Another solid earnings report from Snowflake (SNOW -1.61%) at the end of August is long forgotten. Shares of the data-cloud company are off about 25% since second-quarter earnings were announced -- and down a whopping 55% so far in 2022.
And yet, even after falling so far, Snowflake still trades for 162 times trailing 12-month free cash flow. The company expects to grow product sales by at least 67% this year, so you could still argue the premium price is worth it. But is this stock "cheap" yet given its long-term potential? Let's see.
Balancing incredible potential with near-term valuation
After Snowflake's initial public offering (IPO) in September 2020, I was happy to have just a little exposure to the stock via IPO participants Salesforce (NYSE: CRM) and Warren Buffett's Berkshire Hathaway (NYSE: BRK.A)(NYSE: BRK.B). Each company scooped up $250 million worth of Snowflake stock. Salesforce offloaded most of its stake in 2021, and then sold what remained in early 2022. Buffett and company are still holding -- remarkably still at an unrealized profit thanks to the IPO price of $120 per share on Snowflake. Salesforce cleaned up nicely by selling early and locking in a profit.
Snowflake is a special company, and not just because of its incredible growth. The company's data storage and processing solutions unlock new options for a company trying to make sense of its digital information. A whole set of software technologies is being built using the disruptive data architecture that Snowflake helped pioneer. With many analysts (and Snowflake itself) predicting double-digit growth for many years, it's no wonder the stock fetches such a premium price even after getting clobbered by the bear market this year.
But then there's valuation. This should not be the end-all or be-all consideration when picking stocks, but nevertheless it is worth weighing before buying a stock. Helped in no small part by massive amounts of stock-based compensation paid to employees over the last two years, Snowflake currently has an enterprise value (a more accurate way of measuring the true value of a company than market cap) of nearly $45 billion.
Based on Snowflake's 2022 outlook for revenue to be as much as $1.9 billion and free cash flow profit margin to be about 17% (implying free cash flow of approximately $326 million), Snowflake stock currently trades for 138 times enterprise value to the current year's expected free cash flow. In other words, Snowflake still isn't cheap yet.
Keep an eye on this key metric
Of course, Snowflake's growth will extend well beyond 2022, and free cash flow profit margins can rise beyond 20%, as is often the case for well-established cloud software companies. Based on this direction, an investor might argue Snowflake is indeed a good value at this point if you plan on holding for at least a few years or more. I agree.
However, stock-based compensation needs to be factored in. New stock issued to employees is important in recruiting and retaining talent, but it dilutes ownership of existing shareholders. Snowflake has paid out $381 million in stock-based comp through the first half of 2022. The company also said it expects average weighted share count to be 358 million by year-end, up from 316 million at the midpoint of the year.
That implies another 40 million new shares (a nearly 13% increase in the second half of this year alone) will be issued that will dilute any free cash flow gains. Suffice to say that's a big number.
Investors could conceivably assess Snowflake's returns by measuring free cash flow on a per-share basis. But given that Snowflake's trailing 12-month free cash flow only just turned positive about a year ago, it's too soon to use this metric in measuring the company's progress in managing stock-based compensation.
Data by YCharts.
Let's use an example to illustrate how things might pan out. Let's say Snowflake's free cash flow doubles (a 100% increase) in the next 12 months, but share count grows 20% on an annualized basis. In this scenario, free cash flow to existing shareholders only increases about 67%. That's still a massive gain, but it illustrates the problem with the company's high rate of stock-based compensation.
In other words, though Snowflake has tremendous potential in the decade ahead, I would still preach caution with this stock. It's too soon to tell just how much value there is in making a purchase now. If you want to invest, using a dollar-cost averaging strategy that builds a larger position in Snowflake over time looks like a prudent way to go at this juncture.
