Finding Value In High-Growth, Momentum Software Stocks Using The PSG Ratio

Software application and internet stocks are among the biggest winners this year amid the historic market volatility. Technology companies have been generally resilient to the economic disruptions caused by the COVID-19 pandemic, with some even benefiting from themes like work-from-home and the ongoing migration to cloud computing. Many of these early-stage growth companies with a disruptive product or service benefiting from an expanding market segment are typically rewarded with a large valuation premium.

The challenge for investors is to find a fair value in these companies which often times have a share price that has moved beyond the scope of traditional fundamentals-based models. Considering the focus for these stocks is on the top-line growth and the sales outlook, one tool we like to use is the price-to-sales growth ratio (“PSG”). This alternative metric is useful in that it gives context to various levels of sales multiples allowing for a quick relative valuation analysis.

The Price-to-Sales Growth Ratio (“PSG”)

While we didn’t invent the PSG ratio, the idea is simply a variation of the more commonly used price-to-earnings growth ratio (“PEG”). A stock trading at a P/E of 20x with expected earnings growth of 20% is said to have a PEG ratio of 1.0. Similarly, a stock trading at a P/S multiple of 5x with expected sales growth of 10% has a PSG ratio of 0.5. The idea can be expanded further to consider the forward-PEG and forward-PSG based on the forward P/E and forward P/S ratios and the expected growth rate for the next period.

Essentially, the PSG standardizes the P/S ratio for sales growth. All else equal, a stock trading at a lower PSG implies investors are paying less per unit of sales growth. In this regard, PSG can be helpful when looking at stocks with high-growth but limited earnings or negative free cash flow. The interpretation of the actual PSG ratio for any single stock should be in comparison against a peer group of companies with similar characteristics.

Software and Internet Stocks PSG Valuation

PSG can be applied to any stock or market sector, but today, we are using it to identify trends in software and internet companies with strong momentum thus far in 2020 and a high growth outlook. The filters used in our data set include only companies in the segment with at least $100 million in revenue over the last twelve months, consensus revenue growth for this year of at least 20%, and currently trading with a price-to-sales ratio above 15x.

(source: data by YCharts/ table by BOOX Research)

From the table above, our results find 38 stocks that fit our criteria. While these are mostly tech companies, there is some grey area in terms of industry classification. A few examples like Veeva Systems Inc. (VEEV) and Teladoc Health Inc. (TDOC) are in the healthcare sector but recognized for being leaders with specialty software solutions. With some exceptions, most of the companies here offer some type of cloud-based subscription service following a software-as-a-service (“SaaS”) or platform-as-a-service (“PaaS”) type of business model. The attraction of these companies is the ability to scale quickly at a global level as often replacing inferior legacy solutions.

The major point we want to highlight is the strong stock price performance of the group with an average return of 108% year to date. The high-growth profile is evident as the average stock on the list has an expected revenue (sales) growth of 47% year over year for the current fiscal year. The market enthusiasm has translated to a large growth premium considering an average price-to-sales ratio of 28.9x. Indeed, by most measures, the stocks here are trading at an extreme valuation with 31 of the 38 companies not profitable last year.

Based on the price-to-sales growth ratio, Shopify Inc. (SHOP) with a PSG of 1.75 is the most expensive stock in the group. While its expected 37% revenue growth this year is impressive, the P/S ratio of 65.4x is one of the highest on the list. The only stock with a higher P/S ratio in our screen is Zoom Video Communications Inc. (ZM) currently trading at a P/S ratio of 92.3x. Still, Zoom’s expected revenue growth of 190% helps to explain the large premium as it implies a relatively moderate PSG of just 0.49.

Within internet and software stocks, the PSG ratio helps make some stocks’ current valuation appear even reasonable. Okta Inc. (OKTA), ZScaler (ZS), Cloudflare Inc. (NET) and CrowdStrike Holdings Inc. (CRWD) are all involved in cybersecurity and data protection. While all four stocks coincidentally trade at a similar P/S ratio around 35x, CRWD’s appears to have more value considering its stronger growth and a PSG of 0.59 compared to NET at 0.83, ZS at 0.94, and OKTA at 1.18.

From the list above, it’s also notable a group of Chinese online education stocks including GSX Techedu Inc. (GSX), and Youdao Inc. (DAO) are among the “least expensive” with a PSG under 0.2. GSX and DAO have benefited from the pandemic and a move towards virtual learning is driving a revenue growth estimate of 206% and 114% each this year. The market continues to discount Chinese stocks compared to international peers given concerns over financial transparency.

Analysis and Forward-Looking Commentary

Software and internet stocks represent some of the best high-risk, high-reward opportunities in the market. Given the focus on top-line growth, the upside for each stock is dependent on their ability to maintain and hopefully exceed revenue expectations. What we like to see is accelerating growth and improving margins to justify higher valuation multiples.

As with any other valuation ratio, there are several factors that can explain why a particular stock appears relatively more or less expensive. An important consideration is the long-term growth outlook for each stock beyond just this year. These are all different companies operating in different segments, each with their own story.

When analyzing momentum stocks, qualitative analysis including an assessment of the market opportunity and competitive environment gains importance. The companies that can offer a differentiated product while fending off competition are best positioned to gain market share and maintain a leadership position.

The market will likely place a higher premium on stocks that are expected to maintain growth momentum over many years. Shopify, for example, is expected to grow revenues at an average rate of 33% for each of the next 5 years, while other companies may see a sharper slowdown over the period. Depending on the product or service, varying levels of sustainable gross and operating margins can represent a higher long-term profitability potential. A relative valuation analysis based on the price-to-sales growth ratio can serve as a starting point for further due diligence.

In the context of tech stocks and the NASDAQ 100 (QQQ) trading at an all-time high, we take an overall cautious approach towards the market considering the still uncertain macro outlook. If global financial conditions deteriorate, high growth stocks with large valuation premiums may face the most downside during a period of increasing volatility. The upcoming earnings season also introduces uncertainties related to the companies’ operating environment during a challenging macro environment in Q2. Management guidance will be important to set the tone for the remainder of the year.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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