Datadog (DDOG -3.94%), a provider of monitoring and security solutions, announced recently that tech stalwart Microsoft is expanding its partnership with the company -- a big stamp of approval of Datadog's growing capabilities. Datadog has been delivering great results since going public in September 2019, but many investors are still fretting over the company's high valuation and have avoided investing in Datadog. Let's review why that may turn out to be an ill-advised decision for long-term investors. 

Various blue clouds with data falling from them.

Image source: Getty Images.

Growing dominance in the monitoring market

Reliable technology infrastructure is pivotal for businesses to succeed in today's digital-first world. Datadog, with its growing suite of monitoring and security products, provides early warning signs and key insights to detect and proactively address potential technology problems that may otherwise lead to business disruptions.

On March 30, 2022, Datadog announced that it is now a Microsoft partner within the Azure Cloud Adoption Framework -- Microsoft's roadmap for companies to successfully migrate their technology applications from legacy data centers to Microsoft's Azure cloud computing platform. Datadog was already a Microsoft partner, where customers could find Datadog products in the Azure marketplace. However, the integration and promotion of Datadog in Azure by Microsoft, the second-largest company in the world by market capitalization is a major endorsement of Datadog's capabilities.

Also, businesses looking to move to Azure -- a top cloud provider with about 22% market share in 2021, according to Statista -- will now get to learn about Datadog, and the value it provides, sooner in their Azure adoption journey and are potentially more likely to adopt Datadog.

In addition to Microsoft's Azure, Amazon Web Services, and Alphabet's Google Cloud Platform have also partnered with Datadog. Partnerships with the top three cloud providers that collectively boast a 64% share of the cloud computing market at the end of 2021, highlight Datadog's essential role in the cloud infrastructure, a critical imperative for businesses in the increasingly digital world.

Excellence in product innovation is resonating with customers

With constantly changing business and technology landscapes, IT platforms have gotten increasingly difficult to monitor, operate, and keep running smoothly. Datadog makes these complex tasks easier for its customers. 

Datadog is constantly innovating and adding new products to its offering, serving the broader needs of its customers and, in turn, capturing a greater share of customers' wallets. 

Image shows Datadog's various products.

Image source: Datadog earnings presentation.

As of the fourth quarter of 2021, Datadog's net dollar-retention rate -- how much more the average existing client spends from one year to the next -- has topped 130% for the 18th consecutive quarter. Datadog's largest customers continue to show a growing affinity for its products: Customers with $1 million or more in revenue more than doubled from 101 at the end of 2020 to 216 at the end of 2021. Meanwhile, customers with $100,000 or more grew by 63%, from 1,228 to 2,010 for the same period.

Datadog's outstanding execution led to a whopping 70% year-over-year revenue growth in 2021. That's impressive for any company but especially rare for one with annual recurring revenue over $1 billion. And while the company recognized a modest $2 million loss in operating margin in 2021, it generated over $250 million in positive cash flow. 

With its superior product set yielding such strong traction with customers, it is no surprise that, despite having their own monitoring services, the tech giants are inviting Datadog into their ecosystems. 

Should investors ignore the valuation?

As of this writing, shares of Datadog were trading at an eye-popping price-to-sales valuation of 41. Although that number is down from over 70 in November 2021, it is still higher relative to its historical multiples, which suggests that the market's confidence and expectations of Datadog have grown over time. Any missteps in execution or a miss in the results even for one quarter can dramatically impact Datadog's shares in the short term. Such worries may discourage investors from taking a position in the company. 

DDOG PS Ratio Chart

DDOG PS Ratio data by YCharts.

The market is demanding a relatively higher price premium for Datadog because it has proven to be a high-quality business with sustainable growth. Datadog expects to carry that momentum into 2022 with a revenue growth forecast of about 50%. Thanks to its expanding product suite, Datadog is projecting its addressable market to grow 40% from $38 billion in 2021 to $53 billion in 2025. With its 2021 revenue of $1 billion, the company is barely scratching the surface of the opportunity in front of it. And Microsoft's expanding partnership with the company just reinforces that prospect.

Sitting on the sidelines may mean missing out on great returns in the long run. For investors with long-term time horizons and well-diversified portfolios, a balanced approach could be used to build a position incrementally. Essentially investors take a small position in the company, monitor its performance over coming quarters, and add later at potentially more attractive valuations if the company continues to execute well. 

Overall, Datadog's excellence in product innovation, outstanding execution, and opportunity to grow into a much larger business position the company to be a long-term winner.