Warren Buffett, a Snowflake (SNOW 0.98%) investor, once said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." The logic behind this quote is that you may never get a low price on the best companies in the market, and these companies will consistently outperform decent companies whose stocks are cheaper.
But what about wonderful companies at high prices? That's precisely where Snowflake investors are finding themselves.
While the company just reported another expectation-smashing quarter, the stock is rather pricey. But is it too pricey? Let's find out.
Blowing away management's expectations
Snowflake's data cloud software allows its customers to store massive amounts of data from multiple sources (even unstructured data that doesn't easily fit into the standard "rows and columns" format). Then that data can be harnessed to provide information for cybersecurity, feed machine learning models, or integrate directly with applications to improve business results.
To top things off, Snowflake charges customers only for the storage or computational power they actually use, a win-win for both customers and Snowflake. This ensures customers don't pay for unnecessary resources, while the company would, in turn, allocate cloud resources efficiently.
But a usage-based model can cut both ways, as customers may curtail their usage during difficult economic times like many businesses experienced in Q2. But this slowdown didn't affect Snowflake. Instead, its net revenue retention rate was an astounding 171%, meaning existing customers spent $171 for every $100 they spent last year.
This expansion helped power a revenue beat, with product revenue growing 83% year over year to $466.3 million versus management's Q2 projection of $437.5 million. Still, this doesn't scratch the surface of what management thinks their total addressable market is. Using third-party Gartner's research, Snowflake projects its total addressable market will be $248 billion by 2026.
However, if Snowflake runs out of money before 2026 due to its profitability, this is a moot point. Fortunately for Snowflake investors, the company is free-cash-flow positive, producing $53.8 million in the quarter (an 11% margin). So while its earnings per share may be negative ($0.70 loss in the quarter), Snowflake's cash balance is increasing.
For a young and growing business, investors couldn't ask for too much more in a quarter, which is why the stock skyrocketed 23% the day after the company reported earnings. But does that make the stock too expensive?
How long would Snowflake have to grow to achieve a reasonable valuation?
Snowflake's stock is now trading at 37 times sales. While this marks a significant drop from the 150 times sales Snowflake used to trade at, it's still costly.
However, a dichotomy occurs with soaring sales and valuation. If Snowflake's sales stagnated, the denominator of the price-to-sales (P/S) ratio would stay the same. That said, the numerator (price) would then drop because of a struggling business, dragging its valuation much lower.
On the other hand, if Snowflake's business continues to grow rapidly, the denominator would increase and drop the valuation. However, the latter scenario doesn't occur in a vacuum. If Snowflake's business continues to execute and proliferate, its stock price will likely increase, so its valuation won't drop as much. This back and forth is why looking at forward valuations is helpful to determine if the price you're paying now may be reasonable in the future.
If Snowflake can maintain a 50% annual revenue growth for three years (a lofty goal, but Snowflake has grown much faster than this every quarter it's been public, plus it has an enormous market opportunity), that would put its trailing-12-month revenue total at $5.53 billion in 2025, resulting in 11.4 times estimated 2025 sales.
The 50% revenue growth goal isn't a hard-and-fast projection; it's just a number used to illustrate how fast Snowflake would need to grow to return to the same valuation level as other software companies like Adobe (10.9 times sales) and ServiceNow (13.7 times sales). This exercise illustrates the lofty price investors would have to pay for Snowflake if they bought the stock right now. Remember, that projection also factors in zero price appreciation or shareholder dilution because of stock-based compensation. Plus, if Snowflake is still growing at a pace of 50% or greater in three years, there is little chance its valuation will fall to the level of Adobe's or ServiceNow's.
I'm a Snowflake shareholder and believer, but I add to my position knowing it's a long-term holding. I used a three-year growth projection, but if the company grows rapidly for my ideal holding period of around a decade, the price I pay today will become irrelevant due to a compounding effect.
Snowflake stock is expensive, but I'd rather be a shareholder and take some short-term losses than sit on the sideline and not own one of the fastest-growing tech companies in the market. I think Snowflake is a buy if you've got a long timeline like me. However, if your horizon is shorter, Snowflake may not be your stock.
