Cloud (NASDAQ:SKYY) stocks are trading at lofty multiples. For most of these stocks, traditional valuation ratios and methodologies do a terrible job of justifying their current valuation. Ratios like the P/E, EV/EBITDA, and the ROA are inapplicable without drastic adjustments.
Most investors have been restricted to sales ratios (P/S, EV/S) when benchmarking the valuation of cloud stocks. Some value investors might have been scared of investing in tech stocks because they can’t use multiples like the P/E or EBITDA multiple to value these stocks. Dividend seeking investors might have also been forced to look elsewhere as most tech stocks don’t pay dividends. Also, their return on equity suggests limited payout ratios if they decide to pay dividends in the near term.
Source: Seeking Alpha
I believe these valuation restrictions have a lot of meaning. Firstly, it is worth highlighting that free cash flow is backend loaded in the traditional innovation cycle. When you set out to invest in a project, the investing stage typically isn’t expected to generate a positive net present value. This implies that most tech stocks that can only be valued using their sales multiples are still investing in acquiring market share to build their competitive moat. If these stocks were trading at single to mid-teens sales multiples due to their expected future growth, market participants could digest this based on the forward growth forecasts and potential for margins expansion. In recent quarters, most cloud stocks have been trading at sales multiples north of 20x. A blanket dismissal of a stock based on its huge valuation multiple doesn’t help investors calibrate their risk appetite. As a result, I believe an intuitive explanation of the “sales ratio/multiple” will help investors launch their research on a solid footing.
The Innovation Cycle
I have used the word “innovation” a lot in some of my articles. Yet, the nuance was somewhat lost on me until COVID-19 hit. Most industries in the mature phase of the innovation cycle witness a growth decline. This makes it ideal for companies past the peak of their growth to trade at low single-digit sales multiples. Essentially, the market doesn’t expect them to keep compounding revenue. If we flip this state, we can expect companies at the initial stage of their innovation cycle to trade at loft sales multiples for three reasons:
They are disruptors, and they have the highest potential to generate free cash flow compared to mature companies.
Their growth (both revenue and earnings) can compound for a longer period. They are essentially riding the law of compound interest.
- Since they have the potential to generate the highest IRR compared to other projects, this drives down the hurdle rate (discount rate) investors set for the operators of these companies.
If we assume the points above to be true, a simple growth investing strategy is to study the innovation cycle of different industries, sift for high growth players, and establish a thesis for the market’s reason for valuing them at lofty sales multiples. Cloud stocks have been disruptive to legacy business models since the last economic recession. They’ve forced two trends across most of the industries I cover. This is most evident from the migration of on-prem workloads to cloud platforms and the shift from a perpetual licensing model to a subscription-based model to drive sticky predictable revenue. The market tried to make a run to highlight this cycle last year. The billings volatility of a handful of SaaS players delayed the run. Several months later, COVID-19 happened, and the reality dawned on everyone that a new innovation cycle has kicked in. The ease of raising capital in a low-interest-rate environment also assisted this shift. Overall, it is hard to argue in favor of returning to the old innovation cycle in the presence of a natural catalyst propelling the current one. If there had been doubts in the minds of consumers about the role of tech platforms in the current economy, I believe the remote working trend erased most of it. The adoption of new technology or innovation doesn’t happen overnight. This makes it logical that the market recorded multiple pullbacks when the run started last year. Right now, it is increasingly clear that we aren’t going back to the old normal. This reality is supportive of the lofty multiples of the stocks leading the current cycle.
Since we are mostly restricted to sales multiples when valuing cloud stocks, understanding the components of the sales ratio can help dispel the initial fear when we see a stock trading at a lofty valuation.
Since Price/Sale = Market capitalization /Revenue
We can break this further as follows
Since price [p] represents the sum of all dividend [D] paid to equity owners, discounted at a selected cost of capital/equity [r] for a dividend growing at [g]
We have P (Equity Value) = D/(r-g)
The equation above assumes the stock price is the present value of all cash flows (earnings paid back at 100% payout ratio to investors is equal to dividend [D]). r is the discount rate or cost of capital, which can also be set as the IRR of comparable assets. g is the growth rate of the dividend earned to perpetuity.
Let P = p(stage1) + p(stage2). p (stage 1) for the investment year (1 to 10 years) = 0 since no dividend is paid out in the investment stage.
If we assume all the earnings (D) = earnings (net income) are paid out after revenue has compounded at a huge rate during the lengthy innovation cycle (10yrs to 15yrs), then:
P (stage 2)/S = (100% payout*Profit Margin * [1+ g])/r-g
If we assume that a cloud stock will compound revenue at a CAGR of 40% over the next ten years while expanding income margins to 30% by year ten when it begins to generate cash flows in excess of reinvested capital, then we can play around with r and g. g is the long-term dividend growth, which can be pegged at 3%-4%. g is expected to be lower than r as the dividend growth rate cannot exceed the discount rate r. Remember, r is the cost of equity/hurdle rate/opportunity cost. Because our project is supposed to generate more returns in a low interest rate environment (reduced risk premium/cost of capital), we can play around with r by reducing it.
P /S = (Earnings Margin * [1+ g])/r-g
A profit margin of 30%, g of 3%, using an r of 5% gives a P/S of 15x. That’s largely a function of r. Setting r at 5% assumes a low-risk macro environment; hence, we use a low-risk premium for our cost of equity, which drives the bulk of our cost of capital. The rationale for using a low-risk premium is because we believe the cloud stock we are holding is expected to compound revenue at a sustainable (competitive moat) growth rate for the next ten years or more. We also expect it to be a market leader. These assumptions will drive multiples expansion. These assumptions are applicable to these cloud stocks because they are trading at the beginning of their innovation cycle. This means growth is expected to compound for a longer period compared to other stocks. Therefore, the lengthy growth period pays part of the debt that should be the risk demanded for owning the cloud stock. The risk premium can be as negligible as possible based on the opportunity cost of owning the stock. Since COVID-19 hit, the parallel universe in which growth is only found in tech stocks or stocks with significant tech features has been the most plausible when predicting the future. This makes it logical to set the cost of equity for a debt-free stock to the long-term risk-free rate. Using a DCF, setting the cost of equity for a tech stock expected to compound growth above 30% over the next 10-20 years will result in a lofty valuation multiple.
The real work is not to find reasons to doubt the valuation multiples of cloud stocks; it’s in guessing correctly what the market is trying to predict. This is tough, as disruption doesn’t respect forecasts. It comes unannounced. Also, r is subjective, and it isn’t the same for market participants. However, if a basket of cloud stocks are trading at a P/S of 20x+, that tells us a lot about the risk appetite [r] of institutional investors. Invest accordingly.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.