My Foolish colleagues Rick Munarriz and Matt Koppenheffer have done yeoman's work explaining why SodaStream (Nasdaq: SODA ) could be the next big thing: SodaStream's razor-blade model was proven in the beverage category by Green Mountain Coffee Roasters (Nasdaq: GMCR ) , the company has fended off Coca-Cola (NYSE: KO ) and PepsiCo (NYSE: PEP ) in Europe, and it's growing at lightning speed. Adjusted earnings were up 141% for the quarter.
After living with one of the company's machines, I'd like to add one more thing in its favor.
After using the machine for a week, I began to think Coke and Pepsi products tasted bad. My taste buds have recalibrated to prefer the sweetness of Splenda in diet SodaStream drinks as opposed to the aspartame found in Diet Coke or Diet Pepsi. Assuming I'm not an anomaly, this is a huge breakthrough that should encourage long-term repeat business among diet soda drinkers. The Cola flavor also tastes surprisingly like Coke.
However, the bears argue that the stock is so overvalued that the company's shares can't go any higher, no matter the success. The stock's one-star rating on CAPS, along with 17.5% of shares sold short, bear witness to this. The stock is so maligned it already starts to feel more like a value stock than a growthy fad stock.
So here's why SodaStream is not unreasonably valued.
When you shouldn't use P/E
Most of the fear of SodaStream's valuation has been based on the trailing-12-month P/E (price/earnings) ratio of 59, but P/E is a wildly inaccurate way to value SodaStream.
To see why, let's imagine that SodaStream did not have any earnings over the past 12 months. How would we value it? Would we still be talking about P/E? Of course not, we can't calculate a P/E for a stock with no earnings. We'd be forced to look at a different metric, most likely P/E's second cousin, price to sales.
And then what we'd notice is that SodaStream's trailing-12-month P/S is 4.96, an unsurprising multiple for a growing beverage maker: Coca-Cola trades at 4.02 times sales. Hansen Natural (Nasdaq: HANS ) trades at 4.4 times sales. Green Mountain Coffee trades at six times sales. Coca-Cola paid 12 times 2006 sales for Glaceau when the company acquired the water player in 2007.
Heck, even the world's arguably worst soda company, Jones Soda, still trades at 2.11 times sales. And it's been losing money for years.
While this may not seem like fair comparison since most of those companies don't make machines, it is more fair than first meets the eye. SodaStream's present price is based on forward-looking expectations of future cash flows, as with any stock. In the future, the higher-margin syrup and CO2 markets are what will dominate SodaStream's sales, as they're starting to do in Sweden. The conventional-looking P/S is likely a result of the market already factoring this in.
So why are we complaining that the stock is overvalued when it actually made $17 million? Just because we can calculate a P/E doesn't mean it's useful.
What SodaStream could be worth
This is not to say earnings don't matter or the P/E should never be used to value a company. Far from it: For a mature company, P/S should be scrapped in favor of P/E and P/FCF (price to free cash flow), as well as industry-specific ratios.
But SodaStream is not a mature company. It's a nascent growth stock. Trying to forecast future profitability based on extrapolations of recent profits or free cash flow would be difficult. Today's profits and free cash flow (or lack thereof) aren't meaningful predictors of what things will look like down the road. They don't tell you what future earnings might be if the company succeeds, nor how bleak things will be if it doesn't. That's because with a revolutionary product like SodaStream's, it's either total success or near-bankruptcy.
Earnings do, however, eventually follow sales, which are far less volatile and easier to ballpark. So using the P/S ratio we can make a stab at how much the stock is worth if things continue to go the company's way.
Assuming SodaStream continues to grow sales at management's 2011 projected growth rate of 30% for another three years, and the market continues to give it a 4.96 trailing P/S multiple, by the end of 2014 (3.5 years from now) the price of the company will be $3.24 billion.
Or roughly $163 per share, or 2.8 times the current share price.
If you want 15% annualized returns on the stock to compensate for the risk, you should be willing to pay about $100 per share today. That's almost twice the current share price of $57. Likewise, it's priced for 35% annualized returns if you buy at the current share price, assuming sales grow as stated.
The bottom line: If you really think SodaStream is the next big thing, the current valuation shouldn't make you lose sleep. It's whether the business succeeds that should keep you up. I remain cautiously optimistic about that.