A few days ago, I was mucking around with historical data on Alphabet, the parent company of the internet search engine of our time, Google. I found some interesting data on this company that led to me writing this short but hopefully thought-provoking article.
Alphabet was listed in August 2004 and closed its first trading day at a share price of US$50. By 31 January 2005, Alphabet’s share price had risen to US$98, and it carried an astronomical price-to-earnings ratio of 250. On 31 January 2005, Alphabet’s revenue and profit were respectively US$2.67 billion and US$222 milion, giving rise to a profit margin of 8.3%.
Today, Alphabet’s share price is US$1,418, which represents an annualised return of 19% from 31 January 2005. Its P/E ratio has shrunk to 29, and the company’s revenue and profit are US$166.7 billion and US$34.5 billion, respectively, which equate to a profit margin of 21%.
Today, many software companies – especially the young ones categorised as software-as-a-service (SaaS) companies – carry really high price-to-sales ratios of 30 or more (let’s call it, 35). Those seem like extreme valuations, especially when we consider that the SaaS companies are mostly loss-making and/or generating negative or meagre free cash flow. If we apply a 10% net profit margin to the SaaS companies, they are trading at an adjusted P/E ratio of 350 (35 / 0.10).
But many of the SaaS companies today – the younger ones especially – have revenues of less than US$2.7 billion, with huge markets to conquer. The mature SaaS companies have even fatter profit margins, relative to Alphabet, of 30% or more today. So, compared to Alphabet’s valuation back then on 31 January 2005, things don’t seem that out-of-whack now for SaaS companies, does it? Of course, the key assumptions here are:
- The young SaaS companies of today can go on to grow at high rates for a long period of time;
- The young SaaS companies can indeed become profitable in the future, with a solid profit margin.
Nobody can guarantee these assumptions to be true. But for me, looking at Alphabet’s history and where young SaaS companies are today provides interesting food for thought.
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Once again, you bring an interesting and enlightening perspective to a question I was asking myself. Thank you for the time you take to contribute to this blog.
Thank you Ben!
Great article as usual, thanks Ser Jing!
Thank you Emmanuel!
As an investor who was as trained to avoid investing in stocks with extreme valuations, I initially find it hard to invest in the young US Saas companies, especially if they are still loss making.
But after figuring out how Facebook, Amazon and Google initially started, I decided to take a leap in faith to slowly concentrate my portfolio to a few of such US Saas companies with business model that I think will still be relevant in 5 years time.
5 years down the road, if these companies continue to deliver fantastic growth performance, then the extreme valuations now could be reasonable.
Hi Kean Soon! Thanks for sharing your observation. Yes, extreme valuations can still be reasonable if there’s fantastic growth. If I may, I also want to highlight the importance of diversification. Some of these young SaaS companies may flame out or hit a growth ceiling faster than anticipated – Ser Jing