Technology stocks are all the rage for the past few months. And there is little wonder to it. In a recent article on Markets Insiders, four factors are determined to drive returns in the stock market. They are namely interest rates, macroeconomic, geopolitics and innovation. With the first three factors in a rather unfavourable position in the foreseeable future, we could only rely on the last factor (innovation) for any returns in the stock market and that is probably why technology stocks are the darling of the market.
I have already written quite a few articles on the technology sector generally. You may refer here and here While those articles seem to just focus on the potential of the technology sector in the near-mid term future, I would like to explore deeper on a more fundamental aspect of the technology stock.
And yes, you get it right. How do you value a technology company?
This is an age old question and I'm not arrogant to say that I have a perfect answer to it. Instead, I would like to present a few views and hope they could bring value to your investing journey.
The main reason why it's so hard to answer this question is due to the fact that a technology company could be fundamentally different from a traditional company. You could tell how different they are just by looking at the products they offered. A traditional car company would incur cost by producing another unit of car for sales while a software company could incur almost zero material costs by producing just another license for sales. A traditional car company could be valued using traditional accounting item such as earnings per share etc. Could you use the same metric to value a technology company which is having negative earnings? It might be very wrong to do so as most technology companies are known to have negative earnings in their initial stages of growth as they put in heavy marketing and innovation costs to position themselves in a way to capture as much of the market share as possible. Non-conventional metrics such as number of users or lifetime value of users might be more appropriate for use here.
And hence, it's difficult to value a technology company as some of the traditional/conventional metrics which we use to value companies might not be applicable anymore. You would need to determine what are the right metrics to be used before you could properly value a technology company. Even before understanding what are the right metrics to be used, you would need to first understand the market where the technology company is in and know clearly how their business model is like.
This is where I find this article from Mckinsey & Company particularly insightful. A series of steps are introduced to allow investors or readers to understand how to value high-tech companies. It starts off with first understanding how the future would look like. Most of these technology companies are also high growth companies. This means that these companies are moving in a direction where the industries they are in could undergo phenomenal changes or growth in size. By understanding how the industry would be like in the future and specifically how much of a market size the associated technology company could potentially capture, you could then better understand the future state of that particular technology company. Through the journey, you should also be crystal clear on what kind of customer needs the technology company addresses in the market and also how do they monetise their product/solution offerings.
Now, with all this information in mind, you could then begin to determine what this technology company would look like in relevant metrics such as operating margin and ROIC (Return on Invested Capital). Wait, hold on. Didn't I just mention that some traditional/conventional metrics could not be used to value a technology company? Well, remember that such metrics are usually not suitable when the company is in its hyper growth stage. The future state of the technology company should not be in a hyper growth stage. The future state of the technology company should be of a stable one like any other traditional companies and traditional/conventional metrics such as operating margin and ROIC would then be relevant. From the future state of the technology company, you could then work backwards to determine what should be its right value. Of course, what I'm saying here is a condensed version of it. You should read the article in full to understand it better.
Besides the method mentioned above, there is also another way you could use to value a technology company in its initial stages. And this particular way involves the use of data science.
In a Seeking Alpha article here, bootstrapped regularised lasso regression (a type of linear regression) was used to determine how strong the linear association between over a hundred various different financial metrics and annual returns of the technology stocks relative to the market in the form of a binary indicator is. Eg, does the market capitalisation of the technology stock has a strong positive association with its returns?
At the end of the exercise, seven best metrics are discovered to be used to evaluate a technology stock. They are namely Price-to-Sales Ratio, Beta, Net Income Growth, Free Cash Flow Growth, Market Capitalisation > $10B, R&D Expense Growth and SG&A to Revenue.
Out of these seven indicators, Price-to-Sales Ratio has the highest magnitude of positive association. This means that there is a strong positive correlation between a technology stock's returns and its Price-to-Sales Ratio. This might sounds counter intuitive as you would generally expect that a high Price-to-Sales Ratio could signify the stock being overvalued. A counter argument presented in the article would be that when comparing two stocks with similar Price-to-Earnings Ratios, the stock with a higher Price-to-Sales Ratio could signify a higher profit margin for the company. And higher profit margin is always a strong indicator of an economic moat for the company which could signify future success. The article explores the rest of the indicators in more detail and I would not attempt to cover here in the article. You may refer to the article for more details. In case you are wondering which companies meet all the requirements of these seven indicators, they are your typical FAANG companies. Given the good performance of their stocks in the past few years, I would say that these seven indicators are worth a closer look.
I briefly touched on a few ways you could adopt to assess the value of a technology company here. Hope these provide some clarity in your investing journey. In the near future, I will be covering some of the technology companies in detail. Hence, do keep a lookout for my articles.
Till the next time.
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