Friday, September 12, 2008
Valuing Salesforce.com and its contemporaries
This is sort of a follow-on from my previous post. Should Salesforce.com be added to the S&P 500? Those in favour would cite giants such as Microsoft, IBM and Apple as already being part of the 'club'. Personally I think it is folly because, in my opinion, Salesforce.com is overvalued and soon to go down like a lead zeppelin. At which point another stock will have to be brought in to fill the gap.
So how do we know whether a share is worth what the market is paying for it? This is a really difficult question with no clear answer and this is why share prices jump around as much as they do. Let's compare Salesforce.com with a couple of CRM rivals, say Microsoft (Dynamics CRM) and Sage (Sage SalesLogix). The comparison is not brilliant as both Microsoft and Sage do much more than CRM and both allow for on-premise CRM. However, it will give some insight.
Here are some common indicators of share value:
The most widely known and probably most used. This is the price of the stock divided by the profit. There are a number of ways to interpret this but one way is to see it as the number of years it will take for a share to double your money. For example, if I buy a share for $6 and it has a P/E ratio of 3, then I know it is making a profit of $2 every year. This profit will either get ploughed back into the business, effectively increasing the share value by a similar amount or get directly paid to me as a dividend. Therefore in 3 years I'll either have $6 of dividends in my pocket and a share worth $6 or a share worth $12.
P/E ratio of Salesforce.com: 200 (doing the calculation by hand I get closer to 500)
P/E ratio of Microsoft: 14
P/E ratio of Sage: 16
So looking at this suggests that it would, at the current earnings levels, take you 200 years to double your money on a Salesforce.com share. For the others, around 15 years. Why would anyone invest in a company that is going to take 200 years to return your money? If there is anyone out there who thinks this is a good deal, give me your money and I promise to double it in 100 years, twice as fast!
The reason Salesforce.com is still a darling of the stockmarket is because it is speculated that this P/E ratio will drastically change, that is the 'E' will dramatically increase, sending the ratio plummeting and giving lots of shareholders pots of cash. Being old enough to remember the burst of the tech bubble, I'm inclined to think it will be the 'P' that will plummet, bringing the P/E in line with its contemporaries and sending all those speculators to the poor house.
Tangible book value
This is how much the physical assets of the business are worth, that is. How much money, per share would you generate by selling everything you possibly could of the business. The 'distance' between the share price and the tangible book value also give an indication expected future revenues.
Salesforce.com: $3.55 (price at writing $58.00)
Microsoft: $2.43 (price at writing $27.34)
Sage: -0.55 pounds (price at writing 204.75 pounds)
First of all, Sage's negative means their physical assets (buildings, cash etc.) do not cover their debts. If Sage went under tomorrow, based on these numbers, you'd be out of pocket 200-odd pounds.
For all three, the price is much higher than the value of the assets. This is because the share price also factors in expected earnings. From the P/E ratio, we know investors are expecting big things on this front for Salesforce.com. If either of these stocks went under, you'd be around $25 out of pocket for Microsoft and $55 out of pocket for Salesforce.com
Here, I am just looking at the last four years of revenue growth. An argument could be made that previous market conditions are irrelevant to the future fortunes of the companies but I'll leave such speculations to others.
Again, using msnmoney.com:
Last five years of revenue growth for Salesforce.com (2008-2005): 51%, 60%, 76%, 84%
Last five years of revenue growth for Microsoft (2008-2005): 18%, 15%, 11%, 8%
Last five years of revenue growth for Sage (2007-2004): 24%, 23%, 10%, 23%
If I was an investor in Salesforce.com (which I'm not), given the high P/E ratio, I'd want this growth to be trending the other way because up until now, with no major rivals they were still slowing down, in terms of growth, at about 10% per year. By my rough back of the envelope calculations, assuming the share price of Salesforce.com remains static, the best we could hope for would be to get revenues up to a point where the P/E ratio comes down to about 100 which is still ridiculously high.
Now that Dynamics CRM is on the scene pushing hard I'm thinking this will also do Salesforce.com's revenue growth no favours.
Revenue (the money coming in) and earnings (the profit made) are linked by the margin. That is, how much profit is made for every dollar received. If Salesforce.com could dramatically increase their margin, they could maintain the same revenues and massively increase their earnings, justifying their P/E ratio.
Going back to msnmoney:
Last five years of pre-tax margins for Salesforce.com (2008-2005): 6%, 3%, 9%, 5%, 4%
Last five years of pre-tax margins for Microsoft (2008-2005): 39%, 39%, 41%, 42%, 33%
Last five years of pre-tax margins for Sage (2007-2004): 19%, 24%, 25%, 26%, 27%
First of all, it is pretty clear, if you want to make large profits, do not host software for other people, the margins just aren't there. The advantage is that Salesforce.com is starting from such a low base, it would possibly be easier for them to double their margins. However, there is no indication in these numbers this is likely to happen soon so again I'm left scratching my head why people like this stock.
Free Cash Flow to Equity
A long phrase for a relatively simple concept. Basically, this is the cash generated for the business. This differs to profit in that with credit terms and the like what I report as profit may not actually be yet in my hand.
Looking at the cash flow statement we see that all of them generate their cash from their business and not from borrowing or investing.
In terms of free cash flow, the calculation is quite involved so I'll give a summary of the situation.
Microsoft and Sage both have had healthy free cash flow for the last couple of years. The situation is markedly different for Salesforce.com. Salesforce.com is yet to generate a positive free cash flow. They can talk about revenue growth and subscriptions as much as they like but when it comes to cash they have a problem in that more goes out than comes back to the investor.
There may be good reasons for investors to think that in the short term the Salesforce.com shares will go up but in the long term I can see nothing but a big bubble waiting to burst.