What happened
Shares of Datadog (DDOG 1.29%) sank 12.4% this week through 12 p.m. ET, even though there was little to no information coming from the company over the past five days.
Yet since Datadog sports a very high valuation, it was taken down along with a lot of other promising growth stocks, as long-term interest rates rose amid hawkish Federal Reserve commentary.
So what
Datadog has been one of the true all-stars of the enterprise software space. Its cloud-based observability tools have seen rapid uptake, resulting in the company's revenue surging by an impressive 84% last quarter.
However, in the software world, with great revenue growth usually comes a sky-high valuation, and Datadog possesses that as well. The stock currently goes for about 42 times sales, and about 28 times this year's sales estimates based on guidance for $1.52 billion, or 50% revenue growth this year. Datadog doesn't make profits under generally accepted accounting principles (GAAP) today, although based on forward estimates, it trades at a very high 312.5 times this year's earnings estimates.
Those high valuations caused Datadog to take a big hit when the Federal Reserve came out swinging this week in order to combat inflation. Comments from Fed Governor Lael Brainard on Tuesday and Philadelphia Fed President Patrick Harker on Wednesday suggested the Federal Reserve would be very aggressive in getting inflation down. That could push up interest rates faster than some might have expected.
But beyond short-term interest rates, the Fed released a plan to decrease its balance sheet by $95 billion per month beginning in May. The runoff or sales of securities from the Fed's balance sheet is more relevant for longer-term interest rates, or the "long end" of the curve, and that may be more relevant to Datadog's decline. Just this week alone, the yield on the 10-year Treasury bond has risen from around 2.4% to 2.7%. Over the past month, the 10-year yield has risen all the way from 1.87% to 2.7%, a very rapid increase in a short amount of time.
When calculating the intrinsic value of stocks, investors discount future earnings by a discount rate that is often based on the 10-year yield, plus a premium. The further out in the future the profits, the more they are discounted. So that is why high-growth, expensive stocks get hit disproportionally when long-term rates go up as they did this week.
Image source: Getty Images.
Now what
It's difficult to know where high-growth, highly valued stocks are going in the near term, as much will depend on the pace of inflation and current rate hikes compared with expectations.
Yet over the long term, Datadog looks like a strong company. IT management, software monitoring, and cybersecurity are all secular growth trends that are taking off, so Datadog has many years of strong growth ahead of it. The question is, how much are investors willing to pay for that growth?
Ironically, if the economy weakens and the U.S. heads toward recession, the Fed may stop raising rates and could start to lower them again. When that happens, Datadog may take off again, since it should have the ability to grow even in a weak economy. So even if Datadog looks too expensive for value investors today, it's a strong tech name to keep on your radar.
