A Simple Valuation Ratio for Disruptive Tech Stocks
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If you spend six figures on business school, they’ll teach you cool things like how to value a company. One method is to evaluate the present value of future cash flows (cash today is worth more than cash tomorrow because of inflation). You’ll often hear investors talk about price/earnings ratio or P/E ratio which is simply how much you are paying for a stream of earnings. For most growing tech companies, profitability comes later, so we need another method of examining valuation that doesn’t involve earnings.
A Simple Valuation Ratio
One of the most important metrics we look at when assessing tech stocks is revenue growth. That’s because once a tech company shows traction with meaningful revenues (we’ve always considered upwards of $10 million annual to be meaningful), then everything is about capturing as much total addressable market (TAM) as possible. Revenue is a proxy for market share captured, therefore we want to see double-digit revenue growth for as long as possible. As a company grows in size, that revenue growth becomes more difficult to attain. Given our focus on the importance of revenues, we want a valuation ratio that reflects that.
One ratio we might use is price-to-sales which takes the market cap of a company (the number of outstanding shares multiplied by the share price) and divides it by the last twelve months’ worth of revenue (or the sum of the revenues reported in the last four quarterly earnings). That’s a fine enough ratio, but we want one that’s more responsive, and here’s why.
Take a look at how consistently the below $49 billion market cap company is growing its revenues.
Let’s calculate our simple valuation ratio using three different revenue measures:
- Last full annual (49 / 1.45) = 34
- Last four quarters (49 / 1.625) = 30
- Last quarter annualized (49 / 1.876) = 26
As you can see, annualizing the most recent quarter gives the most accurate picture of growth, all things being constant (This is similar to the annualized recurring revenue point-in-time metric SaaS businesses use.)
Let’s say this company had a bad quarter. The annualized revenue number would then reflect a worse picture based on the most recent data point. As risk-averse investors, we’re fine with that. After all, we’re only going to use this valuation ratio for two reasons:
- To determine a “cutoff point” above which we believe any stock is too expensive to purchase
- To perform comparative valuations
About Comparative Valuation
If you said a stock returned +100% over the past year, that performance means nothing without a benchmark to compare it to. Similarly, we need a benchmark to compare any given valuation ratio to. For example, we might take the average of all enterprise AI stocks in our universe and use that as a reference point. In the below example, we can conclude that UiPath is quite overvalued when compared to other robotics process automation (RPA) stocks.
|Market Cap (billions)||Revenue Data||Annualized Revenues (billions)||Ratio|
It’s important to remember that while a higher number represents a higher expectation of future growth, a lower number means a lower expectation of future growth. The higher the number, the more investors are paying for a vision of the future, not for what’s happening today.
A Valuation Ratio Cutoff
Human emotion will destroy your returns, so we like to have rules in place that help reduce risk. Take our market cap cutoff of $1 billion. That’s a nice round number we use to make sure we’re not investing in companies that are too small. We’ve noted other financial firms also using the $1 billion market cap cutoff, presumably because it’s easy to remember. In the same way we won’t buy companies with less than a $1 billion market cap, we want to only invest in companies with a valuation ratio less than “X.” That will keep us from getting too caught up in the story and hype.
So, how can we determine X? We’ve been using our simple valuation ratio for a while now, and the number 40 seems to be right around where we should set up our cutoff. We can start there and then tighten it down if we need to.
In order to create some usefulness around our simple valuation ratio, we added it to The Nanalyze Tech Stock Catalog for around 60 stocks we love and like. The ratio doesn’t work for pre-revenue companies, but that’s fine, because we don’t invest in them. It also isn’t applicable to special purpose acquisition companies (SPACs), that haven’t disclosed any quarterly revenue numbers yet. Over time, we’ll continue to populate the valuation for more stocks in our catalog when applicable (it doesn’t work on ETFs). Let’s look at a couple of real-world examples where this valuation ratio may have led to better decision making.
We wrote a lot about Desktop Metal prior to the company going public using a SPAC, so it was no surprise we were focused on the story and not valuations. We bought shares around $11 and, when they more than doubled, sold some to recover around half our cost basis. We were very surprised to learn that Desktop Metal is one of the most highly valued stocks in our universe. Here are six of the highest valued stocks we calculated the ratio for so far:
|3D Printing Metals||Desktop Metal||74|
|Medical Devices||Butterfly Network||39|
|Genetics Testing||Guardant Health||39|
|Synthetic Biology||Berkeley Lights||38|
When we entered our position in Desktop Metal, we assumed the offer price – what institutional investors had paid – was a fair valuation. Today, we can see that it’s certainly not fairly valued relative to all other stocks in our universe. If we had our valuation ratio cutoff in place, we wouldn’t be holding this position. The same holds true for our next stock.
One problem with SPACs is that they typically don’t give you a breakdown of quarterly revenues. For that reason, we’re waiting to add valuation for SPACs until they file proper documents with the SEC. However, we can take the 2021E revenue estimates provided by a SPAC and see how fairly valued it is based on that number and the implied market cap. In our piece on Ginkgo Bioworks, we looked at how their valuation compared to other names in our life sciences universe.
Even though Ginkgo was significantly overvalued, we still entered a very small position since we wanted to have some skin in the game. If we had our rule in place, we would have stuck with it and not purchased this stock at such inflated valuation. Admittedly, our very small purchase was a speculation on the future of – what seems to be – a very exciting company.
In both of these cases – Desktop Metal and Ginkgo Bioworks – we would simply wait until the valuation ratio fell below 40 prior to opening a position. Two things could make that happen:
- The stock price falls, consequently reducing market cap
- Revenues could increase
Going forward, we believe it’s in our best interest to not invest in stocks where our simple valuation ratio exceeds 40. That rule would have prevented us from opening a position in both these stocks where we invested heavily in the promise of future growth instead of actual growth today.
Having a simple valuation ratio helps us compare stocks to figure out which ones might be overheated. Of course, they could all be overheated, but we need to start somewhere and establish a “valuation ratio cutoff,” which we’ve decided is 40 right now. If a stock has a valuation of 40 or more, it’s just too rich, no matter how great their story is.
Want to see the valuation ratios for 60 disruptive tech stocks with more to follow? Become a Nanalyze Premium subscriber and down our tech stock catalog now.