Investors looking for "the next big thing" can get distracted by high-tech, rapid-growth stocks that come to market. Even if the underlying company is strong, it could fail to generate returns if the stock is dramatically expensive because it needs time to grow into the share price. Here are two companies that could face this problem over the coming months.
1. A cybersecurity newcomer
Cybersecurity company SentinelOne (S 2.63%) uses artificial intelligence (AI) to identify and eliminate potential cyber threats automatically. The stock went public at the end of June, less than two months ago. It's easy to see why investors might be interested in the stock; SentinelOne grew its annual recurring revenue (it uses a subscription-based business, so this is how we measure the company's performance) 116% year over year in the first quarter. Its 4,700-plus customers spend an average of 124% more on SentinelOne's services year over year once they begin using them. Meanwhile, the demand for cybersecurity is projected to grow at more than 14% annually moving forward, according to Mordor Intelligence.
SentinelOne is a rapidly growing business with an attractive market to grow into over the coming years, which understandably excites investors. However, many fail to take the stock's current valuation into account.
The company is expected to generate revenue of $176 million for its full fiscal year 2022 (the calendar year 2021). The stock trades at a market cap of $12.8 billion, and at a price-to-sales ratio above 70.
Consider that CrowdStrike Holdings, SentinelOne's closest peer (and rapidly growing in its own right), trades at a P/S of 38, using its expected revenue for the current fiscal year. A year ago, CrowdStrike's stock traded at an even lower P/S of 15. Is it possible that SentinelOne continues to trade at such a high valuation? Yes, but is it likely? It could be hard to make that argument.
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2. A "darling" of the tech sector
Content distribution network company Cloudflare (NET 1.63%) has a network of servers worldwide that speeds up how websites update and download by routing them through the closest servers to shorten the distance the information has to travel. On top of this network, Cloudflare is also building security and computing services to become a one-stop shop network solution for its customers.
The company has developed these complementary services quickly, and according to management Cloudflare's addressable market has expanded from $32 billion in 2018 to an estimated $100 billion by 2024. Cloudflare is expected to generate $631 million in revenue for the 2021 full year, a 46% increase over 2020.
The company has a market cap of $37 billion and the stock trades at a P/S ratio of 58, using its expected 2021 revenue. Like CrowdStrike, Cloudflare's valuation has rapidly expanded over the past year; it traded at a P/S of just over 15 in May 2020. In the face of this, Cloudflare is expected to see a slowdown in revenue growth to 33% in 2022, compared to the 46% to 50% growth that revenue has seen in 2019 to 2021. In other words, growth is slowing down while the valuation is going up.
Here's the bottom line
Both SentinelOne and Cloudflare could have very bright long-term futures, as both companies are innovating within their respective markets. But as investors, it's important to be aware of the valuation of stocks. High valuations mean that if the company itself underperforms, or there is a market-wide correction (indexes are at all-time highs), it could be these pricy stocks that investors turn away from.
Investors buying into these stocks today should consider that near-term returns may be underwhelming, simply due to the valuations the stocks already trade at. When stocks of quality businesses are purchased at reasonable valuations, that's when opportunities arise for truly great investment returns.
