It's official: Snowflake (SNOW -1.00%), a company most investors had never even heard of just a few months ago, has become the largest software IPO in history. On Wednesday, the company raised a net of more than $3.25 billion in cash and counts among its new investors a diverse group from Warren Buffett's Berkshire Hathaway (NYSE: BRK.A)(BRK.B -0.31%) to software-as-a-service giant salesforce.com (CRM 2.54%). Shares more than doubled from their IPO pricing of $120 in the first day of trading (although as of this writing, it has cooled off to "only" about $228 a share).
At this juncture, the average investor should read this, take a deep breath, and take a long walk.
Image source: Getty Images.
The ABCs of counting your chickens
There should always be a point where fear should overrule FOMO (fear of missing out). And right now, when it comes to this stock, fear of grossly overpaying should be your primary concern -- assuming you're an investor who didn't get in on Snowflake during its pre-public trade debut.
That's because Snowflake's valuation of over $63 billion as of this writing implies many years of exceptional revenue growth. Granted, there are all sorts of nontraditional (and legitimate, maybe even preferable) ways to measure the value of a cloud data software company like Snowflake. Technology like this can be difficult to put a price tag on since much of its value is tied up in intangible intellectual property. Thus, metrics like total number of customers, integrations and ease of use with other software services, and the size and growth of the industry overall are important factors as they contribute to the firm's long-term potential.
Snowflake without a doubt boasts some impressive figures. Founded in 2012, the company already has over 3,100 customers -- including 56 that pay more than $1 million a year. On average, during the second quarter of Snowflake's fiscal 2021, existing customers spent 58% more with the company than they did a year prior (a byproduct of the platform's scalability as client needs change). And Snowflake's services are designed to break down data silos within organizations and make the information it possesses easier for employees to use -- solving a problem that has developed even for users of cloud platforms such as Amazon's AWS, Alphabet's Google Cloud, and Microsoft's Azure.
Snowflake thus has an opportunity to disrupt the disruptors, giving it massive upside in an already fast-growing and ever-important industry.
As a result, Snowflake's revenue grew by 133% during the first half of this year to $242 million, generating losses of $171 million (or cash-only operating losses of $45.3 million). The red ink looks ugly, but cloud computing is actually highly profitable. Gross margins are quickly rising (product sales at 66% so far this year), and while the company grows and reaches a more efficient scale, it will have $4.64 billion in cash and equivalents on the books after adding in the proceeds from its IPO. That's an ample war chest.
So nontraditional value metrics indicate this company is a buy. But however imperfect traditional valuations may be for gauging a stock like Snowflake, they still have a place in assessing whether it's worth your hard-earned dollars.
Snowflake's profits are nonexistent at the moment, so we're left with the trailing 12-month price-to-sales metric. As of this writing, Snowflake stock is trading for 155 times sales. For the sake of comparison, Zoom Communications (ZM -0.86%) trades for 85 times sales -- also seemingly ludicrous, but its revenue grew by 355% year over year last quarter.
Based on that simple comparison between the two, the faster-growing (at least at the moment) and already profitable Zoom looks like its trading at a deep discount to the incredibly lofty Snowflake.
Exactly how many unhatched chickens are being counted here?
But for the sake of argument, let's say paying more than 150 times sales is perfectly acceptable. After all, someone is the counterparty buyer right now to create the current market for Snowflake shares. But is this investment right for small individual investors? There's no question Snowflake is growing fast and will likely continue to grow for some time. But at some point, valuations can most certainly reach a point where you ought to take a hard pass.
As we all know, the business world can change quickly, and pricing too much future growth into a stock opens the door to a not-so-friendly outcome. As for what would be an acceptable premium here, maybe it's the $120 a share that Berkshire Hathaway and Salesforce paid. At that level, the stock went for a price-to-sales ratio of around 70 to 80, seemingly a steal today.
Maybe that price tag would sit well with you, although even at that level, I'd argue a retail investor should take only a very small starter position and be patient. Making a purchase just because institutional investors and big businesses are putting money into a stock isn't a great idea. Buffett and Salesforce CEO Marc Benioff aren't making their investing decisions based on the need to fund their retirements (or whatever it is you're saving and investing for).
Put simply, at the moment, Snowflake's valuation doesn't look like the market is counting too many chickens before they hatch. It's more like investors are counting the future chickens they think will hatch from the still-unlaid eggs of chickens that have yet to hatch themselves.
The momentum of the world's migration to modern cloud-based operations definitely favors Snowflake's continued growth. But there is far too much uncertainty about whether the company will be able to justify today's share price with its longer-term results. That should make this stock a wait-and-see affair for the average investor right now.
