Author: Jeremy Chia

A company’s earnings conference call can be extremely informative. Not only does it provide information on how a company has done in the last quarter, but management also gives investors a glimpse into the early trends shaping the company’s future.

With many companies having reported their full-year earnings results for 2020, here are some of the key management insights on what to expect in the year ahead. 

Video conferencing is here to stay…

Leading video conferencing company, Zoom Video Communications Inc (NASDAQ: ZM) capped off a truly remarkable year as it reported a 369% year-over-year increase in revenue for the fourth quarter of its fiscal year ended 31 January 2021 (FY2021).

On a full-year basis, Zoom saw revenue increase by 326%. More impressively, the company expects to build on that solid performance as management forecasts a further 42% increase in revenue for FY2022.

Zoom’s founder-CEO, Eric Yuan, said:

“As the world emerges from the pandemic, our work has only begun. The future is here with the rise of remote and work-from-anywhere trends.”

With employers getting used to remote working conditions, many are starting to embrace the convenience, efficiencies, and cost-savings associated with it. In addition, employees prefer the flexibility of working remotely.

We have already seen companies such as Shopify (NYSE: SHOP) announcing a permanent shift toward remote working. As forward-looking employers pave the way, the shift towards permanent remote work is only just beginning.

E-commerce growth to normalise but upward trend to persist

There was an interesting chart put up by Shawspring Partners earlier this year showing the e-commerce penetration growth that took place in early 2020 as countries around the world began lockdowns to combat COVID-19.

As the chart shows, e-commerce penetration in the USA grew as much as it did in the eight weeks leading up to April 2020 as it did in the 10 years before then.

Consequently, the leading e-commerce marketplace for entrepreneurs and DIYers, Etsy (NASDAQ: ETSY) saw a 107% increase in annual gross merchandise sold on its platform in 2020. Meanwhile, e-commerce enabler Shopify experienced 96% year-on-year growth in the gross merchandise volume (GMV) facilitated by its platform during the year.

Although e-commerce growth rates are expected to normalise, the overall upward trend should persist.

Shopify CFO, Amy Shapero, said in the company’s 2020 fourth-quarter earnings conference call:

“Our outlook coming into 2021 assumes that as countries roll out vaccines in 2021 and populations are able to move about more freely, the overall economic environment will likely improve, some consumer spending will likely rotate back to offline retail and services and the ongoing shift to e-commerce, which accelerated in 2020, will likely resume a more normalized pace of growth.”

Similar to how remote work is advantageous over traditional office set-ups, e-commerce holds many advantages over traditional retail. 

Online purchasing is more convenient, offers shoppers a wider selection of products, and tends to be cheaper. It is inevitable that these advantages will result in an eventual migration of more purchases from offline to online over the longer term. 

The rise of BNPL (buy now, pay later)

Consumers are increasingly looking for smarter ways to pay for their purchases.

Enter buy now, pay later services. As the name suggests, buy now, pay later – or BNPL – allows customers to buy a product or service and pay for it in instalments, often interest-free, over a few weeks after the purchase is made.

Millennials increasingly prefer this option as it provides greater cash flow flexibility. And unlike credit cards, BNPL does not result in expensive interest expenses snowballing should they miss any payments.

This year, Shopify teamed up with Affirm (NASDAQ: AFRM) to offer its merchants the ability to accept BNPL functions from customers.

Meanwhile, digital payments giant, Paypal (NASDAQ: PYPL), has also gotten in on the act, as it launched its BNPL service late in 2020. The take up was so good that Paypal CEO Dan Schulman said in the 2020 fourth-quarter earnings conference call:

“I would also highlight the rapid growth of our buy now, pay later functionality. We saw tremendous and growing demand throughout the quarter and witnessed the fastest start to any product we have ever launched.”

Afterpay (ASX: APT), a leading BNPL provider, also reported a staggering 106% increase in underlying sales in the six months ended 31 December 2020.

With the rise of e-commerce and millennials increasingly looking for better ways to manage their cash flow and expenses, it seems that BNPL companies are set for a bright future.

Final thoughts

Covid-19 accelerated the digitalisation of the world.

Although economies will eventually reopen, the way we live, work and play will have changed. As the world adapts, companies that embrace these changes stand to gain the most.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in the shares of Afterpay, PayPal, Shopify, and Zoom. Holdings are subject to change at any time.

The company with the deepest pockets often wins.

Having more money than your competitors can further your technology advantage, allow you to market more aggressively to get a stronger network effect, or simply to scale up production more quickly.

This is why founders can be found scrambling around Silicon Valley trying to raise capital. But raising capital is not reserved solely for privately held startups. 

In fact, many fast-growing public companies are increasingly looking for ways to raise capital cheaply, be it through debt or secondary equity offerings.

Raising capital through secondary equity offerings

One of the more common ways to raise money in today’s market is through a secondary offering. A secondary offering is simply the sale of new shares to investors by an already public-listed company. This is especially appealing for a company when its stock price has increased to a lofty valuation, a likely phenomenon for tech stocks in today’s market.

We need to look no further than one of 2020’s hottest stocks, Tesla Inc (NASDAQ: TSLA). The electric vehicle company took advantage of its rising stock price to raise money no less than three times last year. Tesla first raised US$2 billion in February at a split-adjusted share price of around US$153. It quickly followed that up in September and December, raising another US$5 billion each time as its share price soared.

Despite raising around US$12 billion in capital through secondary offerings in 2020, Tesla’s effective dilution to shareholders was likely less than 5% from all the offerings combined. This is a huge advantage that Tesla has over its competitors. 

The leading electric vehicle company now has deeper pockets, giving it the ability to scale production faster and to invest more to improve its battery and software technology. 

Tesla is not the only company that has taken advantage of soaring stock prices. Singapore’s e-commerce and gaming company, SEA Ltd (NYSE: SE), and communications API leader, Twilio Inc (NYSE: TWLO), are just two other examples of prominent large companies that have pounced on their soaring share prices to raise relatively inexpensive capital through secondary share offerings.

Debt markets

Another way to raise money is through the debt markets. Rather than diluting shareholders, bond offerings and bank loans are another way to raise capital. 

Even though companies incur interest expenses and will eventually need to pay back their creditors, debt does not dilute shareholders. In addition, the current low-interest-rate environment enables companies to issue bonds or take up loans at very competitive rates.

Netflix Inc (NASDAQ: NFLX) is an example of a company using the debt market effectively. In the past few years, Netflix’s operating cash flow was negative, as it was spending heavily on content creation. As such, the company needed more capital. Netflix CEO Reed Hastings and his team decided that rather than dilute shareholders through equity offerings, it would issue high yield bonds to pay for its expenses. The result was that the company managed to get the required capital, whilst not diluting existing shareholders. 

Although Netflix’s balance sheet may look weak because of the debt, the streaming giant has a clear path to free cash flow generation and should be able to start paying off some of its debt this year.

Over the longer term, Netflix shareholders could start reaping the returns of management’s careful planning and the fact that they were not diluted from Netflix’s debt offerings.

A mix of both?

So far I have discussed companies that have raised capital through secondary share offerings and debt. Another way for companies to raise capital is through an instrument that could be considered a mix of both – and it may be the best way to raise capital.

Convertible bonds are bonds that can be converted to shares at a certain date or when a certain event occurs. These bonds tend to have very low coupon rates and if converted, are usually done so at a large premium to current share prices.

For instance, leading website creation company, Wix.com Ltd (NASDAQ: WIX) raised US$500 million in August 2020 by issuing convertible bonds that are due in 2025.

Get this. The bonds have a 0% coupon, meaning that Wix does not pay any interest to bondholders. On top of that, these bonds convert to Wix shares at a whopping 45% premium to Wix’s last reported share price prior to the announcement of the sale of the bonds.

As such, if the bonds do get converted to shares, the amount of dilution is lower than if the company simply offered a secondary offering which is usually priced at a discount to current share prices.

Why then would anyone want to buy such an instrument? Personally, I much rather buy equity directly than to own convertible bonds. Nevertheless, convertible bonds do serve a purpose for more risk-averse investors.

First of all, bondholders will get their principle back even if the company’s shares fall below the conversion price. They also have a more senior right to the company’s assets should the company run into financial trouble – this provides additional downside security for investors. The convertible aspect of the bonds also offers bondholders “equity-like” upside if Wix’s share price rises beyond the conversion price. However, bondholders are paying a huge premium for the hedge, which I personally would not want to do for my portfolio.

Closing words

The ability to raise capital cheaply is a competitive advantage for a company that is often overlooked by investors.

Having deep pockets could give companies a leg up against their competition in a time when scale and technology are increasingly important.

Shareholders may sometimes frown on companies that are issuing new shares or taking on more debt. But if the company uses its newfound financial muscle to good effect, the new capital could be the difference between emerging a winner or ending up as an obsolete wannabe.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in the shares of Tesla, Twilio, Netflix, and Wix.com. Holdings are subject to change at any time.

Technology is changing the world, fast. The COVID-19 pandemic has accelerated software and other technology adoption around the globe. And this is likely just the beginning of a multi-year trend. With this in mind, here are some tech trends that I am keeping an eye on.

Programmatic advertising

Programmatic advertising is a way to automatically buy digital advertising campaigns across a wide spectrum of publishers rather than from an individual publisher. Instead of going to a specific vendor to reserve a digital space on their website, advertising real estate is aggregated in ad exchanges where they can be bought or sold. Programmatic advertising software, in turn, communicates with these ad exchanges to buy and sell these advertising spaces, streamlining and optimising the advertising campaigns for advertisers.

In 2021, a whopping 88% of all digital display advertising in the USA is projected to be transacted via programmatic advertising.

According to Research And Markets, the global market for programmatic advertising platforms is estimated at US$5.2 billion in 2020 and is expected to reach US$33.7 billion in 2027, a nearly 31% compounded annual growth rate.

Alphabet (NASDAQ: GOOGL)(NASDAQ: GOOG), the parent company of Google, is likely going to be a key beneficiary of this as they dominate the programmatic advertising space with their Adwords platform. Amazon Inc’s (NASDAQ: AMZN) demand-side platform for advertisers has also gained market share in recent years. But we shouldn’t write off independent specialised programmatic advertising companies such as The Trade Desk (NASDAQ: TTD).

A key advantage that an independent programmatic advertising platform such as Trade Desk has over Google Adwords is that it is truly independent, so it will help ad buyers purchase the best digital ad-spaces the platform can find for the buyers’ needs. Google Adwords, on the other hand, may have a preference for Google properties, which may not be the best properties for ad buyers on certain occasions.

Whatever the case, with programmatic advertising exploding in popularity, there will likely be room for multiple winners in this space.

Solar energy

Under the Paris Agreement, participant countries have set a goal to limit global warming to an increase of preferably less than 1.5 degrees celsius compared to pre-industrial levels. This can only be achieved if more of the electricity the world produces comes from clean sources.

One of the most reliable sources of clean energy will be the sun. Solar power is 100% clean, renewable, and reliable. As such, governments around the world are creating policies to incentivise greater use of solar energy for homes and for commercial purposes.

Just as importantly for uptake, the cost of solar energy is coming down. According to the International Renewable Energy Agency, since 2010, the cost of energy production has dropped by 82% for photovoltaic solar and 47% for concentrated solar energy.

Global solar production capacity has also risen from 40GW in 2010 to 580 GW in 2019, suggesting the global demand for solar energy is taking effect. China continues to lead this space, accounting for 35.4% of the global market in 2018. This is driven by huge government initiatives in China in a bid to accelerate clean energy adoption.

In the USA, with the environment-conscious Democratic party taking the majority of the Senate, political observers expect greater impetus for the US government to support solar power.

Companies such as First Solar (NASDQ: FSLR), SolarEdge (NASDAQ: SEDG), JinkoSolar (NYSE: JKS), Enphase Energy (NASDAQ: ENPH), and ReneSola (NYSE: SOL) could stand to benefit.

Electric vehicles

In a similar vein to solar energy, electric vehicles are a cleaner alternative to ICE (internal combustion engine) vehicles. In the past, electric vehicles were slow to gain adoption due to the high cost of batteries and slow charging times. There were also the concerns of short range (distance that can be driven before the vehicle requires charging again) and poor charging infrastructure for electric vehicles due to a lack of charging stations.

But all of this has changed.

The infrastructure in many countries have slowly taken shape while the specifications of electric vehicles are improving at a tremendous pace. Most prominently, charging times, range, and cost have all improved, leading to greater demand from environmentally conscious consumers.

In addition, governments have stepped in to implement policies to encourage the sales of electric vehicles. California has gone as far as to ban the sale of new gasoline-powered vehicles by 2035.

Global passenger electric vehicle sales jumped from 450,000 in 2015 to 2.1 million in 2019. But there is still huge room for growth. In 2020, only 2.7% of total vehicle sales were electric. That figure is expected to rise to 10% by 2025. In the next decade, more than 100 million electric vehicles are expected to be sold around the world.

Tesla (NASDAQ: TSLA) is the largest electric vehicle player in the market, delivering close to 500,000 vehicles in 2020. But this is just the beginning. Tesla is ramping up production quickly, breaking ground on new factories in Berlin and Texas. It is also expected to start production of vehicles in its New York factory which used to be solely for solar panels.

On top of that, its Shanghai and Fremont factories are both not producing at full capacity yet. The two existing factories can increase their annual output in the next few years. Some are projecting Tesla to deliver between 840,000 to 1 million cars in 2021.

With no shortage of demand and no need for advertising (due to incredible consumer mind share), ramping up production will lead to more car sales and more revenue and gross profits for Tesla.

Tesla has also recently taken advantage of its soaring share price to raise new capital. It raised at least US$10 billion in the second half of 2020 through issuing new shares, and these moves provides the company with ammunition to accelerate its production capacity further.

But Tesla is not the only electric vehicle company in town. In the USA, legacy automobile manufactures such General Motors Company (NYSE: GM) and Ford Motor Company (NYSE: F) have been investing in their own electric vehicle models.

Global giants, Toyota (TYO: 7203) and Volkswagen (ETR: VOW3), have also signalled their intent to pivot their business. Other pure play electric vehicle startups in China such as Nio (NYSE: NIO), Li Auto (NASDAQ: LI), and  Xpeng (NYSE: XPEV) are also jostling for a piece of the pie. Analysts estimate that there will be 500 different models of electric vehicles globally by 2022.

Whatever the case, multiple winners are set to emerge from this fast-growing space.

Conscious eating

Sticking to the same theme of environmentally conscious consumers, fake meat is becoming the next big trend in conscious eating.

Fake meat refers to either plant-based protein, or lab-grown cell-based protein. In the plant-based space, proteins are extracted and isolated from a plant and then combined with plant-based ingredients to make the product taste and look like meat. Examples of plant-based proteins are Beyond Meat (NASDAQ: BYND) and Impossible Meat.

In lab-grown cell-based meat, an animal cell is extracted from an animal and grown in lab culture. This technology is still not yet in mass production as far as I know, but Singapore was the first to approve lab-grown meat for commercial sales.

Although fake meat is clearly better for the environment, consumer take up has not been rapid due to the high cost of production. Like electric vehicles, in order for fake meat to truly become mainstream, it needs to reach or exceed cost parity with traditional meat – and it needs to taste good.

Temasek-backed Impossible Foods is on the path to reduce cost to consumers. Earlier this year, Impossible Foods announced that it will be lowering prices by around 15% for its open-coded food service products, its second price cut since March 2020.

Another key driver of growth is the sale of fake meat in restaurant chains. McDonald‘s (NYSE: MCD) has decided to debut its own plant-based meat alternative called McPlant in 2021, which Beyond Meat helped to co-create.

According to the research firm, Markets and Markets, the plant-based meat market is estimated to be US$4.3 billion in 2020 and is projected to grow by 14% per year to US$8.3 billion by 2025.

Final words

We are indeed living in exciting times. The world is so dynamic and with new technologies and trends emerging, companies at the forefront of these shifts in demand are primed to reap the rewards.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in the shares of Amazon, Alphabet, The Trade Desk and Tesla. Holdings are subject to change at any time. Holdings are subject to change at any time.

Positive returns in stocks are never a guarantee. Stay far, far away from anyone who tells you otherwise.

Company-specific risks, such as competition or regulatory risk, plus market-wide systemic risks, such as interest rates hikes and global recessions, pose risks to a stock’s long-term return. These risks result in what I call a wide distribution of outcome probabilities. 

And yet, in today’s stock market, it seems that more and more investors are starting to ignore these risks and go big or even all-in on just a single stock. Some argue that the large spread in returns between winners and laggards makes a concentrated portfolio more appealing.

But before diving headfirst into building a super-concentrated portfolio, consider the following risk.

What is the distribution of outcomes?

Let’s start with the basics.

When I talk about the distribution of outcomes, I am referring to the probability-distribution of the long-term returns of a stock. For example, a company can have a 20% chance to go to zero, a 60% chance to double up and another 20% chance to triple in value over five years (note that the probability percentages add up to 100%).

As such, there is a distribution of outcome possibilities, each with its own probability of occurring.

In the example above, over a five year period, investors in the company have a 20% chance to lose all their money, a 60% chance to double their money, and a 20% chance to triple their money.

Every stock has a different distribution of outcomes. The probabilities of returns and the range of returns will also differ drastically from stock to stock.

You found a great investment… now what?

Most stocks have a curve of different outcomes but for simplicity’s sake, let’s give the example of a stock that has just two possible outcomes.

This particular stock, let’s call it Company A, has a 30% chance to go bankrupt and a 70% chance to triple in value in five years. Simple mathematics will tell you that this is an amazing bargain. A gambler will take these odds any day.

We can calculate the average expected return we get from this stock by multiplying the probabilities with the outcomes. In this scenario, the expected return is 110%* (calculation below) in five years. Annualised, that translates to an excellent 15.9% return per year, which easily outpaces the returns of the S&P 500 over its entire history.

As such, any investor should happily take this bet. But don’t get too carried away. Even though this stock is a great investment, there is still a 30% possibility that we lose our entire investment in this stock. Would you be willing to take that risk?

Diversification reduces the risk

This is where diversification comes into play.

Instead of making a single bet on Company A, we can add another company into the portfolio.

Let’s say we find another company, Company B, that has slightly lower expected returns than Company A. Company B has a 35% chance of going broke and a 65% chance to triple in value, giving it an expected return of 95%**(calculation below).

The table below shows the probabilities of investing solely in Company A or Company B or investing half into each company.

	Company A Only	Company B Only	Half Each
Expected Annual Return	15.9%	14.3%	15.2%
Chance to Lose it All	30%	35%	10.5%

From the table above, we can see that the odds of losing your entire portfolio drops to 10.5% after splitting it between the two companies.

This seems counter-intuitive. Even though you are adding Company B into the portfolio, a stock that has a higher chance of going bust than Company A, the combined portfolio still ends up with a lower chance of going to zero.

The reason is that in order for the combined portfolio to go to zero, both companies need to go broke for you to lose your entire portfolio. The probability of both companies going bankrupt is much smaller than either of Company A or Company B going broke on its own. This is true if the two companies have businesses and risks that are not co-related.

What this shows is that we can lower our risk of suffering portfolio losses by adding more stocks into the portfolio.

Even though investors sacrifice some profits by adding stocks with lower expected returns, the lower risks make the portfolio more robust.

The sweet spot

This leads us to the next question, what is the sweet spot of portfolio diversification? Ultimately, this depends on the individual’s risk appetite and one’s own computation of an investment’s probability of outcomes. 

For instance, venture capital firms bet on startups that have a high chance of failing. It is, hence, not uncommon for venture capital funds to lose their entire investment in a company. But at the same time, the fund can still post excellent overall results.

For instance, venture investments in any single company may have a 95% chance of going to zero but have a small chance of becoming 100-plus-baggers in the future. A single winning bet can easily cover the losses of many failed bets. Given this, venture capital funds tend to diversify widely, sometimes betting on hundreds of companies at a time. This is to reduce the odds of losing all their money while increasing the odds of having at least some money on a spectacularly winning horse.

Similarly, in public markets, the same principle applies. Some early-stage companies that go public early have significant upside potential but have relatively high risks. If you are investing in these stocks, then wide diversification is key. 

Key takeaway

Many young investors today see the stock market as a place to get rich quick. This view is exacerbated by the raging bull of 2020 in some corners of the stock market across the world. 

They are, hence, tempted by the allure of making huge wins by concentrating their portfolio into just one or two companies. (You likely have heard stories of many Tesla shareholders becoming millionaires by placing their whole portfolio on just Tesla shares)

Although expected returns may be high, a concentrated portfolio poses substantial risks to one’s portfolio. 

I can’t speak for every investor, but I much rather sleep comfortably at night, knowing that I’ve built a sufficiently diversified portfolio to lower my risk of losing everything I’ve worked for

Nevertheless, if you insist on building a concentrated portfolio, it is important to learn the risks of such a strategy and make sure that you are financially and emotionally prepared with the very real possibility of losses.

*(0x0.3+300%x0.7-100%)=110%

**(0x0.35+300%x0.65-100%)=95%

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have any vested interest in the shares of any companies mentioned in this article. Holdings are subject to change at any time.

Investors often use the price-to-sales multiple to value a company. This makes sense as sales is a proxy for how much cash the company can generate for its shareholders (there’s no way to generate cash without sales). It is also more useful than price-to-earnings when a company is not yet profitable.

However, in the stock market, there is a disparity between the price-to-sales ratios that various companies have.

Take a look at the table below. It shows the price-to-sales multiples of some prominent “retail” companies around the world.

Company	Current price-to-sales multiple
Shopify Inc (NYSE: SHOP)	51.7
Alibaba Group Holdings Ltd (HKG: 9988)	8.9
Amazon.com Inc (NASDAQ: AMZN)	4.6
Costco Wholesale Corporation (NASDAQ: COST)	0.96

As you can see, these four companies trade at remarkably different sales multiples. Costco trades at the lowest price-to-sales multiple of less than 1. This means that if you buy Costco’s shares now, you are paying less than a $1 for every dollar of sales that the company earns.

On the other end of the spectrum is Shopify, which trades at a price-to-sales multiple of 51.7. For every dollar of revenue that Shopify generates, investors need to pay $51.70.

Just looking at this table, you will likely assume that the shares of Costco are much cheaper than Shopify’s. 

But the truth is that the price-to-sales multiple is just one part of the analysis. There are often good reasons why paying a premium multiple may make sense. In this article, I describe some of the main considerations and why you should never look at the price-to-sales multiple at face value without considering these other factors.

Growth

Perhaps the most obvious reason to pay a premium price-to-sales multiple is for growth. A company that is growing revenue quickly should command a higher multiple. 

For instance, take two companies that are generating $1 in sales per share. One company is growing at 50% over the next five years, while the other is growing at 10%. The table below shows their revenues over five years.

	Fast Grower Revenue per share	Slow Grower Revenue per share
Year 0	$1	$1
Year 1	$1.50	$1.10
Year 2	$2.25	$1.21
Year 3	$3.37	$1.33
Year 4	$5.06	$1.46
Year 5	$7.59	$1.61

In this scenario, even if you paid a price to sales multiple of 20 for the fast grower and a price-to-sales multiple of 10 for the slow grower, the fast-grower still ends up as the company with the better value for money. The table below illustrates this.

	Fast Grower Revenue per share	Price paid	Price-to-sales multiple	Slow Grower Revenue per share	Price Paid	Price-to-sales multiple
Year 0	$1	$20	20	$1	$10	10
Year 5	$7.59	$20	2.6	$1.61	$10	6.2

By the fifth year, the price-to-sales multiple based on your share price at cost is actually lower for the fast-grower than the slow grower, even though it started off much higher.

Let’s relate this back to the four companies mentioned earlier.

The table below shows their revenue growth in the last reported quarter.

Company	Current price-to-sales multiple	Year-on-year revenue growth rate for the last reported quarter
Shopify	51.9	96%
Alibaba	8.9	30%
Amazon	4.6	37%
Costco	0.96	17%

Based on the figures above, we can see that Shopify has the highest growth rate, while Costco has the slowest.

Margins

The next factor to consider is margins. Of every dollar in sales per share that a company earns, how much free cash flow per share can it generate?

The larger the margins, the higher the price-to-sales multiple you should be willing to pay.

As some companies are not yet profitable, we can use gross margins as an indicator of the company’s eventual free cash flow margin.

Here are the gross margins of the same four companies in the first table above.

Company	Current price-to-sales multiple	Gross Profit Margin
Shopify	51.7	53%
Alibaba	8.9	43%
Amazon	4.6	25%
Costco	0.96	13%

There is a clear trend here.

Based on current share prices, the market is willing to pay a higher multiple for a high margin business.

This makes absolute sense as the value of every dollar of revenue generated is more valuable to the shareholder for a high margin business.

Shopify is a software business that charges its merchants a subscription fee. It also provides other merchant services such as transactions and logistics services. As a software and services business, it has extremely high margins.

On the other end of the spectrum, Costco is a typical retailer that has its own inventory and sells it to consumers. It competes in a highly competitive retail environment and sells its products at thin margins to win market share. Due to the razor-thin margins, it makes sense for market participants to price Costco’s shares at a lower price-to-sales multiple.

Predictability of the business

Lastly, we need to look at other factors that impact the predictability of the business. Needless to say, a company with a more steady revenue stream that recurs every year should command a premium valuation.

There are many factors that can impact this. This includes the business model that the company operates, the company’s brand value, the presence of competition, the behaviour of customers, or any other moats that the company may have.

A highly predictable revenue stream will be valued more highly in the stock market.

Shopify is an example of a company that has a predictable revenue stream. The e-commerce enabler charges merchants a monthly subscription fee to use its platform. It provides the software to build and run an e-commerce shop. As such, it is mission-critical for merchants that built their websites using Shopify. Given this, it’s likely that many merchants will keep paying Shopify’s subscription fees month-after-month without fail. Investors are therefore willing to pay a premium for the reassurance of the predictability of Shopify’s existing revenue stream.

Final thoughts

There is no exact formula for the right multiple to pay for a company. As shown above, it depends on a multitude of factors. 

But the main takeaway is that we should never look at a company’s price-to-sales or price-to-earnings multiples in isolation.

Too often, I hear investors make general statements about a stock simply because of the high or low multiples that a stock is priced at.

These multiples may be a good starting point to value a company but it is only one piece of the puzzle. It doesn’t capture the nuances of a company’s business model, its growth, or its unit economics… Only by considering all these factors together can we make a truly informed decision.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in the shares of Amazon, Costco Wholesale Corporation, and Shopify. Holdings are subject to change at any time.

The finance community often use the term “passive investing” to apply to investing in index funds. But is investing in an index fund really a “passive” strategy?

Actually not.

Most indexes actually have an active method of selecting their stocks. For example, the S&P 500 only includes the top 500 stocks by market capitalisation that are listed and headquartered in the USA. In addition, the stocks need to have at least four consecutive quarters of profitability.

The S&P 500 is also market-cap weighted. As such, bigger companies have a larger weight in the S&P 500 index, and their returns have a bigger impact on the index’s overall return.

I consider this method of selection and weighting as an active method of selecting stocks. Moreover, the selection criteria are determined by a committee and the committee also has the final say on whether a stock should be included in the index. This was the case for Tesla Inc (NASDAQ: TSLA), which was only included after it reported its fifth profitable quarter (instead of fourth).

Portfolio weighting

Ultimately, these active decisions made by a committee impact the index’s returns. For instance, the simple act of choosing to weight the index based on market cap has had a profound impact on the S&P 500 index over the last 10 years.

The table below shows the returns of the S&P 500 index against the S&P 500 equal-weighted index.

As you can see, the market-cap weighted index far outpaced the equal-weighted one. This is because larger stocks, which have a bigger weighting in the market-cap-weighted index, have outperformed their smaller counterparts over the last 10 years.

Choosing the right index 

All of which points to the fact that not all indexes are made equal.

Each index has specific selection criteria and a specific method of weighting its constituent stocks. Ultimately, these are active choices made by the committee building the index. 

As investors, we may think that “index investing” is a passive strategy.

But indexes are not completely passive. The stocks within an index have been picked based on criteria that are “actively” chosen.

Even in Singapore, the Straits Times Index (STI), which is a commonly used indicator of the health of Singapore’s stock market, may not be truly representative or passive.

The rules for inclusion into the STI are based on a stock’s market cap, liquidity, and a minimum amount of voting rights in public hands. As such, the stocks selected in the STI are actually picked by the committee based on a selection methodology that they have actively chosen.

Index investing is actually “active”

Ultimately, investing in any index is not a truly passive way to invest. The exposure you gain is based on active decisions made by the index committee that built the index.

In addition, with so many indexes available, choosing an index to invest in is also an active decision made by the investor. Within the US alone, there are funds that track the S&P 500, S&P 500 Equal Weight, MSCI USA, MSCI USA Equal Weighted Indexes, and many more. Each of these indexes has performed differently over the last 10 years.

Index investing is, hence, not truly “passive”.

By investing in any index, you are actually making an “active” decision that the “active” selection and weight criteria used in that particular index will work best for your investment needs.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in the shares of any companies mentioned. Holdings are subject to change at any time.