not exactly conservative from where they are at today!” you say. And I wouldn’t disagree. Let’s see where the numbers fall out if both P/S and Rev Growth % drop by 15% per year for the next three years:

Scenario 2 -15%


	Year 3 P/S	Year 3 Revenue	      Market cap year 3     Cumu 3yr MC inc 	Compound Annual %
							
MDB	 13.6 	          598,298,771 		 8,144,659,580 		71.1%	          19.6%
ZS	 14.6 	          623,211,897 		 9,119,828,716 		79.2%	          21.5%
NEWR	 7.3 	          816,457,060 		 5,979,639,162 		21.3%	           6.6%
AYX	 12.9 	          500,332,670 		 6,452,495,003 		68.5%	          19.0%
OKTA	 12.6 	          961,257,038 	        12,066,819,135 	        63.3%	          17.8%
TTD	 9.0 	        1,132,934,387 		10,200,738,261 	        65.9%	          18.4%
TWLO	 10.2 	        1,587,358,276 		16,247,244,391 	        73.8%	          20.2%

and what if the P/S ratios and Rev growth %'s decrease by 20% per year each:

Scenario 3 -20%


	Year 3 P/S  Year 3 Revenue          Market cap year 3 	  Cumu 3yr MC inc 	Compound Annual %
							
MDB	 11.3 	      543,487,037 		 6,168,182,287 		29.6%	           9.0%
ZS	 12.2 	      564,017,041 		 6,881,076,016 		35.2%	          10.6%
NEWR	 6.1 	      763,731,891 		 4,663,325,586 		-5.4%	          -1.8%
AYX	 10.8 	      455,070,223 		 4,892,833,276 		27.8%	           8.5%
OKTA	 10.5 	      876,540,361 		 9,173,569,862 		24.1%	           7.5%
TTD	 7.5 	    1,031,758,507 		 7,744,940,538 		25.9%	           8.0%
TWLO	 8.5 	    1,440,133,497 		12,289,117,265 	        31.4%	           9.5%

So even in a scenario where the P/S contracts significantly, as does the revenue growth rate, the overall market cap valuation rises three years from now, compound growth rates on par, or a bit above the stock market’s long term historical averages (with the exception of NEWR in this example). Of course, we aren’t invested in these companies to settle for single digit returns, but it still shows that we probably aren’t going to lose our shirt, or even lose much money at all, even after the P/S ratios come down significantly from where they are today, assuming they keep growing the way we expect (which assumes that growth will slow over time).

Some of our companies may not do as well as even the -20% worst scenario that I’ve modeled above. New competition or poor management could cause them to do far worse. I’m not suggesting that -20% is “the worst scenario possible”, it’s just the worst of the three I’ve modeled.

But I would argue that several of these companies should do even better, much better, than even my best scenario above (Scenario 1, that shows -10% declines/contractions) given the possible TAM available to be gobbled up over the next few years by these companies.

Even Scenario 1 shows only 3 of these 7 companies reaching $1 billion of revenue three years from now, and none of them reaching $2 billion. I would wager that a few of them will do much better.

Also, I used total revenue %'s in my starting point above. Some of these companies have software revenue growth rates even higher than the legacy business, which are becoming a bigger part of their businesses, and should help to keep the overall total revenue growth %'s from slowing as quickly than I may have modeled.

Ultimately, these are just numbers, and just a small subset of the numbers and performance that will ultimately determine how successful these companies will be and how well our investments in them will do. But I think this is an excellent exercise to show that you shouldn’t be completely scared of high P/S valuations. These companies are in the right place at the right time, will have recurring revenue, and incredible margins. Some will fail or ultimately be mediocre. Some will probably get acquired or taken private in the next three years.

But just a couple of them achieving outstanding success should lead to big overall investor profits, even from today’s valuations.

-mekong

78 Likes

Nice analysis. Share dilution can substantially distort the pic. If Ethan and Chris’s calcs are correct both MDB and ZS had 30% dilution in the last 12 months!

https://discussion.fool.com/zs39s-quotvaluequot-playing-with-num…

5 Likes

Nice analysis. Share dilution can substantially distort the pic. If Ethan and Chris’s calcs are correct both MDB and ZS had 30% dilution in the last 12 months!

Yes, absolutely. Especially for young tech companies like we are looking at, dilution will be significant and we need to keep our eye on it.

However, also keep in mind that MDB and ZS both IPO’d in the past year. I suspect that dilution is generally going to be highest immediately after an IPO since public company stock options/awards will be granted to lots of employees at that time.

For reference, I took a look at ANET filings (seemed like a good example since they IPO’d a few years ago in June 2014 are a tech company, although primarily hardware).

Just looking at the weighted average number of shares for each year on their income statement

2013 27 million
2014 48 million
2015 65 million
2016 68 million
2017 72 million

so it probably will slow for our companies over the next few years as well

-mekong

8 Likes

True, as companies mature and start earnings, cash flow they should have less dilution. I looked at the annual share dilution over the last 2 years of some of our companies based on their earnings reports. Nutanix 12.5%/y. TTD was 5%, TWLO 8% and dropping, AYX 4%, SHOP 8%, SQ 10%.

Did’nt complete my thought in the last post. So, if you took an average share dilution of 9% your Scenario 2 CAGR drops from about 20% to about 10%. So, a non-negligible drop in returns.

Nice analysis. Share dilution can substantially distort the pic. If Ethan and Chris’s calcs are correct both MDB and ZS had 30% dilution in the last 12 months!

I checked the Mongo numbers in the SEC filings


**Source         Date        Shares     Increase**
Prosectus   10/19/2017   48,968,305	
10-Q        10/31/2018   52,702,526     7.63%

Caveat: when reporting a loss, shares outstanding shows only actual shares, not the potential shares from stock options. A 30% dilution would be 63,658,797 shares. I’m assuming that the 49 million shares in the Prosectus also did not include stock options.

With mature companies I do worry about stock option abuse but not with start-ups. Stock options are a much more efficient way to pay for talent than cash, both the for the company and for the talent.

Denny Schlesinger

5 Likes

A general comment - precision doesn’t imply accuracy.

The story with these stocks is pretty simple; as long as revenue growth continues; valuations will be supported. The challenge/risk is that as soon as that story stops there will be a significant re-adjustment that will be painful as both the revenue and the mulitplier both drop.

Example: Consider a company that is forecasting strong revenue growth.


        Revenue   Multiple  Stock Price
Year 1: $100      15x       $1500
Year 2: $150      15x       $2250

Then for some reason (poor business management, competition, saturation, anything really) revenue growth slows. The story has changed and the mulitple drops to 6x (or perhaps even lower really).


Year 3: $160M    6x        $960

This is the risk/reward story you are buying into with these stocks - the key is being able to get out before the story changes (and it will always change at somepoint).

Summary - your forecast of a smallish reduction in the multiple is not likely to materialize; what is more likely is a continued high multiple; then a sudden drop.

PS: The best investments are those when you find a stock growing quickly that has not yet had mutliple expansion - these are the home runs.

tecmo

20 Likes

as both the revenue and the mulitplier both drop.

Hi tecmo, I think you misspoke there. The revenue doesn’t drop. It’s the rate of growth that slows down. Revenue still keeps going up if it’s a successful SaaS company.
Saul

6 Likes

Hi tecmo, I think you misspoke there. The revenue doesn’t drop. It’s the rate of growth that slows down. Revenue still keeps going up if it’s a successful SaaS company.
Saul

I did, I meant to say revenue GROWTH drops.

tecmo

BTW: I will say much of the critism of the “Saul approach” to investing is a failure to understand the methodology and risks. For many people this type of investing is just to risky - the thought of losing 50% of your capital all at once would be paralyzing.

One concern I have is that the recent returns have pulled in investors into a methodology they don’t really understand. As an example the recent pullback in some of the “Saul Stocks” is only a fraction of the potential losses that are possible.

It really is simple risk=reward; for those that are willing to accept the risks; and can execute the strategy it can be very rewarding (and Saul provides good evidence of that). But know what you are signing up for.

tecmo

7 Likes

Why criticize? Over the course of the last several years it has greatly outperformed. It is like criticizing Alexander the Great’s military strategies!

Sure things will change and Saul will change w it. But dang what is the deal? Results are results. If you don’t like the form then that is your issue not the investing criteria.

Tinker

11 Likes

One concern I have is that the recent returns have pulled in investors into a methodology they don’t really understand.

But shouldn’t you just have concerns about your own investment decisions?

Why do you need to be overly concerned about others?

Everybody knows the risk involved in investing in hyper-growth stocks in a concentrated portfolio. But everybody has their own risk profile and investment goals.

3 Likes