It's good to see the stock market reward a quality stock with a higher share price, but sometimes the market can overreact, a knee-jerk reaction that can send a stock into "silly" valuations. Cloud-based internet services company Cloudflare (NET 1.40%) has been on a run, appreciating nearly 40% over just the past month.
Is Cloudflare a "silly" stock now, and is it too late for investors to benefit from owning it? The answer may depend on your time horizon.
Just how expensive is Cloudflare?
Cloudflare's among the hottest stocks on the market. It's up 40% over the past month and 230% over the past year. The stock now has a market cap of $56 billion, while analysts are looking for revenue of $632 million for the full 2021 year.
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This values the stock at a price-to-sales ratio of almost 89, making it one of the most expensive companies on the entire market. For comparison, its closest competitor, Fastly, has a P/S ratio of 16. While Cloudflare has seemed to perform at a much higher level lately, is it worth a valuation fivefold that of Fastly's with a similar level of revenue growth?
Cloudflare has grown its revenue at an average rate of 50% since 2018, but the stock's valuation has continually expanded. Just before the COVID-19 pandemic, Cloudflare's stock traded at a P/S ratio under 20, so investors need to justify this (much) higher valuation when buying the stock now.
Is the valuation justified in the short term?
That's why I think now may not be the right time to invest in Cloudflare. Could the stock go higher in the short term? It might, but it's hard to find room for a stock already at a valuation like this to continue soaring.
Consider that while the company's revenue has grown at an average of 50% over the past several years, analysts believe revenue growth might be slowing down over the coming years. Consensus is projecting 46% revenue growth for the full 2021 year and 34% growth in 2022. If these estimates are accurate, it's hard to see investors being willing to pay such a high valuation for slowing growth.
Making things worse, the company isn't yet profitable. It's normal for a growing business not to show a profit because it's pumping the cash generated by the business back into it to fund expenses like sales and marketing and research and development.
However, when a stock is this expensive, investors set a high bar for the company to perform. In its most recent quarter, the second quarter of 2021, Cloudflare hasn't even yet reached a positive operating margin, though at negative 3%, it's getting close. Analysts are looking for earnings to break even in 2023, but that also means actual profits for the business could be two to three years away yet.
Cloudflare is still a long-term winner
While I don't think Cloudflare is a good buy today, it is a company to consider when the valuation comes down. It has proven to be very innovative, evolving from its core content delivery business, which uses local servers worldwide to increase the speed of websites it supports, to becoming an edge-computing platform that is increasingly capable in new areas like cybersecurity.
Management estimates that its new services have increased its total addressable market size from $32 billion in 2018 to what could be $100 billion by 2024. Additionally, its customers seem to like its services; its net retention rate is 124%, indicating that customers spend more money once they become customers.
The ability to bring new products and services online, and get customers to spend more, leaves room for the possibility that Cloudflare outperforms analysts' long-term revenue estimates. Cloudflare is picking up large customers (defined as spending $100,000 or more) at a fast rate, growing 67% per year since Q2 2018. Just 19% of the Fortune 1000 are paying customers, leaving room for the company to continue picking up new customers moving forward.
The bottom line is that Cloudflare is an innovative company with different ways to drive growth through product expansion and new customer acquisition. But this doesn't make up for what is currently a very expensive valuation that could certainly come down in the future. Therefore, I don't think today is the best time to buy Cloudflare and would like to see a significant pullback before considering buying shares.
