Cloud-based data management company Snowflake (SNOW 3.69%) and advertising technology (adtech) company The Trade Desk (TTD 1.67%) have dropped by 59% and 51% respectively year to date, as of this writing. And I'm still hearing some investors say that both stocks remain grossly overvalued and have more room to fall in 2023 before either is a compelling buy.
I believe there's a lot of truth to these complaints. However, valuation is a nuanced subject in investing. For this reason, I think we'd all be well-served to consult the master of value investing, Warren Buffett, to help us determine whether Snowflake or The Trade Desk is the better "overvalued" stock to buy in 2023.
Snowflake and The Trade Desk are growth stocks, though -- right?
In his 1992 letter to Berkshire Hathaway shareholders, Buffett laid out one of his greatest explanations of investing ever, in my opinion. And he took direct aim at the terms "value investing" and "growth investing" because such a dichotomy is nonexistent. As Buffett wrote, "In our opinion, the two approaches are joined at the hip."
This statement might surprise growth investors. I often hear this crowd say that valuation doesn't matter for Snowflake and The Trade Desk because of their superior growth. To be fair, growth for Snowflake and The Trade Desk is undeniably sensational. Year to date, Snowflake's revenue is up almost 77% from the comparable period of last year. For its part, The Trade Desk's year-to-date revenue is up 36%.
Investors who are focused solely on growth are enthralled with growth rates like these. But many (using the dichotomous thinking Buffett warned of) are consequently content to ignore Snowflake's and The Trade Desk's expensive valuations. To put concrete numbers to it, let's look at the price-to-sales (P/S) ratio. Snowflake trades at a P/S of 23, and The Trade Desk trades at a P/S of 15. For perspective, that's roughly 11 times and 7 times the average of the S&P 500, as shown below.
SNOW PS Ratio data by YCharts
Growth investors will happily buy shares of Snowflake and The Trade Desk, citing their superior growth rates, which are true. Conversely, value investors will steer clear of both since they're expensive, which is also true. However, the arguments for growth and for value need to be combined, not separated.
As Buffett went on to write in 1994, "Growth is always a component in the calculation of value." [emphasis added]
It's all about the future cash flows
Now let's surprise the value crowd as well. Buying stocks at high valuation multiples "is in no way inconsistent with a 'value' purchase," Buffett wrote, as long as the price paid now is justified by the cash the business generates in the future.
Therefore, let's not disregard these two stocks simply because of their high P/S ratios. Rather, let's look at some cash flow assumptions. For Snowflake, management has conveniently given us cash flow assumptions through fiscal 2029, which is six years from now. For this year, fiscal 2023, management is hoping to generate about $400 million in free cash flow. By fiscal 2029, it's hoping to generate around $2.5 billion.
Assuming steady gains over this time, Snowflake could possibly generate $8 billion to $9 billion in cumulative free cash flow over the next six years, based on management's guidance. Now remember that this is just an optimistic forecast and in no way guaranteed. Moreover, the stock's market capitalization is $44 billion, meaning investors are still paying a premium now for Snowflake's future cash flows by Buffett's value standards, even though top-line growth and margin projections are superb.
Turning to The Trade Desk, its management hasn't provided six-year forward guidance like Snowflake's. But the business has generated $500 million in trailing 12-month free cash flow. With a market cap of just $21 billion, its valuation already looks far more palatable than Snowflake's.
Many investors question the health of the adtech market, especially heading into 2023. But don't count The Trade Desk's management among those biting their nails. The company is launching a new product this coming year that will make it easier for publishers to access its ad inventory, which management believes will allow it to take more market share in 2023.
The Trade Desk has successfully taken market share in the past -- it notably grew revenues in 2022 faster than many other adtech players. Moreover, many third-party reports predict substantial market growth going forward. For example, a recent report from ReportLinker projects a nearly 27% compound annual growth rate through 2026 for programmatic advertising, which is The Trade Desk's specialty.
Assuming the programmatic ad market grows as expected, The Trade Desk keeps taking market share, and the business maintains strong free cash flow margins, then The Trade Desk stock could indeed be a good buy in 2023, assuming you're buying and holding for the long term.
This is certainly far from a comprehensive analysis of The Trade Desk's business and its future prospects. However, hopefully it serves to show the relation of value and growth when it comes to stocks like these. It also shows why I'd take The Trade Desk stock over Snowflake going into the new year.
