Thread by @CCM_Brett

Some notes on price-to-sales ratios and why investors should care about them ⬇️

The market is currently at an all-time high valuation on a P/S basis

However, corporate profit margins have also reached all-time highs (ignoring 2020 as an outlier)

This has led to the normalization of double-digit sales multiples

Higher profit margins = more $ returned to shareholders per $ in sales = acceptance for higher sales multiples when buying stock in a company. Makes sense.

For example, an auto manufacturer may have 5% profit margins at scale

This means that for every $1 in revenue, only $0.05 can be returned to shareholders or reinvested in the business

Compare this to a software company like $ADBE with 40% profit margins (and recurring revenue, but that is another topic).

For every $1 in revenue, $0.40 can be returned to shareholders or reinvested in the business

You shouldn’t be surprised, then, when a company like $ADBE trades at a P/S north of 18, as it does today

Not cheap by any means, but a lot less crazy than a car company at the same P/S

Investors get a lot of flak when using sales ratios as a valuation metric. I don’t understand this

Sales ratios tell you the implied margins/fundamental growth needed to get an acceptable return on an investment

This can be especially helpful when a company isn’t profitable or close to maturity when you are deciding whether to invest

Just as an aside, the “hurdle rate” or acceptable return varies for everyone, but I’ll use 15% for this next example.

Take $SHOP. Shopify trades at a P/S of 58

Now, this is where assumptions come in, and many people may disagree. But when you take into account all the different parts of $SHOP’s business, a P/S of 8 seems like a reasonable multiple at maturity

This mainly stems from gross margins heading towards 40% over the next decade

(don’t confuse this with $ADBE, which has 40% NET margins)

Ok, this is where we invert the situation. Assuming $SHOP can compound its intrinsic value for 15% indefinitely (a rough estimate), it will take 14(!) years to reach the value implied by the sales multiple today

Can $SHOP compound its intrinsic value at more than 15% a year? Maybe.

Will it trade at a double-digit sales multiple indefinitely? Maybe.

A lot of you seem to think so

https://twitter.com/CCM_Brett/status/1363267779114135552?s=20

Again, I want to reiterate that this methodology isn’t perfect, and there are many more factors that go into underwriting an investment.

But price does matter, and always will.

To wrap-up, let’s look at $DBX, the other company from that poll

$DBX trades at a P/S of 5.2

Management has guided for 30% profit margins (It already has 26% FCF margins) as what they can achieve at maturity

This makes sense as the company has gross margins close to 80% and an asset-light business model

P/S of 5.2 at 30% profit margins = 17x earnings multiple before estimating fundamental growth and reducing share count by 2-3% a year (which $DBX is doing)

So while $SHOP shareholders will be fighting multiple compression for 10 years, $DBX shareholders (of which we are) are betting on fundamental growth and a reduction in share count

(wouldn’t be surprised if there was multiple expansion, but you don’t need it to make it work)

Don’t think this means I believe investors should avoid a P/S above 10. I mean, we own $MTCH and $ADSK, so clearly we aren’t deep value guys!

Just understand the growth/margin assumptions of a high P/S, and why it can hurt you as an investor even if the business is phenomenal (like with $SHOP)