I get up every morning feeling pretty spry. It doesn’t hurt to get out of bed, and I’ve got lots of energy. I should. I’m only 38 -- I’m getting up there, but I’m still pretty young.
And while I’m relatively young, especially in investing terms, I remember well the valuations that were assigned to technology and internet stocks in the late '90s. Even with the financial panic of 2008 in the interim, the tech bubble is still very clear in my memory.
Because my memory of the tech bubble and the brutal aftermath for investors in internet stocks is so clear, I have to wonder, just how young are the investors willing to hold shares of Salesforce.com today? Because they can’t seem to remember that holdings stocks at nosebleed multiples ends badly.
I’ve got no problem with Salesforce.com as a company; I think it is doing fine. But the company can’t control how ridiculous or pessimistic the valuation Mr. Market assigns might be. It is the responsibility of investors to recognize when Mr. Market has lost touch with the true value of a business. And I think in the case of Salesforce.com, Mr. Market is forgetting that valuation eventually matters.
My primary method of valuing a business is by looking at its free cash flow yield. Here is what Salesforce.com looks like for 2011:
- Cash Flow From Operations: $459 million
- Capital Expenditures: $90 million
- Free Cash Flow: $369 million
With a share count of 136 million fully diluted shares and a share price of $125, Saleforce.com has a market capitalization of about $17 billion. Deduct the $1.3 billion in cash and marketable securities and the Salesforce.com enterprise value is $15.7 billion.
That means a free cash yield of: $369 million / $15.7 billion = 2.3%. Invert that and you are looking at a free cash flow multiple of 100/2.3 = 43 times. That looks about as appetizing to me as the yield on Treasuries these days.
It is quite possible that Salesforce.com can keep growing for the next five years and justify the current share price. The question I have, though, is what can the company possibly due to expand the multiple the market is assigning? This is a company priced for perfection.
A rule of thumb for high-growth companies is that the P/E multiple should roughly equal the rate of growth. Over time, simply due to the laws of large numbers, growth has to slow. Companies can’t grow at 30% per year indefinitely. When growth does eventually slow, the multiple of any fast-growing company is likely to contract. Consider Microsoft (MSFT), Cisco (CSCO), Intel (INTC), Dell (DELL) and every other tech company that is sitting with the same share price it had over 10 years ago.
And what if Salesforce.com stumbles for a year and growth halts? How far can the company stock price fall? A long way, I’d say. A no growth company might typically trade a multiple of 10x; if Saleforce.com were to trade at 10X free cash flow it would be a $4 billion company. That isn’t much more than 25% of the current share price, which values the business at roughly $16 billion.
To have investment success holding or buying a company at the kind of multiple that Salesforce.com is trading, the company needs have years and years of very high growth. That is hard to do, especially as competitors are attracted to the high growth and make life more difficult.
This is not the kind of investment that interests me. Operating perfection required for any hope of making money at the current share price. Huge downside if the company starts to struggle.
What Are Insiders Doing?
Apparently insiders are in my camp when it comes to holding Salesforce.com at current valuation multiples.
A quick look at the last six months of activity from insiders shows zero insider buys totaling zero shares, and 239 insider sells totaling 1,193,000 shares.
This is a good company doing good things. But valuation matters. Old timers like me learned that by watching the great tech bubble companies valuations collapse. I think Salesforce.com investors are forgetting that experience.
You want to make your bet on good companies like this when the market is pricing them as being average. Not when the market is pricing them for perfection. You can be excited about the company and its product, but at the same time be apprehensive about the valuation the stock market is assigning. And I think that is what is required here.