The "fear of missing out," or "FOMO," is a tricky emotion for investors to fight. Nobody wants to feel like they missed out on a great opportunity. When a stock goes to the moon and begins to fall back, it can be tempting to buy it on the first dip you see, sure that it will fly high once again.
Cloud computing company Cloudflare's (NET +0.14%) stock went bonkers in 2021, going as high as $221, making it a multi-bagger from where it traded earlier this year. But before rushing to buy that dip now that the stock is back to $160, consider this.
The stock is still really expensive
Let's put some perspective on this situation. Cloudflare is an innovative company, expanding its growth opportunities by building feature after feature into its cloud platform.
Image source: Getty Images
A few years ago, Cloudflare was primarily a content delivery network (CDN) that used a network of servers worldwide that worked to speed up web content delivery by routing traffic through the nearest servers.
The company estimated its total addressable market to be just $32 billion in 2018. After several years of product development, seeing the business evolve into a feature-packed cloud platform, its self-estimated addressable market is now $86 billion and could hit $100 billion by 2024.
The continued growth of its addressable market means more room for the business to grow, which is part of the reason that investors have been buying shares hand over fist. However, the stock has been traded to very lofty valuations, with its price-to-sales (P/S) ratio crossing 100, even using forward revenue estimates.
NET PS Ratio (Forward) data by YCharts
This valuation puts Cloudflare among the most expensive stocks in the entire stock market; its P/S ratio is now near 75, even after the most recent pullback off 52-week highs. To be clear, this is a very premium valuation that needs significant support from the business fundamentals to justify it.
The fundamentals might not justify the price
It's questionable whether Cloudflare is financially remarkable enough to carry such a high valuation and still be beneficial to shareholders. For starters, Cloudflare will grow revenue 50% over 2020 this year by meeting analyst estimates, which certainly qualifies it as a high-growth company. But 50% growth isn't extraordinary, given the current valuation metrics, in my opinion.
Worse yet, analysts are looking for growth to slow in 2022, currently estimating revenue growth at 36% and calling for $884 million. Investors will often punish stocks with a lower valuation when growth slows down, so shareholders need to hope that Cloudflare comes in ahead of analyst expectations.
A rich premium should also imply that the business is very profitable. Many companies don't show a profit because they invest in growing the business. Amazon is a classic example of a business that showed losses but produced free cash flow for years before posting actual earnings.
Not only is Cloudflare not posting a profit, but the business isn't free cash flow positive yet either. This isn't a terrible thing -- many young companies burn cash. But remember, we are looking for a reason to pay an exceptional price for this stock; the fundamentals also need to be remarkable.
Consider that fellow cloud-based technology company CrowdStrike, which does cybersecurity, is:
- Growing revenue at 63% this year
- Generating positive free cash flow
- Highly likely to show profits this year
One could argue that CrowdStrike is financially superior to Cloudflare, yet CrowdStrike's forward P/S ratio is 32, less than half of Cloudflare's!
Overall market conditions could push shares lower
Meanwhile, inflation has increased due to how much money the Federal Reserve has injected into the U.S. economy during the pandemic, which could encourage the Federal Reserve to raise interest rates to counter it.
US Inflation Rate data by YCharts
As interest rates rise, it becomes a headwind for expensive, non-profitable companies because higher rates make it more costly to borrow money for growth. Higher rates also reduce the value of a company's future cash flows, a common component of how Wall Street values companies.
In other words, high rates tend to push valuations of growth stocks lower, so this could be bad news for stocks like Cloudflare. With such a high valuation, it wouldn't surprise me to see the stock continue to trend lower over the months ahead. That's not to say that Cloudflare cannot be a great investment, but investors should always be mindful of the price they pay for a stock.
