Adobe (ADBE -0.94%) stock has made it onto many investors' radars this year, mainly thanks to all the hype surrounding generative artificial intelligence (AI). The prospects are real for this emerging tech to significantly boost the value of its platform, after all, and improvements are already making their way into products like Photoshop and Premier Pro.
It is too early to have a firm idea of the impact that AI will have on Adobe's earnings prospects, though. That's why smart investors are more focused on three core metrics that clearly translate into higher returns for this stock.
1. Engagement is king at Adobe
The first, most important step in Adobe's growth cycle is engagement. The company can't reliably monetize its services without attracting a steady stream of new users and keeping its existing customers thrilled with the platform.
Sales trends are helpful to watch as a proxy for engagement, but investors will want to look beyond that broad headline figure. Revenue was up 13% last quarter, for example, implying solid demand for cloud services. But there were several indications of more robust engagement.
Over 3 million downloads were clocked for Adobe's recent beta releases of Photoshop and Illustrator, for example. And more than 2 billion images were created with its AI product, Firefly, within the first six months of its release. Rising usage in these areas should translate into higher sales over time.
2. Cash flow trends paint an encouraging picture for Adobe
Adobe is a software-as-a-service business at its core, and so cash flow is a critical metric to watch when judging its true earnings potential. Most of its sales are subscription-based, meaning revenue is recognized over time even though cash often arrives upfront. Smart investors know that these cash trends paint an encouraging picture right now.
Operating cash flow was nearly $2 billion last quarter, or a blazing 38% of sales. Adobe is sitting on $6.6 billion of cash as of early September, giving management plenty of resources it can direct toward growth initiatives like AI. Executives can also use the cash to take advantage of stock price declines through aggressive repurchases, should the opportunity come along.
3. Adobe is an expensive stock
Any way you look at it, Adobe is an expensive stock. Shares are currently valued at 14 times annual sales and 50 times earnings, and both figures represent 2023 highs. Microsoft is valued at 12 times revenue and 34 times earnings, for context.
This elevated valuation raises the risk that an investor will end up paying too much for this stellar software business. Adobe can earn its share price premium over the next few years by finding ways to accelerate sales growth, cash production, and bottom-line profitability. On the other hand, falling even slightly short of those high expectations could push the stock lower. Wall Street doesn't like surprises, especially negative ones.
Yet if you have a long enough time horizon that stretches past several years, you can feel more confident about looking beyond Adobe's likely short-term volatility. Still, many investors will want to watch this stock for a potentially more appealing price. Another good reason to buy would be if sales trends accelerate even in this sluggish tech spending environment. In any case, Adobe is an excellent growth stock worth following.
