Investors often focus on various valuation metrics to determine if a stock is a good buying opportunity. Valuation metrics can be useful, but the majority look back over just the past year. The irony is that long-term investors should be looking forward. As we look three, five, or 10 years into the future, backward-looking valuation metrics can be less helpful than you might intuitively think.
This is why growth stocks are so appealing to investors who plan to patiently hold for years. Given enough time, top growers can compound returns many times over, making supposed overvalued stocks look like bargains in hindsight. Therefore, paying attention to growth stocks is important. And Digital Turbine (APPS -4.17%), Peloton Interactive (PTON -3.26%), and Snap (SNAP -0.90%) are three of the highest-growth stocks around. Here's why their revenue growth rates are so important for prospective investors.
Image source: Getty Images.
1. Digital Turbine
Just a little over a year ago, Digital Turbine's market capitalization was less than $1 billion. But CEO Bill Stone had visions of the company becoming what he calls a "unique next-generation [advertising technology] ecosystem" to capture its slice of what it believes to be an over $300 billion addressable market opportunity. Over a year ago, it acquired a company called Mobile Posse to help build the ecosystem. And during the past year, it's acquired AdColony, Appreciate, and Fyber. Its market cap has now soared past $7 billion, in part thanks to these acquisitions.
Here's how fast Digital Turbine's business is growing: For fiscal 2020 (which ended in March 2020), the company generated revenue of almost $139 million, which was up 34% year over year. For fiscal 2021, its revenue jumped to almost $314 million, up 126%. And for fiscal 2022, management believes it can hit a whopping $1 billion -- that's nearly eight times what its revenue was just two years ago.
Digital Turbine helps developers get their apps downloaded on mobile devices by partnering with wireless carriers like T-Mobile US and AT&T. Because there are relatively few carriers, this exposes Digital Turbine to risk should any of these choose not to work with the company anymore -- for perspective, 26% and 23% of fiscal 2021 revenue came from mobile devices on T-Mobile's and AT&T's networks, respectively. Furthermore, most of its business is on Google's Android platform, part of Alphabet. And with Google changing up its ad business lately, perhaps it will start building something that encroaches on Digital Turbine's space.
Finally, some might see some execution risk with Digital Turbine considering how many big acquisitions it's made recently. It's challenging to integrate everything and make the combined company worth more than the sum of its parts. That said, it trades at just around seven times its sales for fiscal 2022 and just 35 times forward-earning estimates. For a growth stock, this is a relatively reasonable value that will pay off if Digital Turbine executes.
But execute it must. When it acquired Fyber in May, Stone said "We believe that we now have all of the critical elements" to deliver on the company's vision. Therefore, this next year will be crucial to prove whether management's strategy is a good one.
Image source: Peloton Interactive.
2. Peloton
Unlike Digital Turbine, Peloton hasn't grown all that much via acquisitions thus far. But it's grown its top line at a better than 100% compound annual growth rate (CAGR) since its founding nonetheless. Revenue for fiscal 2020 (which ended in June) was up roughly 100% year over year to $1.8 billion. For fiscal 2021, management is now guiding for revenue of $4 billion, which will be up 122% from 2020. This guidance has been revised higher a couple of times because of ongoing incredible demand, and even takes into account the negative $75 million impact from the recall of its treadmills.
Peloton's impressive revenue growth is worthy of investors' attention because the profit margin for its subscription business is simultaneously expanding. The company has a two-sided business: It sells the workout equipment for a one-time sale and charges an ongoing monthly subscription for the connected features. Through the first three quarters of fiscal 2021, Peloton's gross margin for its subscription service was 62% compared to 57% during the comparable period last year.
Long term, Peloton's management believes the gross margin for its subscription business will be over 70%. And over time, if the company can continue retaining its customers as it has in the past, it seems likely that the subscription business will make up a bigger part of the revenue mix, boosting overall margin. Moreover, the subscription business has fewer expenses related to net profits. For example, you don't need to advertise it (people who own a Peloton are already well aware of the service), so sales and marketing expenses are lower.
Peloton finished its most recent quarter with over 2 million active subscriptions. Long term, management wants 100 million. That sounds like a crazy ambitious goal, and maybe it is. But achieving just a fraction of it would take the company's subscription business to enormous heights and turn this into a much more profitable business at maturity. Therefore, this is a growth stock to keep on your radar at the very least.
Snap's Spectacles 3. Its Spectacles will be a key part of its AR opportunity. Image source: Snap.
3. Snap
Snap, the parent company of popular social platform Snapchat, is growing fast, and it just keeps speeding up. The company's full-year revenue grew 43%, 45%, and 46% year over year in 2018, 2019, and 2020, respectively. However, for the first quarter of 2021, revenue was up an even better 66% compared to the same quarter last year. And it's guiding for 81% to 85% year-over-year revenue growth for the second quarter. Therefore, it's looking like 2021 will be Snap's third consecutive year of accelerating revenue growth -- a noteworthy feat for a multibillion-dollar business like this.
Snap's growth is much slower than that of Digital Turbine and Peloton. But it makes this list thanks to how long it might be able to sustain this stellar growth. At its investor-day presentation in April, management said it expects to drive greater than 50% annual revenue growth for the next "several" years.
For what it's worth, Snap's outlook seems reasonable to me. Consider that Snap has an engaged and growing user base among Gen Zers, an important demographic whose purchasing power is only increasing. And businesses are shifting advertising dollars to digital channels like Snap, which offer measurable results. This is leading to more competition for ad slots, which increases rates and leads to higher revenue for Snap.
However, I'm really eyeing Snap now because of its bottom-line growth. In the first quarter, the company was free-cash-flow positive for the first time since it went public in 2017, and its operating cash flow was $137 million -- a more than 20-fold increase from the meager $6 million it had in the same quarter last year. In short, it seems like Snap has finally turned the corner on profitability, meaning its ongoing revenue growth should drive stellar cash flows for the foreseeable future.
This cash flow will give Snap a lot of optionality for the future. Specifically, the company sees a big opportunity in augmented reality (AR), making several big acquisitions in recent months. According to Reportlinker.com, the AR market was valued at around $49 billion in 2020 but is expected to reach almost $300 billion by 2025. Therefore, it seems Snap has indeed found a worthy place to reinvest its cash flow to grow its business for the long term.
Investor takeaway
For investors looking at growth stocks, Peloton and Snap are especially instructive stories. Revenue growth is important, yes. But are margins expanding as well (like Peloton's are)? If not, investors should dig deeper -- it might not be a great long-term opportunity. Furthermore, if business booms, will the growth company have a place to reinvest cash flow for more growth (like Snap has)? Expanding margins and a place to invest future cash flow are both important aspects to any growth investment, and both of these companies offer this to investors today.
