For the past two decades, we’ve seen a lot of technology companies (or tech stocks for that matter) sprout like mushrooms after the rain.
19 years ago, during the dot com era in year 2000, we saw top tech stocks like Google, Amazon, Adobe start to make their appearances and had since grew gradually throughout the decade, flourishing and experiencing massive growth.
This parade of companies was later joined by the likes of Facebook, Alibaba, Tencent almost a decade later which would later go on to generate billions and billions of revenues for shareholders.
If by now you’re banging your head against the wall for missing your chance to invest in these companies when they first started, STOP, sit down and read on.
Even though it looks like you’ve missed out on a lot of opportunities, believe it or not, there are still plenty of growing tech stocks. For example, Sales Force and Atlassian Corp.
Often times though, these companies’ prices tend to experience massive fluctuations, and without a strong anchor, you would be like a boat swept away by the ocean waves, and before you know it, you’re in the middle of the sea with no directions whatsoever.
So, what is this anchor am I referring to then?
It is of course, the intrinsic value.
In our previous article, we have shared three valuation methods and the step-by-step to find them.
However, if you’ve used those methods to value tech companies, they would not appear investable at all as they would always turn out to be overvalued.
I mean, who in their right mind would you purchase these companies at such high valuations, which at times, don’t even have any earnings or cash flow?
*Pssst! Read this article if you have not learned how to valuate fast-growing companies using earnings and cash flow.
But HERE’S THE CATCH.
It is normal for new tech companies that are still growing to have very low earnings, as they would spend a fair bit to expand the business, putting a lot of resources back into the business for growth.
How it works is, the company would first focus on growing the revenue. Eventually, as company makes more and more money, they would put lesser and lesser resources back into the business. And that is when earnings would flow back into the company.
So, the BIG QUESTION is, how do we value the business its current stage?
Well... we use Price to Sales.
Price to sales simply compare their current share price over their revenue. In short, how much the investors are willing to pay for every dollar of revenue that the company generate.
To better illustrate, let’s look at Salesforce. Salesforce.com develops enterprise cloud computing solutions with a focus on customer relationship management worldwide. The company has been growing aggressively for the past 10 years, and their 10-year constant annual growth rate is almost 30%. In other words, their sales revenue has exploded by more than 1000% in 10 years!
Now, there are 2 ways we can use Price to Sales to look at this company.
1. Historical Average Price to Sales.
At its current price of USD 150, Salesforce.com is at 8.94 times of their Revenue. Historically, for the past 5 years, its average Price to Sales is at 7.58 times. Hence, Salesforce.com is trading at a price to sales that is higher than its average. In short, it is slightly overvalued at current price to sales.
2. Peer Average Price to Sales
Another way of using Price to Sales for valuation is to compare them side by side with their peers. As we can see from the screenshot below, the average Price to Sales ratio for tech companies is at 7.03. This shows that on average, the market is willing to purchase the companies at 7 times their revenue.
Looking at Salesforce’ current Price to Sales of 8.94 however, it shows that they have one of the highest Price to Sales ratio in the industry.
Now, we know that there are hundreds or thousands of up and coming tech companies out there that you would like to valuate, review and possibly invest right now, but you only have so much time.
That’s why we’ve pooled them together under Peers in WealthPark; all you need to do is sort them by Price/ Sales and voila! All of them will be sorted in order.
Bear in mind though, there are 2 caveats here. If the growth of the business slows down, or the business is unable to become profitable; the more the business grew, the more it would need to spend. From there, profit margins will not increase, and the valuation of the business will nosedive. Some great and recent examples are WeWork and Uber.
All in all, if you’re an investor who actively seek for capital growth, growth companies (gorillas and cheetahs) such as tech stocks are the ones to look out for. HOWEVER, when it comes to valuations, especially using Price to Sales, it is CRUCIAL to first have a better understanding of the company’s business model, or at least understand their current profitability status.
Disclaimer: All facts and opinions presented are for educational purposes only. This is not a recommendation to buy or to sell. The author(s) involved in the writing of this piece do not have current vested interest of the company. Please consult a competent professional for expert financial, or other assistance or legal advice.