In search of a better valuation metric
Musings: How I plan to track valuation of my favorite growth stocks
I have been refining my scoring methodology for more than six months now and I am happy with how it has been performing…helping me identify high-growth stocks that can perform well in the 2022 and 2023 rising rate environment, with healthy margins, improving cash flows and low debt-to-cash ratios.
Looking at how the scores have shaped up over the past 2 earnings seasons, it has helped me separate the wheat from the chaff. I have used the scorecard to re-organize my portfolio and shrink it down from 56 positions to only 12 positions (at last count). I have also used the quantification method to compare two stocks e.g. CRWD or S? MDB or CFLT?
And recently I came to the conclusion that the phrase LTBH is not an investing mantra that I want to follow anymore. I do not want to have blinders on when it comes to making a cold-hearted decision on whether to trim any of my stocks. There will be moments when these stocks get overbought and their prices rise too high, too fast. After all, retail investors are human beings, FOMO sets in at the wrong time, and herd-mentality is the path of least resistance.
When my stocks are given a richer valuation than they deserve, I want to:
Be aware that it is happening
Quantify the degree of the over-valuation
Make an informed decision about whether I will trim a little
Identify a viable trim price-point
Identify an attractive add-more price-point
We are not in 2020 anymore, Toto….when we could buy every dip and ride these stocks up to the clouds. The market will continue to be volatile with fast and furious ups and downs. As an investor, I want to juice my portfolio returns by raising cash when markets are up and putting that cash back to work when the markets slide lower.
After evaluating a variety of valuation metrics, I am leaning towards using this metric
Enterprise Value (EV) / Annual Gross Profit (GP)
EV = Market cap + Total debt - Total cash
GP = (Total quarterly revenues - Total quarterly cost of revenues) * 4
See some sample numbers below
What I like about this valuation metric:
It seems to be more sensitive than EV/NTM…NTM is next 12 months revenue. As per the table above, CRWD, DDOG and S could be more over-valued than we think they are.
Debt and cash in the numerator ensures that we do not ignore these two original sins that have led many high-fliers to the dumpster.
Gross profit reflects operating efficiency, market share growth trends and pricing power, which we want to see at healthy levels in our companies.
Since many of our favorite growth companies are not yet profitable, we cannot use net income, earnings, free cash flows or even EBITDA consistently across the cohort….see the invalid negative numbers above.
One might argue that EV/GP is backward looking, meaning it ignores future growth potential. Why not use EV/NTM?…Because the macro conditions have changed significantly and I need to adjust my investing lenses accordingly. NTM would be based on company forward revenue guidance or analyst estimates…these are predictions that may not come to fruition. I do not want to ignore the potential of slower economic growth and its impact to the revenue pipelines of these stocks. EV/GP helps me take a more conservative valuation stance in this regard.
It will take a few earnings cycles to identify appropriate over-bought and over-sold thresholds e.g. Is 40 and above the time to trim? Perhaps 20 and below is best for adding back? Maybe the trigger levels for SaaS companies are different than those for semiconductor companies.
Going forward, I will use EV/GP as my main valuation metric, while also tracking EV/NTM as a basis for comparison. Lets take stock of the results in early 2023.