If you set aside analyst expectations, CrowdStrike (CRWD 0.69%) is doing just fine. The cybersecurity company grew revenue by 53% year over year in the third quarter of fiscal 2023, and its annualized recurring revenue reached $2.34 billion. It's downright impressive for a company this size to still be growing so quickly.

CrowdStrike's customer count expanded by 44% year over year, and 60% of customers are now using at least five of the company's modules. Even as economic uncertainty ramps up, CrowdStrike is seeing strong demand for its services.

The company did note that sales cycles are getting longer with smaller customers, and that some larger customers are tweaking subscription start dates in ways that push back revenue recognition. In a tough economy, nearly every business will be taking steps to keep a lid on costs. CrowdStrike guided for fourth-quarter revenue between $619.1 million and $628.2 million, below the average analyst estimate.

Valuation matters

Shares of CrowdStrike were down around 17% in premarket trading on Wednesday following the third-quarter report. The market's reaction was justified, but not because the company missed expectations. CrowdStrike is a strong business with a set of products that clearly resonates with its customers. Growth will slow in a recession, but the macroeconomic picture doesn't change the long-term story.

The problem with CrowdStrike is not slowing growth. The problem is valuation. The company's stock has slumped this year along with most other tech stocks, but it's still richly valued. With a market capitalization of $32 billion prior to Wednesday's open, the stock was trading for more than 14 times forward sales.

That kind of price-to-sales ratio would have seemed like a bargain last year, when growth stocks were still flying high. But that's not the case anymore. With the era of ultra-low interest rates seemingly over, and with a recession sometime next year a real possibility, paying sky-high prices for fast-growing stocks has lost its appeal.

Relative to free cash flow, CrowdStrike doesn't look nearly as expensive. The company expects to grow subscription revenue by a low to mid-30s percentage in fiscal 2024, and it expects to convert around 30% of revenue into free cash flow. That would put free cash flow around $900 million next year and the price-to-free cash flow ratio prior to the post-earnings plunge at roughly 36. That doesn't seem egregious.

The problem with free cash flow

Free cash flow is a useful metric, but for a company like CrowdStrike, it is absolutely not a good measure of true profitability. The main reason is stock-based compensation. Like most fast-growing tech companies, CrowdStrike hands out equity to executives and employees as part of their compensation. This is a noncash expense, so it gets added right back when calculating free cash flow. But it is a real expense, and it needs to be accounted for somehow.

If you simply back out stock-based compensation from CrowdStrike's free cash flow, the picture doesn't look nearly as rosy. For the first nine months of fiscal 2023, free cash flow would be reduced from $467 million to just $93 million. Free cash flow would still be positive, but not by much.

So that modest price-to-free cash flow ratio isn't really what it seems. CrowdStrike's stock is not cheap by any reasonable measure. And the company is not profitable on a GAAP basis. For a subscription software company, that's not necessarily a huge deal. Revenue is recognized over time, while some costs are incurred up front, which can push the bottom line into the red. But this is not a stock market that looks kindly on unprofitable tech stocks.

If your time horizon is long enough, valuation should only be a minor concern. CrowdStrike has the potential to grow swiftly for many years and eventually produce real profits, and the cybersecurity market is only going to grow over time. But the higher the price you pay, the more the odds are stacked against you. CrowdStrike may be a good company, but the stock is just too expensive.