Read This Before Chasing Snowflake's Hot IPO

Snowflake (SNOW -1.61%) recently became the biggest software IPO ever after the cloud-based software company raised $3.4 billion by selling 28 million shares. The stock was priced at $120 a share on Tuesday -- well above its previously anticipated range of $75 to $85 -- and started trading the next day.

Snowflake then opened at $245 a share on Wednesday and ended its first trading day at $253.93 -- marking a 112% gain and valuing the company at $70.5 billion. Investors were clearly impressed by Snowflake's triple-digit revenue growth, and big purchases by Warren Buffett's Berkshire Hathaway and Salesforce at the offering price reinforced that bullish sentiment.

That's great news for bigger investors who bought IPO shares, but retail investors who weren't as fortunate are probably wondering if it's wise to chase this high-flying stock. Let's discuss four key things you should consider before buying shares of Snowflake.

Image source: Getty Images.

1. How does Snowflake make money?

Snowflake doesn't operate a big public cloud infrastructure platform like Amazon (AMZN -1.65%) Web Services (AWS) or Microsoft's (MSFT -2.45%) Azure. Instead, it provides data storage and analytics services that run on top of those public cloud services.

Companies pull that data from Snowflake and run it through a third-party data visualization platform, like Salesforce's Tableau, to gain clearer insights into their business. Snowflake claims this streamlined approach breaks down data silos across an organization, requires "near-zero" maintenance, and is easy to scale as an organization grows.

Snowflake's total number of customers, which include enterprise heavyweights like Capital One and Adobe, more than doubled year-over-year to 3,117 at the end of July. That list includes 146 of the Fortune 500 companies, which accounted for 26% of Snowflake's revenue in the first half of 2020. It also serves seven of the Fortune 10 companies, which accounted for 4% of its revenue.

2. How fast is Snowflake growing?

Snowflake is still consistently generating triple-digit revenue growth, which is remarkable for a company that already generated more than $400 million in revenue over the past four quarters:

Source: Snowflake S-1 filing. YOY = Year-over-year.

Snowflake's net retention rate -- which gauges its ability to retain existing customers, gain new ones, and cross-sell new services -- hit 158% over the past six months. A net retention rate above 100% is considered sticky, so Snowflake's platform seems much stickier than those of many of its cloud-based peers.

3. But can Snowflake ever become profitable?

Snowflake's revenue rose 174% to $264.7 million in fiscal 2020, but its net loss widened from $178 million to $348.5 million. In the first six months of 2021, its revenue rose 133% year-over-year to $242 million, while its net loss narrowed slightly from $177.2 million to $171.3 million.

Image source: Getty Images.

Snowflake's bottom line remains in the red because it hosts its services on cloud platforms like AWS and Azure. Most of its cloud hosting expenses are paid to Amazon, which is ironic because AWS also develops Snowflake's biggest competitor, Redshift.

Snowflake is gradually reducing its dependence on AWS by increasing its usage of Azure and Alphabet's (GOOG -1.96%) (GOOGL -1.97%) Google Cloud, but Microsoft and Google also compete against Snowflake with Azure SQL Data Warehouse and BigQuery, respectively.

Snowflake's dependence on these tech giants is troubling since they can lure customers away with lower prices and aggressive bundling strategies. However, investors should note plenty of smaller cloud players survived competition from AWS and other cloud giants before by establishing first movers' advantages in their niche markets.

4. Consider the valuation

Lastly, investors should take a deep breath and look at Snowflake's valuation. At $70.5 billion, Snowflake trades at 266 times last year's sales. Assuming that its revenue rises another 130% to $610 million in fiscal 2021, it would still be trading at 116 times this year's sales.

By comparison, Zoom Video Communications (ZM -0.99%), which is expected to generate 286% sales growth this year, is already considered expensive at 48 times that estimate. Some investors claim valuations aren't relevant for high-growth companies, but these numbers indicate Snowflake's IPO price already valued it more richly than Zoom, and now retail investors are paying more than double that premium.

The key takeaways

Snowflake's business model is attractive, its ecosystem is sticky, and it's gradually narrowing its losses. However, its valuation has hit cult levels, and it faces competitive threats from its biggest cloud partners. Snowflake's momentum could carry it higher over the next few days, but investors who plan to hold the stock over the long term should consider waiting for a big pullback before starting a position.