What happened
Shares of data cloud company Snowflake (SNOW 2.53%) fell 18.6% in January, according to data from S&P Global Market Intelligence. Snowflake issued a couple of press releases in the month, and the stock received multiple upgrades from analysts even as its price dropped. There was nothing truly negative published about the company, and investors didn't learn anything that would meaningfully change its long-term fundamentals. The stock was clearly another victim of the growth stock sell-off in January.
So what
Snowflake is an enterprise data-storage platform with an innovative revenue model. It's a promising disruptor in a high-growth industry, which propelled it to 110% sales growth in its most recent quarter. Remaining performance obligations, an indication of future revenue that's been booked but not yet recognized, grew 94%. It's fair to assume that its rapid growth will continue. Moreover, Snowflake reported a 173% net revenue retention rate, which shows that it is keeping its customers happy, and that they are rapidly expanding their relationships.
Image source: Getty Images.
Those are all hugely bullish signs -- investors have always paid a premium to buy growth stocks of that caliber. But that premium was around an all-time high late last year, with a price-to-sales ratio above 160, and it was around 95 at the start of January. The company is unprofitable, and just about breakeven on free cash flow, so most other valuation ratios aren't applicable.
That's expensive. Established tech stocks that are outpacing the market generally have price-to-sales ratios between 5 and 10. For all the justifiable excitement around Snowflake's growth prospects, there's an enormous gap between its valuation and stocks like Alphabet (GOOGL 0.55%), Amazon (AMZN -1.64%), or Microsoft (MSFT 0.37%). Snowflake can only maintain such high valuations if investors are willing to assume relatively high amounts of risk.
Right now, risk appetite is dwindling as interest rates are starting to rise.
Now what
Snowflake has been operationally excellent in recent periods and has tons of potential. As a result, the stock is still expensive, with a price-to-sales ratio around 80. It could provide fantastic long-term gains, but as is often the case, the potential for high reward comes with high risk.
Stocks with aggressive valuations tend to be more volatile. Snowflake investors should be ready for significant drops in the short term if market conditions continue to be challenging.
