Facing high levels of inflation, rising interest rates, and other macroeconomic pressures, cloud software stocks have gotten hit hard across 2022's trading. Snowflake (SNOW 2.53%) and DigitalOcean (DOCN 0.95%) are among the category-leading service providers. Both have seen dramatic sell-offs, and big valuation pullbacks could present worthwhile buying opportunities for risk-tolerant investors on the hunt for discounted growth stocks.
But which of these companies is likely to be the better buy? Both companies have some appealing strengths and long runways for expansion, but I think that one of them will ultimately go on to deliver superior returns. Here's why.
These two businesses approach growth differently
Before diving into recent business performance and valuation metrics, investors should understand Snowflake's and DigitalOcean's core service offerings and how the businesses are approaching growth.
Snowflake's Data Cloud platform provides data warehousing services that make it easy for businesses and institutions to combine and analyze data generated from applications on Amazon, Microsoft, and Alphabet's distinct cloud infrastructure services.
Meanwhile, DigitalOcean actually competes in the cloud infrastructure services space, but its offerings cater to smaller customers rather than the enterprise operations that the giants of the industry are most focused on.
While Snowflake has largely concentrated its customer acquisition and growth strategy on large customers, DigitalOcean is focused on providing cloud infrastructure services to independent developers, start-ups, and small businesses. The two companies are taking very different approaches to their respective core service markets, and both look to have viable service growth strategies. On the other hand, one of them is growing at a much faster clip.
Growth and valuation pictures
Snowflake has been doing a fantastic job when it comes to landing new customers and winning business from those already using its platform. Last quarter, it posted a net revenue retention rate of 171%, which means that existing customers increased their spending 71% compared to the prior-year period. Along with a 36% increase for the company's total customer count, this helped Snowflake grow its product revenue 83% year over year to reach $466.3 million in the second quarter.
DigitalOcean's revenue grew 29% year over year in Q2, and average revenue per user rose 24% to hit $71.76. The company is having success increasing spending per customer, and there's still a lot of room for growth on that front. While Snowflake has been posting much more rapid sales increases and may have a larger addressable market to tap into over the long term, it also has a much more growth-dependent valuation.
SNOW PS Ratio (Forward) data by YCharts
While DigitalOcean is trading at roughly 6.2 times this year's expected sales and 48 times expected earnings, Snowflake has a whopping forward price-to-sales multiple of 27 and is still a ways off from generating meaningful profits.
With a market capitalization of roughly $3.6 billion, DigitalOcean is also much smaller, which could make it easier for the stock to deliver explosive returns compared to Snowflake. But that doesn't necessarily mean that DigitalOcean gets the nod as the better buy.
Market positioning and competitive outlook
Ultimately, I think that Snowflake is building a stronger competitive moat and will have more market opportunities that help it live up to its growth-dependent valuation.
In addition to simply being a leading provider of cloud-based data warehousing services, the company is positioning Data Cloud as a foundation for creating and running applications -- giving customers the benefit of building on a software platform that makes it possible to natively combine and analyze data from otherwise walled-off cloud infrastructure providers.
DigitalOcean's specialization in cloud infrastructure services for smaller customers means it's not being crushed by competitive pressure from Amazon, Microsoft, and Alphabet right now. But there's a risk that the competitive landscape will become much more challenging in the future. If existing rivals gain ground, new players move in on its corner of the industry, or larger players in the space focus on the small business market, DigitalOcean could find it much more difficult to attract new customers or maintain pricing power.
Which stock is the better buy?
Both Snowflake and DigitalOcean are providing services that should benefit from demand tailwinds related to digital transformation trends and the rise of cloud-based services and analytics. DigitalOcean has strong service offerings and a much less growth-dependent valuation, but I think there's greater risk that it will face potentially destabilizing competitive pressures.
With Snowflake's platform potentially emerging as a go-to tool for building and running analytics-based applications, the business could be laying the foundations for an incredibly powerful long-term growth engine. I think Snowflake looks like the better buy right now, but risk-tolerant investors on the hunt for beaten-down growth stocks with big upside may want to consider investing in both companies.
