Since going public in 2020, enterprise-data company Snowflake (SNOW 3.69%) experienced revenue growth at a level that few businesses ever have. And that's a great thing, considering revenue growth is one of the most important things for investors to look for when buying a stock.
Investment company Boston Consulting Group (BCG) published a study in 2006, looking at what makes a stock go up. The study found that revenue growth doesn't guarantee good stock performance -- indeed, many high-growth companies fail to beat the market. However, among the best stocks over a 10-year period, most of the best performers outperformed thanks to growth.
Therefore, there's strong evidence that revenue growth is an important factor for investors to consider. And Snowflake has growth in spades. Since going public just three years ago, its trailing 12-month revenue is up a mind-boggling 500%, as the chart below shows.
SNOW Revenue (TTM) data by YCharts
Despite its massive growth, Snowflake stock has been a huge loser. The stock started trading at $245 per share. Investors who bought then are down a disheartening 40% as of this writing.
Here's why Snowflake stock is losing to the market since its initial public offering (IPO) and whether things are finally going to turn around for shareholders in the near future.
Paying the price for growth
If revenue growth were the only important thing for investors to consider, we'd all be rich. Using a stock screener, all investors could simply filter for the public companies with the highest growth and invest only in those stocks. But there's obviously more to it.
In this case, Snowflake went public at an extreme valuation. Shortly after its IPO, shares shot up to a price-to-sales (P/S) valuation of over 180, whereas a more typical P/S valuation is around 1 or 2.
SNOW PS Ratio data by YCharts
In some cases, a business is just starting and has minimal revenue but large prospects. And it can make sense to have an extreme P/S valuation in that case -- context is important. But in Snowflake's case, it was quickly approaching $1 billion in revenue, which means it was already a big business.
Something as big as Snowflake with such an extreme valuation didn't make for a good investment. And unfortunately, those who bought then have done poorly.
What to expect with Snowflake stock now
So what is the right price to pay for Snowflake? Unfortunately, there's no definitive answer. Investors will have to juggle its valuation, the business economics, and its forward prospects.
Regarding business economics, things are looking good for Snowflake. In the second quarter of its fiscal 2024, which ended in July, the company's revenue grew 36% year over year to $674 million. It added 370 net new customers since the previous quarter. And it had $3.5 billion in remaining performance obligations -- the company expects 57% of this money to come in over the next year.
Importantly, Snowflake's profitability is also improving with revenue growth, another key factor for stock performance. The company's Q2 gross margin was 74%, improved from a gross margin of 72% in the prior-year period. The improvement continues the long-term trend illustrated in the chart below -- its gross profit has grown faster than revenue.
SNOW Gross Profit (TTM) data by YCharts
The business economics look good and are improving for Snowflake. However, the forward outlook is getting murkier. The company generates revenue with a usage-based model. Enterprises are trying to save money wherever possible because of macroeconomic headwinds. And Snowflake's management noted that its customers are trying to use its services within the confines of their contracts, rather than spending extra by exceeding their usage limits.
Perhaps unsurprisingly, Snowflake's growth rate is coming down to earth. Whereas Q2 revenue was up 36% year over year, management expects revenue for the third quarter to rise by only 28% to 29%.
The more its growth rate comes down, the more investors will expect to pay a lower price for Snowflake stock. Its P/S valuation may be down 90% from its peak, but at 19 times its trailing sales, the valuation is still lofty for Snowflake. I believe it's reasonable to expect it to fall further in coming months.
Putting it all together, I'd say that Snowflake still isn't a stock that I'd buy today. Its valuation is much tamer than before. But it's still pricey in light of its moderating growth rate. That said, the business economics are good and make this a business worth watching. Investors might just want to keep waiting for a more ideal buying opportunity.
