What happened
Shares of Cloudflare (NET -1.14%) jumped 24% in August after it published impressive quarterly earnings. A sell-off in growth stocks forced the cybersecurity leader to lose some of those gains later in the month, but it still posted a solid return for shareholders.
So what
While some tech stocks reported weakness in August, Cloudflare was one of the bright spots. The company maintained a high growth rate, notching 54% revenue expansion over the prior year. It also revised full-year guidance upwards, increasing its top-line forecast by $13 million and operating income by $3 million.
Investors are looking for suitable options as economic activity slows and interest rates rise, and growth stocks are getting hit the hardest. That's exactly why Cloudflare stands out so much. The company is delivering on several key factors that are bullish for future returns. Growth is obviously great, but Cloudflare is also reporting excellent customer retention along with strong cash flows. Its customers are satisfied, it's expanding its offering, and all of this is being accomplished efficiently.
Image source: Getty Images.
Now what
Cloudflare is adding to its massive market share in a high-growth industry. It is used by more than 15% of websites, and its platform allows users to access data in a more efficient and secure manner. That makes it a major vendor for websites and internet-enabled businesses, and it enjoys a wide economic moat as a result of its scale and product quality.
It's hard to come up with a reason to dislike Cloudflare, at least on the basis of business fundamentals and strategy. The glaring issue with this stock is valuation. It trades at a price-to-sales ratio above 23, which is quite high. The company isn't prioritizing profit generation as it invests in growth, so its forward P/E and price-to-cash flow ratios are also enormous. Investors have to pay a premium for promising growth stocks -- that's nothing new.
Instead, the issue lies with the volatility inherent in that sort of valuation. Even if it keeps producing good news, the stock is likely to fluctuate much more wildly than the market in general. Any whiff of bad news could send it tumbling. If we see the market retreat over the next few months as interest rates continue to rise, Cloudflare could deliver steep losses through no fault of its own.
That's all fine if you're in it for the long term, but investors need to be comfortable with excess volatility to find this suitable.
