Investors often pay the wrong price for the right company when they can't objectively separate its business from its stock. A great company might have a terrible stock if it's trading at unsustainable valuations, while a mediocre company might have a great stock if it's significantly undervalued.
Over the past several months, many of the market's top growth stocks crashed amid rising interest rates and other macro headwinds. That sell-off has created great buying opportunities in some high-growth stocks, but some high fliers remain grossly overvalued even after being cut in half.
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Snowflake (SNOW -1.86%), Cloudflare (NET -0.85%), and Shopify (SHOP -2.03%) are three of those stocks. They all have great underlying businesses, but their frothy valuations need to be reset by another market crash before they can be considered safe long-term investments.
1. Snowflake
Snowflake's stock price has declined nearly 50% from its all-time high of $401.89 last November. However, it still trades almost 80% above its IPO price of $120 a share and remains richly valued at 33 times this year's sales.
The bulls believe Snowflake's high growth rates and the stickiness of its cloud-based data warehousing platform justify its premium valuation. Its product revenue rose 120% in fiscal 2021, which ended in January of the calendar year, and increased another 106% to $1.14 billion in fiscal 2022. Its net revenue retention rate rose from 168% in 2021 to 178% in 2022, while its total number of customers increased 44% to 5,944.
Snowflake also believes its annual product revenue will grow to $10 billion by fiscal 2029, which would represent an impressive compound annual growth rate (CAGR) of 36.4% over the next seven fiscal years.
That confident guidance convinced many investors to overlook Snowflake's net losses, which widened from $539 million in fiscal 2021 to $680 million in fiscal 2022, and competitive threats like Amazon Web Services' Redshift and Microsoft's Azure Synapse.
Snowflake is a promising company, but there's just too much growth baked into its valuations. Therefore, I'd only be interested in buying the stock if a market crash reduces its price-to-sales ratio to the mid-teens.
2. Cloudflare
Cloudflare, which provides content delivery networks (CDN), cybersecurity services, and bot-blockers for websites, is another richly valued company. The stock price has dropped nearly 50% from its all-time high of $217.25 set last November -- yet it still trades at 38 times this year's sales.
The bulls love Cloudflare because it's growing like a weed. Its revenue rose 50% to $431 million in 2020 and increased 52% to $656 million in 2021, and it expects 41%-42% growth in 2022. It's also growing much faster than comparable CDN providers like Fastly.
Cloudflare isn't profitable by generally accepted accounting principles (GAAP) yet, but it expects to generate a non-GAAP net profit in 2022. Over the long term, the company expects to become a "water filtration" system for the internet that reduces the need for traditional cybersecurity services by blocking bots and distributed denial of service (DDoS) attacks.
Cloudflare's business looks healthy and its outlook is rosy, but its high price-to-sales ratio will limit its near-term gains. Therefore, I think a market crash could easily cut Cloudflare's stock in half again and reduce its price-to-sales ratio to about 20 -- which would arguably be a more sustainable valuation and comparable to companies with similar growth rates.
3. Shopify
Shopify's stock has lost more than 60% of its value since it hit its all-time high of $1,690.60 last November. However, the stock still trades at about 300 times forward earnings and 12 times this year's sales.
Shopify flourished throughout the pandemic as small businesses flocked to its e-commerce platform to launch their own online stores, process payments, fulfill orders, and manage their own marketing campaigns. However, that momentum waned as more brick-and-mortar businesses reopened.
Its revenue surged 86% in 2020 and grew 57% to $4.6 billion in 2021, but analysts anticipate just 31% growth in 2022 as that slowdown continues. As its top-line growth decelerates, Shopify plans to reinvest "all" of its gross profits back into the expansion of its international business, integrated point of sale (POS) systems, consumer-facing Shop App, and the Shopify Fulfillment Network (SFN). Analysts expect its operating margins to contract as it expands that ecosystem, and for its bottom line to dip into the red again in 2022 after achieving GAAP profitability for the past two years.
That combination of slowing growth and rising expenses has driven investors away from Shopify. I believe that the sell-off could continue until its price-to-sales ratio hits single-digit levels that are more comparable to those of other fallen e-commerce growth stocks like MercadoLibre or Sea Limited, so investors shouldn't rush to buy Shopify until a market crash resets its valuations again.
