Software Valuations and the Rule of 40

Software Valuations and the Rule of 40



recipes for technical trading success in cooks kitchen why our software stocks so darn expensive and just getting chased higher here leading the market today we're gonna explore why based on a metric called the rule of 40 first take a look at my screen we're gonna look at some of these valuations I put together a portfolio I've been tracking of 30 software stocks in the Zacks portfolio tracker here just I mean there's obviously a hundred to choose from I picked 30 that I've had my eye on here they are alphabetically from Akamai and a peon – all the way down to Zen Zen desk and Z scalar and workday and Viva but let's rank them according to growth so go over here click on growth and I want to see price to sales cuz that's really the way we need to talk about software stock so I'm sorry I need to I need to click on value 2 because if I look at evaluations I'm still used to clicking on growth anyway so here we go we've got price to sales PS ratio let's sort it whoa some are really cheap some are super expensive look at this Z scalar at 39 times octa at 35 times sales koopa software 30 times sales smart systems and vive near 27 28 all right so caveat here is that the prices sales ratios I just showed you are trailing 12 months and if we're truly growth investors we're not looking at trailing we're looking at forward and so the prices sales ratios are considerably lower maybe a Z scalar is under 30 times Viva is 20 21 22 times but still expensive if you're when you look at the valuations and software the stocks that are running to new highs here are trading 15 20 in some cases 25 times forward sales so you know this is how expensive the soft dough sphere is as I call it the soft dough sphere is in the stratosphere now why is that comes back to the rule of 40 let's take a look at a commentary I wrote for my taser subscribers on June 21st the rule of 40 equals software valuations that make some sense and I pivoted off of I had done a lot of work in software in q2 a couple of different Zacks confidential pieces here was one in April the tech supercycle continues where I just looked at some of the drivers you know here's the here's the software equal weight ETF xsw we'll take a look at that at a moment where it's trading now but you know off to new highs included Nvidia in the discussion of software because look at this stack Nvidia Jensen Wang he knows what he's doing he just doesn't create the the parallel architecture for artificial intelligence he creates an entire stack of systems algorithms and applications so it's a unified architecture including software obviously and then I showed this graphic of you know the smart city where money is going to make cities smarter well that's all software base right and my for recommendations back in April were smart sheet Viva systems proof point and pega all went on to make new highs then in June took another dive into software because you know you just can't you can't study this area enough it is the future software continues to eat the world as I say because or as Marc Andreessen originally said but but I keep reiterating it because software doesn't consume time and space and it actually creates more of them there's infinite variations of programs that suit a particular businesses needs so in June I did something called Big Data gold rush harness chaos or be disrupted and I took a closer look at some of the companies that are doing data mining here's an incredible chart from statisti on the expected growth of big data and analytics to a 274 billion dollar market by 2022 alright so that might explain what's driving the gold rush and my for stocks recommended in June we're Alteryx Domo Splunk and Microsoft because you Microsoft you know they're there they're gonna be a player in fact I think they might buy a data mining company like a Splunk or an Alteryx if they're not already building their own data mining a modeling engine ok so back to my recent report on the rule of 40 again here's another snapshot of the growth this is incredible from a this is from an i bank research team where we just crossed a hundred billion in sales in the SAS industry in 2018 and the next hundred and that took that took over 10 years the next 100 billion is going to come in like three years and then they're projecting a four hundred billion dollar market by 2023 alright so let's get down to the rule of 40 this comes from Brad Feld Brad Feld was a famous Silicon Valley DC and his rule 40 he wrote about it in 2015 it's just really simple it's he wants to he wants to own software companies if they have at least a common a at least 40% a combination of sales growth and some metric of profit growth so you know you they could have no profit margin at all and be growing sales at 40% and he would consider that a software company don't so i'll read directly here from from felt the 40% rule is that your growth rate plus your profit should add up to 40 so if you are growing at 20% you should be generating a profit of 20% if you are growing at 40% you should or could be generating zero profit if you are growing at 50% you can lose 10% so obviously anything better than 40% was great for him but here's the question what metric of profit is he talking about and this is again from his 2015 blog on the rule of 40 are we talking about evita operate an income net income free cash flow cash flow or something else he says he prefers EBIT dot is a baseline and then he backed tests with other percentages for example he says hey if you're running your SAS on AWS your costs are consistent and so your EBIT ah should be consistent – all right now so that's basically the rule of 40 and that's why these valuations are so high and why investors keep plowing into them because listen when you think about it how many software stocks are gonna be impacted by the trade war some but very few they're not shipping they're not shipping products they're not shipping the disks of software it comes from the cloud and their growth is in cloud infrastructure or cloud services you know globally where you know it's just it's you know software as a service said it send it to them you know over the Internet and whether that's updates or continual service a monthly subscription and annual subscription you know it's it it's a universe of its own all right so let's take a look at some companies here that have you know this magic gross and this is from an eye bank where they're looking at a couple of Tears here who's growing it over 50% well you got companies like zoom that's why is that's why the zoom IPO is so popular because they just came off of growing revenues in a quarter at a hundred percent so that's why they're 2019 enterprise value over sales is trading over 50 times and based on 2020 sales they're only trading at 38 times but you know that's why they're so expensive and 50 times because they've got hundred percent growth here's MDB Mongo DB Mongo database growing at 85 percent you would think that their price to sales would be higher there's Twilio 80 percent growth trading at only 13 times Z scalars in their square smartsheet ayx Shopify of course Shopify Shopify is a massively interesting story right here because I mean it's obviously not just software it's a platform and investors have just piled in here lately because they think that this is a credible threat to Amazon that you know they they didn't name the platform cell if I just just for sellers which is which is the way I've always thought of it but I was talking to another investor it's like he they didn't name itself I didn't but Shopify which tells you where they're going in terms of creating a shopping platform they're not just catering to the small business that wants to sell they are out there out after a big retail market all right infinitely I own square smartsheet and Alteryx which are you know in in the top tier growing over 50% then you've got some growing 40 to 50 percent octa act as the really fascinating security company that focuses on identity you know so instead of managing passwords I assume that they're using either biometric credentials or something to where the security is for the individual to have access you've got kupah software and here's an alright so over 40 percent growth commands a distinct increase in valuation and the average price to sales for twenty twenty of these companies for next year sales the average price to sales ratio is over 17 times and that's why you have some of these companies like Aviva over 20 times Z scale are over 25 times I'm not sure where Shopify is right now so this is why people are paying so much for software because of the growth and because of this idea the rule of 40 is a different valuation metric that it's you know that it's okay to pay 20 to 30 times or even 40 times sales for you know growth of 40 to 50 percent or 80 percent or a hundred percent look at our latest IPO in the space slack symbol work and they also are teamed up with Atlassian team so team work but that slack IPO again this thing came out of the gate trading 30 times and I think it's ready to size 40 times sales projections and investors were willing to pay that I mean large investors because they're looking at you know software growing at high double digits then they'll pay you know 20 to 30 times for those sales interestingly enough Goldman wants to be short slack symbol work and so does the team at hedge I they just think that you know they're not calling a top on the whole software sector but they're pointing to you know some of these new IPOs are ridiculously overvalued and maybe zooms not with 100 percent growth alright so the rule 40 very simple you want to have 20 percent sales growth and in some form of 20 percent profit growth whether that's you know EBIT da or some other you know operating margin and that's where large investors that's what they're putting in their models and coming up with what they'll pay for some of these stocks so if you want to look at any of these reports I've written just email ultimate at Zach's calm and get a trial to tazer or does act confidential you can see my Zacks confidential reports from April and from June on software and then a bunch of that stuff ends up in my taser commentary throughout q2 it great stuff to go back and read to understand how to pick software stocks alright thanks for joining me in the kitchen

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