What happened
Shares of enterprise software star Snowflake (SNOW 4.04%) fell today, down 4.1% as of the end of trading -- much more than the broader markets.
There wasn't much in the way of new news for Snowflake today, but the severe risk-averse mood that has permeated the market since this month's inflation reading appears to be continuing this week.
Snowflake is perhaps one of the best-performing businesses in the enterprise software space. However, its stock is also among the most expensive. Therefore, when interest rates rise at a fast clip like they are now, Snowflake is highly susceptible to a rerating. That's what's happening today.
So what
The Federal Reserve held its September meeting last week, whereby Fed governors gave their projections for interest rates hikes in the near and medium term. Unfortunately for growth stock investors, the Fed's projections, often referred to as the "dot plot," showed even a more hawkish path than investors had been expecting...and investors were already anticipating hawkish comments.
Short- and long-term bond yields have been rising ever since. The 10-year Treasury bond yield continued rising to 3.88% today, now well above the June highs and at levels not seen since early 2010.
Any stock's value is predicated on the present value of future cash flows, and that "present value" is determined by how far out in the future a company's cash flows are, as well as the discount rate one uses on those cash flows. The higher the discount rate, which is usually based on Treasury bond yields plus an equity risk premium, and the further out those cash flows are, the less those cash flows are worth.
Snowflake is growing revenue at a very fast clip, up 83% last quarter; however, it also inked an operating loss of more than $200 million last quarter alone. As a high-growth company, it's likely that Snowflake will keep investing, so it's hard to tell when it will be profitable and how profitable it may be at maturity. While management does point to being free-cash-flow positive, that ignores the effect of stock-based compensation, which is still a cost to shareholders due to dilution.
Additionally, Snowflake trades at an eye-popping 31 times sales, which is as high a multiple as I have seen in the market, even among the expensive software cohort.
Since Snowflake's ultimate profits are far out into the future, it is quite sensitive to the rapid rise in interest rates. Given another move higher for interest rates, it's no surprise to see Snowflake stock selling off.
Now what
Snowflake has a terrific business. In fact, late last week the stock was initiated at "Buy" by Needham & Company and given a $240 price target, well above today's price of around $165.
The upgrade was due to Snowflake's impressive cloud-based data lake product, which has a strong competitive advantage in cloud data management. Going forward, businesses are only going to be using more and more data in their decision-making, so it's no wonder people like the stock.
Still, investors shouldn't own a stock they like at "any" price, no matter how good the business is. Amid rapidly changing interest rates, it's clear many investors are trying to figure out the price at which owning unprofitable software names makes sense.
