How To Value High Growth Companies

High growth names dominated 2021.

But how do investors come up with the right share price for those stocks?

We want to show you how to use the Price-To-Sales (P/S) ratio to value different companies.

Some of those names like Zoom (ZM) and Square (SQ) turn a profit. But in Square’s case, the price-to-earnings ratio is so high it becomes meaningless.

Others like Zscaler (ZS) and DataDog (DDOG) aren’t yet profitable although they are cash flow positive.

Then there are companies like Rivian (RIVN) that have yet to make a sale.

We’ll explain how the technique works and then how to correct for different growth levels.

Price To Sales Ratio

Our first valuation metric is known as the price-to-sales (P/S) ratio. 

You calculate the P/S as follows:

Company Market Capitalization / Total Revenue

P/S works whether a company turns a profit or not.

When you use this calculation, you assume that companies in a similar industry eventually achieve similar profitability.

From there you compare revenue growth as well as risk, and then make adjustments.

Let’s use Zscaler (ZS) as an example, which provides internet security through the cloud, ideally making things faster for consumers.

Competitors include Crowdstrike (CRWD), Fortinet, (FTNT), Checkpoint (CHKP), Cisco (CSCO), and Palo Alto Networks (PANW).

Although each of these companies is slightly different, with Cisco and Palo Alto heavily invested in communications equipment, we can use them as a potential future state.

Looking at the P/S ratio only, we can make the following conclusions:

• Zscaler is 1.6x more expensive than Crowdstrike.
• Crowdstrike is 1.9x more expensive than Fortinet.
• Fortinet is 2.6x more expensive than Checkpoint.

Turning to profitability, we see that:

• Gross profit margins are pretty close to one another across the board with Zscaler and Checkpoint out front.
• However, Zscaler has negative margins in every other category as does Crowdstrike and surprisingly, Palo Alto.

Lately, growth tells us:

• Zscaler’s revenue growth YOY and looking forward is similar to Crowdstrike’s and about twice that of Fortinet and Palo Alto’s.
• Compared to Checkpoint, it’s ~12x better.

Adjusting P/S for Differences In Growth

Now, we need to adjust for growth.

Assume that Checkpoint is our baseline since it has positive earnings and growth.

We’ll then look at Fortinet which is also profitable but trades at significantly higher P/S multiples because of its growth.

Fortinet P/S ratio is 18.75/7.33 = 2.6x greater than Checkpoints .

When we compare their forward growth, Fortinet’s expected growth is 22.52/3.79 = 4x that of Checkpoint.

We can create a ratio of the P/S and the revenue growth rates as follows:

Revenue growth rate comparison/price-to-sales ratio comparison = 

6.0/2.6 = 2.3. 

This equation gives us a ratio of the comparison between the growth rates to the comparison of the price-to-sales ratio.

Now, let’s do the same thing but with CheckPoint and Zscaler.

We find that Zscaler grows revenue at 13.85x the rate of Checkpoint. That’s our numerator.

With a P/S ratio that is 7.9x higher than CheckPoint, our calculations come out as…

12.1/7.9 = 1.5

Said differently, investors are willing to pay more for Fortinet’s growth compared to Zscaler’s when we compare it to Checkpoint.

Now, the question is why.

And it’s pretty simple – profitability.

Fortinet is profitable, Zscaler isn’t.

In fact, if we perform the same analysis on Crowdstrike, which is not profitable, we get…

16.1/4.9 = 3.3

Based on this analysis, we could conclude that Crowdstrike is too expensive compared to the other companies.

However, this is just one method of valuation. You would need to incorporate others to get a full picture.

The Bottom Line: Price-to-sales is a great ratio to value a stock. But, it only works when growth rates are similar. Otherwise, you need to adjust to create a relative comparison.