By SA Editor Marc Pentacoff:
Lab-Test Valuations
Ben Graham called 1932 valuations a “laboratory test” and his investment style came to reflect the lessons of this test. When Buffett joined Graham-Newman, for instance, the firm was focused primarily on net-nets and other statistically-cheap securities. In other words, Graham-Newman was focused on stocks which would still be cheap during a financial catastrophe.
The coronavirus sell-off offers us a modest laboratory test for SaaS growth valuations - although, to be sure, it is not even in the same class as the 1930s laboratory test. It is useful to do this now since the software sector of 2020 is quite different from the software sector of the last major test in 2008 and 2009. Salesforce (CRM), to take one example, hadn’t yet cracked $10 billion in market cap.
Graham's section was titled, “Depression Performance as a Test of Merit” but we cannot say that this is remotely a depression style test. Instead, we are just looking at panicked pricing in software firms which have (1) historically very rapid growth and (2) which have substantial subscription based business models.
Since these firms are priced more liberally than most firms due to their growth rates, it would be worthwhile examining how pricing looked in the depths of the coronavirus sell-off.
Growth Pricing Between March 15th 2020 And April 1st 2020In this period, there were 12 market days. For each day, based on my estimate for forward 1-year growth and using TTM revenue figures, we run a simple regression to describe EV/Revenue pricing (the dependent variable) relative to growth rates (the independent variable). The R-squared for these regressions varied around 0.45.
Below are the 12 regressions for each day (capped at 50% per annum):
The way to read this is that a 20% grower was roughly trading around 5.5x and 6.5x revenues. The 30% growers were trading around 7x-8.5x revenues in the sell-off.
Obviously, this is hard to see - so let's use the above regressions to find the min, mean and max for all of them taken together:
The above shows how liberally these software firms are valued when compared to other sectors of the market more generally. The S&P 500 trades at 2x sales and this is historically quite pricey: in January 2001, the S&P 500 traded at 1.77x sales; between 2005 and 2013, it sold below 1.5x sales. If software continues to "eat the world" we'd expect the P/S of the S&P 500 to to modestly increase overtime, even if its P/E remains constant.
I will be using the table below to stress test growth valuations in future exclusive PRO coverage (see exclusive coverage list at bottom).
EV/Revenue to Growth Table - Coronavirus Sell Off, March 2020
| Forward Growth | Min | Mean | Max |
| 5% | 4.4 | 5.5 | 6.7 |
| 10% | 4.6 | 5.3 | 6.1 |
| 15% | 4.9 | 5.5 | 6.0 |
| 20% | 5.5 | 6.0 | 6.5 |
| 25% | 6.1 | 6.8 | 7.4 |
| 30% | 7.2 | 7.9 | 8.6 |
| 35% | 8.4 | 9.4 | 10.2 |
| 40% | 9.9 | 11.1 | 12.0 |
| 45% | 11.7 | 13.2 | 14.4 |
| 50% | 13.7 | 15.6 | 17.1 |
| 55% | 15.9 | 18.4 | 20.2 |
| 60% | 18.3 | 21.4 | 23.7 |
| 65% | 20.9 | 24.8 | 27.6 |
| 70% | 23.8 | 28.5 | 31.8 |
| 75% | 26.9 | 32.5 | 36.4 |
Of course, this is not a method of finding “intrinsic value” or even of finding some minimum investment value. The intrinsic value of a firm will still be its long-term cash flows.
Rather, the above can serve as a guide to arrive at conservative valuations for rapidly-growing software firms, relative to their growth rates. Any given firm, depending on the nature of its specific market, is likely to trade in times of stress at some deviation from the above.
These figures just represent the min, mean and max from best-fitted polynomial regressions between March 15th and March 31st for some 50+ rapidly growing software firms. They can only provide context for valuing rapidly-growing firms on an EV/Revenues basis.
Illustration For ClarityTo illustrate the way this can be used, take the 30% growth section. This suggests that in a major liquidity-driven sell-off, a firm which is likely to grow 30% in the next twelve months (and with a good outlook thereafter) can easily trade as low as 7.2x revenues. Naturally, this also means that if the outlook for a firm is good, and if markets are “normal” in terms of the desire for liquidity, a likely 30% grower may trade well above 7.2 revenues. In current conditions, a 30% grower might trade over 10x sales, something which was also the case in January and February of this year.
That is, if you have a 30% grower that you believe in and who you think will obtain that growth rate, 7.2x can probably be seen as inexpensive unless they have a much lower profit margin than other software firms.
PRO Exclusive Tech and Growth Coverage:
- Berkshire Hathaway In Lockdown (5/3/2020)
- Pure Storage (4/26/2020)
- The Advertising Shortfall Signaled by Snapchat (4/22/2020)
- We Need More Pessimism (4/19/2020)
- 2 More Growth Firms To Check Out On Further Declines (4/6/2020)
- Alphabet: The Strongest Balance Sheet In Tech (3/29/2020)
- Pockets of Value In Growth Land (3/15/2020)
- A Growth Shopping List for Panicked Selling (3/8/2020)
- PagerDuty (3/3/2020)
- Growth Note: Alphabet SOTP (2/4/2020)
- Dropbox versus Box (1/26/2020)
- Dropbox (1/21/2019)
- Square (1/12/2020)
- 4 Growth Stocks To Watch In 2020 (1/5/2020)
- Elastic (12/22/2019)
- PagerDuty (12/15/2019)
- Nutanix (12/8/2019)
- EverQuote (11/24/2019)
- Note on Skew in Stock Returns (11/17/2019)
- Arista Networks (11/7/2019)
- Dynatrace (11/5/2019)
- New Relic (10/27/2019)
- Pluralsight (10/20/2019)
- VMWare (10/13/2019)
- Spotify (10/7/2019)
- Roku (9/29/2019)
- The Dangers of DCF for Growth Valuations (9/22/2019)
- DocuSign (9/15/2019)
- Yext (9/8/2019)
- Growth Stock Write Up Best Practices (9/2/2019)
- The State of Ad-Tech And The OTT Industry (8/25/2019)
See also Alamo Group Inc. (ALG) CEO Ron Robinson on Q2 2020 Results - Earnings Call Transcript on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
