Analyzing Growth Stocks: Beyond Price-to-Sales Ratios

The Pitfalls of Price-to-Sales Ratios for Growth Stocks

When evaluating growth stocks, many investors make the mistake of relying too heavily on price-to-sales ratios. This simplistic metric can be misleading, especially for high-growth companies with strong profit margins. Let's dive deeper into why this approach falls short and explore more effective methods for analyzing growth stocks like Palantir and Zscaler.

Why Cash Flow Matters More Than Revenue

One of the key lessons from analyzing companies like Palantir is the importance of focusing on cash flow rather than just revenue. For instance, Palantir's cash flow grew from $462 million to $779 million, nearly tripling while revenue only doubled. This demonstrates the power of leverage in a business model - revenue doesn't need to grow as much for cash flow to increase significantly.

This concept of leverage is crucial for understanding the potential of growth stocks. When a company can scale its operations efficiently, small increases in revenue can lead to outsized gains in profitability and cash flow. This is why investors need to look beyond simple revenue multiples when valuing high-growth companies.

The Difference Between GAAP Earnings and Free Cash Flow

It's important to distinguish between GAAP (Generally Accepted Accounting Principles) earnings and free cash flow. While both are measures of profitability, free cash flow often provides a clearer picture of a company's financial health and ability to generate returns for shareholders.

GAAP earnings can be influenced by non-cash charges and accounting decisions, while free cash flow represents the actual cash generated by the business that can be used for investments, debt repayment, or returned to shareholders. For growth companies, free cash flow is often a more relevant metric than GAAP earnings.

The Importance of Margins in Valuation

When comparing companies using price-to-sales ratios, it's critical to normalize for margins. A company with 50% net margins (like some high-growth tech firms) is fundamentally different from one with 5% margins, even if they have the same revenue.

For example, Zscaler, another high-growth tech company, boasts impressive free cash flow margins. With 50% of revenue converting to net earnings after tax, Zscaler demonstrates the kind of profitability that justifies higher valuation multiples.

Common Mistakes in Analyzing Growth Stocks

Using Trailing Twelve Months (TTM) Data

One of the most common errors investors make when evaluating growth stocks is relying on trailing twelve months (TTM) data. For rapidly growing companies, historical data quickly becomes outdated and fails to capture the current trajectory of the business.

Instead of using TTM figures, consider the following approaches:

1. Current quarter annualized: Multiply the most recent quarter's results by four to get a more up-to-date picture.
2. Forward-looking estimates: Use analyst projections or company guidance for the next 12 months.
3. Growth-adjusted metrics: Apply the current growth rate to recent results to estimate near-term future performance.

Ignoring Growth Rates in Valuation Multiples

Simply looking at price-to-sales or price-to-earnings ratios without considering growth rates can lead to flawed conclusions. A company growing at 40% per year justifies a much higher multiple than one growing at 5%, all else being equal.

To account for this, investors often use the PEG (Price/Earnings to Growth) ratio, which divides the P/E ratio by the expected growth rate. This provides a more balanced view of valuation in the context of growth.

Failing to Consider Market Opportunity and Saturation

While current growth rates are important, it's equally crucial to assess the total addressable market and potential for continued expansion. A company may be growing quickly now, but if it's approaching market saturation, that growth could slow dramatically in the near future.

For example, when analyzing Zscaler, we need to consider not just its impressive current growth but also the long-term potential of the cybersecurity market and Zscaler's position within it.

A Deep Dive into Zscaler's Financials

Let's use Zscaler as a case study to illustrate these concepts and demonstrate how different analytical approaches can lead to vastly different conclusions about a company's valuation.

Revenue Analysis

1. Trailing Twelve Months (TTM) Revenue: $2.3 billion
2. Current Quarter Annualized: $628 million * 4 = $2.5 billion
3. Forward 12 Months (assuming 30% growth): $2.5 billion * 1.3 = $3.26 billion

Free Cash Flow Analysis

1. TTM Free Cash Flow: $635 million
2. Current Quarter Annualized: $314 million * 4 = $1.26 billion
3. Forward 12 Months (assuming 40% growth): $1.26 billion * 1.4 = $1.76 billion

Valuation Multiples

Assuming a market cap of $32 billion for Zscaler:

1. P/S Ratio (TTM): 32 / 2.3 = 14x
2. P/S Ratio (Forward): 32 / 3.26 = 10x
3. P/FCF Ratio (TTM): 32 / 0.635 = 50x
4. P/FCF Ratio (Forward): 32 / 1.76 = 18x

This analysis demonstrates how dramatically our perception of Zscaler's valuation can change depending on which metrics we use. Using trailing revenue, the company might appear expensive at 14x sales. However, when we consider forward free cash flow, the multiple drops to a much more reasonable 18x for a high-growth company.

The Importance of Free Cash Flow Margins

One of the most compelling aspects of companies like Zscaler and Palantir is their impressive free cash flow margins. When a company can convert 50% of its revenue into free cash flow, it justifies a much higher valuation multiple than a company with lower margins.

High free cash flow margins indicate:

1. Operational efficiency: The company can generate significant profits from each dollar of revenue.
2. Scalability: As revenue grows, profits can grow even faster due to operational leverage.
3. Financial flexibility: Strong cash generation allows for reinvestment in growth, acquisitions, or returning capital to shareholders.

Growth Trajectory and the Second Derivative

While high growth rates are exciting, it's crucial to pay attention to the trend in growth rates over time. This is often referred to as the "second derivative" of growth.

For example, if we look at Zscaler's recent quarterly growth rates:

• 40% -> 35% -> 32% -> 30% -> 26%

This declining trend in growth rates is something investors need to consider. It's natural for growth to slow as a company gets larger, but the rate of deceleration can provide insights into market saturation or increasing competition.

Questions to consider:

1. Is the slowdown in growth rate expected given the company's size?
2. Are there new products or market expansions that could reaccelerate growth?
3. How does the company's growth compare to the overall market and key competitors?

Beyond Traditional Metrics: Enterprise Value and EBITDA

While we've focused primarily on revenue and free cash flow, it's worth noting that professional investors often use additional metrics to evaluate companies.

Enterprise Value (EV)

Enterprise Value is considered superior to market capitalization for several reasons:

1. It accounts for a company's debt and cash position.
2. It provides a more accurate picture of the total cost to acquire a company.
3. It allows for better comparisons between companies with different capital structures.

When calculating multiples, using EV instead of market cap (e.g., EV/Sales or EV/EBITDA) often provides a more accurate valuation picture.

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)

While not perfect, EBITDA can be useful for comparing companies across different industries or tax jurisdictions. It provides a rough approximation of operating cash flow and is less affected by accounting decisions regarding depreciation and amortization.

However, it's important to remember that EBITDA ignores the real costs of capital expenditures and can sometimes paint an overly optimistic picture of a company's profitability.

The Limitations of Single Metric Analysis

Throughout this discussion, we've emphasized the importance of looking beyond single metrics like the price-to-sales ratio. It's crucial to understand that no single financial metric can capture the full picture of a company's value and potential.

Instead, a comprehensive analysis should consider:

1. Multiple financial metrics: Revenue, earnings, free cash flow, margins, and growth rates.
2. Industry context: Competitive landscape, market share, and industry growth trends.
3. Company-specific factors: Management quality, product differentiation, and long-term strategy.
4. Macroeconomic conditions: Interest rates, economic growth, and regulatory environment.

Applying These Lessons to Your Investment Process

To improve your analysis of growth stocks, consider the following steps:

1. Focus on cash flow: Prioritize free cash flow over revenue or GAAP earnings when evaluating profitability.

2. Use forward-looking metrics: Base your analysis on projected future performance rather than historical data.

3. Consider growth rates: Incorporate growth rates into your valuation metrics, such as using PEG ratios.

4. Analyze margins: Pay close attention to profit margins and their trends over time.

5. Assess market opportunity: Evaluate the total addressable market and the company's potential for continued growth.

6. Look at multiple timeframes: Consider short-term, medium-term, and long-term projections to get a complete picture.

7. Compare to peers: Evaluate the company's metrics and performance relative to industry competitors.

8. Stay updated: Regularly reassess your assumptions and projections as new information becomes available.

Conclusion

Analyzing growth stocks requires a nuanced approach that goes far beyond simple price-to-sales ratios. By focusing on cash flow, considering growth rates, and using forward-looking metrics, investors can gain a much clearer picture of a company's true value and potential.

Remember that companies like Palantir and Zscaler, with their high growth rates and strong cash flow margins, often justify higher valuation multiples than traditional value stocks. However, it's crucial to continually reassess these companies as they mature and their growth rates potentially slow.

By applying these analytical techniques and maintaining a comprehensive view of each company's financial and competitive position, investors can make more informed decisions when evaluating high-growth opportunities in the stock market.

Investing in growth stocks can be challenging, but it's also potentially highly rewarding. With a deeper understanding of the metrics that truly matter and the ability to look beyond surface-level valuations, you'll be better equipped to identify promising opportunities in the dynamic world of growth investing.

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