Investor euphoria pushed many growth and technology stocks to stretched valuations in 2020 and early 2021. Cloud services company Cloudflare (NET -0.23%) was among them, trading at more than 100 times sales, making it one of the most expensive stocks on Wall Street at one point. Naturally, investors have sold highfliers like Cloudflare during the current bear market, and shares of the company are down more than 70% from their highs of $221. Investors may hesitate to buy a stock in free fall, but here's why Cloudflare could reward long-term investors, even if the share price keeps falling in the short term.
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Growth has accelerated
Investors have seen Cloudflare's trailing-12-month revenue nearly triple to approximately $730 million since the summer of 2019. Most companies see their growth slow down as they get bigger, because large numbers often have a harder time increasing than small ones. But in Cloudflare's case, quarterly revenue growth has accelerated from the high 40s to the low 50s on a percentage basis, as shown below.
NET Revenue (Quarterly YoY Growth) data by YCharts
Customer growth has played a prominent role in this; the company's customer count has grown at an average of 28% over the past three years, and now totals more than 178,000 paying accounts. Additionally, existing customers are spending more over time, evidenced by the company's 127% net revenue retention (NRR).
An innovation flywheel
Cloudflare's growth doesn't just come from selling the same products and services to more companies -- instead, constant product innovation opens up new business opportunities. Cloudflare's legacy business is its content distribution network (CDN). Servers worldwide help Cloudflare's customers upload and download faster by bringing the physical boxes that make that happen closer to the customer, instead of clumping them in a centralized location.
Over time, the company has steadily added capabilities to this infrastructure, including networking, security, etc. Cloudflare's mission statement is to "help build a better internet," building out edge computing that's no longer centralized but exists closer to where it's needed.
Management estimated that its total addressable market was just $32 billion in 2018, but has grown to $115 billion today and could reach $135 billion by 2024. Adding new capabilities gives Cloudflare a firmer grasp on its customers and encourages increased spending that helps drive revenue growth.
Valuation finally makes more sense
Cloudflare's valuation peaked in late 2021, when the stock traded at a forward price-to-sales ratio of more than 100, one of the highest valuations of any company on Wall Street. You can see below how a combination of revenue growth since then, plus a roughly 70% decline in share value, has dramatically decreased the P/S ratio.
NET PS Ratio (Forward) data by YCharts
Is Cloudflare "cheap" at a forward P/S of almost 19? It's all relative, but investors probably shouldn't assume that the stock will run up to another high-double-digit P/S ratio. The market environment remains volatile, and shares may keep falling from here.
However, Cloudflare has shown the ability to maintain steady revenue growth at around 50% per year and has a large market to grow into over the coming years. Interested investors could utilize a dollar-cost average strategy to buy shares slowly and build a position through multiple purchases, ensuring that missing "the bottom" doesn't sting too badly in the long run.
