A Simple Valuation Ratio for Disruptive Tech Stocks

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.

Credit: Yahoo Finance

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 DataAnnualized Revenues (billions)Ratio
UiPath412021 Actual0.60768
Pega9.6Q1-20210.93910
Blue Prism1.3Q4-20200.2076
NICE14Q1-20211.828

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.

Desktop Metal

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 MetalsDesktop Metal74
3D BioprintingCELLINK43
Genomics10X Genomics41
CybersecurityCrowdStrike39
Medical DevicesButterfly Network39
Genetics TestingGuardant Health39
Synthetic BiologyBerkeley Lights38

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.

Ginkgo Bioworks

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.

CompanyTickerMarket Cap RevenuesRatio
IlluminaILMN55.734.3613
Guardant HealthGH12.110.31638
Invitae CorporationNVTA5.860.41614
TeladocTDOC22.531.81612
10X GenomicsTXG15.040.42435
Twist BioscienceTWST4.890.12539
Berkeley LightsBLI2.870.08733
SchrodingerSDGR4.370.13233
BASKET AVERAGE27
Gingko BioworksSRNG150.150100

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.

Conclusion

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.

2 thoughts on “A Simple Valuation Ratio for Disruptive Tech Stocks
  1. Sorry for being a smart ass but there is a small but impactful mistake in this reasoning I cannot ignore: Revenues are generated by the entire capital funding of a company, ie equity + debt. Putting revenues in relation to market cap ignores the leverage can can meaningfully distort the metric.

    Simple example:
    Company A generates 100m revenues, market cap 1000m, market value debt 0 –> price/sales = 10
    Company B generates 100m revenues, market cap 500m, market value debt 500 –> price/sales = 5

    Valuation metrics should always follow the rule that numerator and denominator relate to the same source/allocation. That’s why investors use multiples like enterprise value (EV) / sales. For the simple example, that ratio is 10 for both companies.
    P/E (earnings is after deduction of interest) in contrast only sets equity related metrics in relation.

    Best
    Hendrik

    1. You are not being a smart ass at all Hendrik. This is a very good point. The author of that piece admits an oversight by not covering this exact point you bring up. Why are we using market cap instead of enterprise value which is defined as follows:

      Enterprise Value = Market Capitalization + Total Debt – Cash and Cash Equivalents

      We’ve largely avoided valuation ratios until recently because we believe in keeping things as simple and jargon-free as possible. Anyone can calculate our metric by looking up a ticker on Yahoo and clicking once (on the chart to show the latest quarterly revenues). If we start considering enterprise value, we’ll then need to consider cash and debt – two data points that then need to be scrounged up by our readers. We’d much rather keep it as simple as possible so that more investors feel comfortable calculating it themselves. We also believe the impact of this decision isn’t that great in our universe.

      The impact of using market cap instead of enterprise value depends on how much debt these growing tech companies have taken on. It’s usually not much from where we’re sitting, but we’ll plan to do a sensitivity analysis to understand this better. As for cash-rich SPACs, we feel that not subtracting cash makes the ratio higher, which is great because companies with loads of cash burning a hole in their pocket (cough, cough, Nano Dimension) are then stuck trying to find something to spend it all on. We’d much prefer companies raise cash as they need it instead of making hay while the SPAC sun shines.

      Your point is very well taken, but we’re going to start out with our simple valuation ratio and see how it goes. Thank you for taking the time to point this out.

Leave a Reply

Your email address will not be published.

[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]