What happened
Shares of DigitalOcean Holdings (DOCN -2.11%) crashed 20.3% in December, according to data provided by S&P Global Market Intelligence. It appears investors have soured on expensive stocks like this and are actively betting they'll go down to more reasonable valuations. Considering there wasn't any other news to report during the month to explain this outsize drop, it seems investor sentiment was the primary driver of DigitalOcean's stock price.
So what
Investors can make money when a stock goes down by shorting. When it comes to DigitalOcean, a provider of cloud services for small and medium-size businesses, we see that investors are increasingly making this bet. According to Yahoo Finance, 5.25 million shares of DigitalOcean were sold short as of Nov. 15. But by Dec. 15, this had increased a whopping 83% to 9.62 million shares.
Image source: Getty Images.
Investors are betting DigitalOcean stock will go down because it's currently expensive. Consider that the company has generated almost $400 million in trailing-12-month revenue (TTM). And it has roughly 121 million shares, which trade at roughly $73 per share as of this writing. Therefore, its fully diluted market capitalization is around $8.8 billion. Given its TTM revenue, this puts its price-to-sales ratio at 22, which is considered expensive and explains why investors are willing to short DigitalOcean.
When investors short a stock, it doesn't make it go down. Indeed, stocks can go up even when short interest is high, sparking a short squeeze. Therefore, it's not correct to say short-sellers caused DigitalOcean stock to go down 20% in December. But the rapid increase of short-sellers indicates that general market sentiment has turned against DigitalOcean. And this bearish sentiment is enough to cause a pullback like this.
DOCN data by YCharts.
Now what
To be sure, with its still-pricey valuation, DigitalOcean will need years of stellar revenue growth and earnings growth to be a market-beating investment. Fortunately, the company is in an industry that lends itself to this. When it went public, it cited data from market research company International Data Corporation that said DigitalOcean's market could have a 27% compound annual growth rate through 2024, becoming a $115 billion opportunity. Therefore, the company has an undeniable chance for growth.
One thing that impresses me with DigitalOcean is how big it already is. It's only about 10 years old but already has 598,000 customers. And it's done this while spending just 11% of revenue on sales and marketing in 2020 and just 12% through the first three quarters of 2021. That's efficient.
Customer growth does appear to be slowing, however, which is something to watch. Its customer count was up only 7% year over year in the third quarter. However, revenue growth is still strong because customers are increasing their spending. Average revenue per customer was almost $62 in the third quarter, up 28% from last year.
The takeaway for investors is that there are valid concerns with an investment in DigitalOcean today. But there's also good reason to believe the company can prove the doubters wrong in time.
