I was reading in a book the other day about real estate investing and came across the following words: “You’re not buying a property, but a set of financial assumptions.” Obviously, that statement is particularly relevant in equity investing as well – yet many times I read investor articles/comments that are ignorant of that basic tenant of valuation; many people would rather talk about the beauty of the property or the potential of the city to grow in the future rather than taking a simple look at the numbers and seeing that the assumptions implied by the price are wildly optimistic.
With that, I wanted to lay some quick numbers on Salesforce.com (CRM), and see what we can extract about the current valuation. In the most recent fiscal year, the company generated $2.266 billion in revenue, an increase of more than 36% from the year before. Looking back, we can see that the law of large numbers is starting to slow the company’s momentum (in terms of percentage increases), with revenue growth since 2006 looking as such: +76%, +60%, +51%, +44%, +21%, +27%, and the most recent figure, +36%; averaging out the final three years, the CAGR in revenues was 28%.
As I noted a second ago, the law of large numbers should continue to weigh on the percentage gain CRM can attain, but let’s set a wide range to see where the company could possibly be 10 years from now:
Even with continued pressure coming from much larger competitors, let’s assume for the sake of argument that CRM can attain an astounding 25% annual increase in revenue over the next decade, and pulls in $21.1 billion ten years from today (just for one last example to show you how lenient this assumption is – in the ten years after Microsoft (MSFT) released Windows 95, their revenue increased by 20.8% per annum).
Unfortunately, estimating CRM’s margins will be somewhat difficult, because they are unprofitable at this time. Based on data posted online by NYU professor Aswath Damodaran, the average after-tax net margin for 184 computer software firms (relatively comparable to Salesforce’s business) is 24.7%, roughly 3x that of the average industry; using that as our proxy, we can assume that the company’s net profit could hit roughly $5 billion.
Of course, there is one other variable that must be considered in the case of Salesforce: the company’s serial dilution of the stock; using GuruFocus’ data, the dilution has resulted in an increased share count of more than 4% per annum since 2005.
Putting this all together, we are left with the following: If the company can increase their revenue at an astoundingly high rate (in an industry amongst larger competitors willing to spend billions on acquisitions in the hope of gaining share) while simultaneously attaining net margins 3x higher than the average industry (compared to currently unprofitable operations), the company is on track to generate roughly $24.75/share in profit ten years from now (at dilution rate of 4% per annum over the next decade, likely shortchanging the increasing pace of dilution).
Assuming that the market adjusts for this growth and values it like the “old tech” names of today at that point, the company could expect an earnings multiple of 10-12x, resulting in a share price of $248-295 per share. At Monday’s close of $157.18, the implied rate of return in that range is from 4.67% to 6.5% per annum.
The intelligent investor should look at that wildly optimistic set of financial assumptions and still come to the conclusion that the current valuation does not offer an adequate ex-ante implied return in comparison to other securities when looking at the risk/reward trade-off; make sure to check the basic assumptions of a growth/story stock before buying into the hype.
As I noted in a previous article, I’m short CRM, but assume that it will head higher in the near future due to the hype around the name and the industry; just like when I’m long a security, I plan on holding CRM until it gets closer to its intrinsic value, and hope that short-term volatility will result in the stock moving higher and allowing me to increase my position as the margin of safety increases.
For investors shorting story stocks like CRM, make sure that you position yourself accordingly so that the market doesn’t determine your timeframe; if a short-term jolt in the market causes your stomach to churn, you should reassess your position and decide whether or not you are investing or speculating like many of the people on the other side of this security.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.