5 Crucial Things for Value Investors to Consider When Evaluating Stocks

Value investors use specific metrics to find great deals. Some popular ones they use include the price-to-sales ratio, the price-to-earnings ratio, and the price-to-book ratio. And these tools certainly have their place. But they’re not everything investors need to find great deals in the market.

In this video from Motley Fool Live, recorded on Sept. 9, value investor at heart and Motley Fool contributor Matthew Frankel talks with fellow contributor Jon Quast about five other things value investors should keep in mind when buying stocks. Matt and Jon think investors should consider a company’s sales growth, gross margin, margin expansion, total addressable market, and net dollar-based retention rate.

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Jon Quast: What Matt just talked about was these valuation metrics, and I want to underscore: When we talk about valuation with stocks, we are not talking about the price per share. It’s really irrelevant in many ways. I’m going to liken it to the grocery store. You pick up a pack of chicken. It says 10 bucks on the package and it’s five pounds. Is that more expensive than a $8 bag of chicken that only has two pounds? No, the price per pound is different in those two situations. While you might spend less on an $8 package of chicken, if it’s $4 a pound, that’s more expensive than the $10 package that is $2 a pound. That’s what these valuation metrics are doing. They’re measuring, not the stock price, but the valuation based on the sales, the earnings, things like that.

But most of those are backwards looking, so they’re looking back over the last 12 months. And at most, most of them are looking forward over the next year. But as investors, we’re thinking about something way bigger and way more long term than what has happened over the last 12 months or what might happen over the next 12 months. We’re really thinking more long term, and that’s why we need to use valuation metrics, yes, but in inappropriate context.

Some of the things that we look at here are sales growth. Why might this matter? A company might look expensive on a price-to-sales valuation. But what if they’re doubling their sales in each of the next three years. Well, all of a sudden — and that’s the time frame that we’re looking at as investors, three to five years. What if they’re going to grow, doubling each year. Well, all of a sudden their sales are going to be much bigger in three to five years than they are right now. The valuation as we project out, maybe it’s not so expensive once we add in that context.

Gross margin and margin expansion. This is another important thing for investors to incorporate into their valuation understanding. What is gross margin? This is how much it cost a company for its revenue. If it had to spend $5 for a product and is able to sell that product for $10, their gross margin is 50%. It cost them $5, they sold it for $10. Gross margin is a very important thing to consider because this shows you your profit potential. Maybe the company is spending most of its gross profits on building a new warehouse or just growing the business, spending a ton on sales and marketing and it will show that they are unprofitable. But if you look at the gross margin, you see that the company is not structurally unprofitable. This actually is a very good business, but they’re spending to continue to grow the top line.

One that comes to mind here, as we talk about gross margin and how this might play in, software-as-a-service companies. Many times these companies have very high gross margins, sometimes even 80%, 90%. Why? They built their software, they have that cost of building it, but they can sell it many, many times, and so their cost is fixed right there at what it cost to build it. But as they onboard more and more customers, their costs aren’t going up, but their sales are, so their gross margin is actually quite high. That is a very valuable revenue stream. Whereas a grocery store by contrast, typically grocery store margins are quite small. It’s very hard to gain operating leverage because a product is going to cost what it costs and you can sell more of that product, but each one of those is going to have the costs associated with it.

Margin expansion as well. Again back to the software-as-a-service company, in the early days, the gross margin might not look that good, but you see that they’re signing up a lot of new customers and they are selling the same product. So, you can project this gross margin is going to tick up over time because that cost is fixed and they have more business coming in.

Total addressable market, this is another very important thing for investors to keep in mind for context. One example that came to mind was cybersecurity. Maybe a cybersecurity stock trades at what appears to be a very expensive valuation, but they’re growing fast. When looking at that total addressable market, they can continue robust growth for a long time. Here’s why, this is from Grand View Research. According to Grand View Research in 2020, the cybersecurity market was valued at around $167 billion. That’s a [laughs] very big market. However, over the next few years by 2028, it’s expected to be over $380 billion. Better than an 11% compound annual growth rate for the next seven years. This market is growing by leaps and bounds, so a richly valued cybersecurity company, when you consider the market they’re going after, perhaps it deserves the premium valuation.

Then Matt, here you’re going to explain net dollar-based retention rate, because, I think, you’re going to do it more succinctly than I.

Matt Frankel: Yeah, before I do that, this slide really shows you the importance of using valuation metrics together. Jon just talked about total addressable market. That only matters if a company is growing its sales, has good margins, and looks good on a price-to-sales basis. For example, if I set up a table right now outside and start selling hot dogs and hamburgers, I’m participating in the $50 billion restaurant industry. [laughs] That doesn’t tell you anything about my future business potential. That’s a silly example, but the point being a total addressable market that’s in the billions or even the trillions, only is an important data point, if a company is really growing into it. The stock I’m going to talk about in a second is really a good example of that.

Finally, net dollar-based retention rate. You might see this called by different names, by different companies. Some just call it dollar-based retention, some call it net dollar retention. It all means the same thing. Essentially, this is a metric that tells you how much a company’s existing customers are spending over time. A 100% net dollar-based retention rate means that the average customer that was spending $100 a year ago is spending $100 today. A net dollar-based retention rate of, say, 120% would mean that the average existing customer who has been with the company for a year, who was spending $100 a year ago, is now spending $120 today. That tells you that customers are finding so much value in a company’s product, that they’re willing to spend more and more over time maybe buying other products and services, things like that.

This is a very popular metric in the tech market, especially in software companies. So, those are some of the metrics to keep in mind.

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