Should You Buy Cloudflare's Stock on the Dip? – The Motley Fool

Date:

- Advertisement -

Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services.
Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services.
Motley Fool Issues Rare “All In” Buy Alert
You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More
Cloudflare (NET -0.09%) is a tricky stock to understand. The business checks several boxes I like to see in an investment and the company has strong financials. However, the stock is richly valued, presenting an internal conflict for investors.
With the stock down 64% this year, has it finally reached a buying point? Let’s find out.
Cloudflare’s mission is simple: “to help build a better internet.” It does this by hosting websites in its data centers across the world. Instead of distant users accessing a website from a single point, Cloudflare’s solution is much faster because a user is routed to the nearest data center.
Cybersecurity is another aspect of Cloudflare’s offering, strengthening the company’s value proposition. Not only do customers save on IT teams, but they also avoid expensive security software, not to mention the potential savings from thwarting a cyberattack that may have been successful with second-rate protection.
Leading Cloudflare is one of its co-founders, Matthew Prince, who has a 90% approval rating, according to Glassdoor.
A company led by its founder that attacks a large addressable market with success is a great place to look when searching for investible companies. Of course, having solid financials is also a must-have.
In its life as a public company, Cloudflare’s revenue growth has stayed steady at around 50% each quarter.
NET Revenue (Quarterly YoY Growth) Chart
NET Revenue (Quarterly YoY Growth) data by YCharts. YOY = year over year.
It’s rare to find a company that grows at that level and even rarer to find one that does it consistently. For the fourth quarter, Cloudflare expects revenue growth of 42%, but management consistently undershoots its guidance historically. I’ll be curious to see what 2023’s guidance looks like, but if Cloudflare can keep this growth pace up, it will become a huge company quickly.
While Cloudflare reported $4.6 million in free cash outflows in Q3, management believes it will return to a free-cash-flow state in Q4. However, Cloudflare does have a hefty stock-based compensation bill to factor in.
In Q3, Cloudflare paid $55.9 million in stock-based compensation — 22% of revenue. That’s a significant expense that shareholders shouldn’t overlook, as it caused the share count to jump nearly 4% year over year (YOY). Flooding the market with more shares effectively makes each share less valuable as it increases the number of pie slices.
Still, Cloudflare is a relatively young company. While profits are important, establishing its brand and capturing a large chunk of what it believes will be a $135 billion opportunity by 2024 is critical. If it increases its share count and is marginally profitable for some time but beats the competition, it will be worth it in the end.
But even the most outstanding company in the world must be bought at a reasonable price.
Fortunately for investors, Cloudflare’s valuation has significantly declined over the past year.
NET PS Ratio Chart
NET PS Ratio data by YCharts. PS = price-to-sales.
This decline happened for two reasons. First, the stock price has fallen drastically. Second, Cloudflare’s sales have risen, driving the valuation down even further. But is 17.5 times sales too expensive?
Analysts project Cloudflare will grow by 35% in 2023. So let’s say its growth declines by 5% each year until 2026. Cloudflare’s revenues would look like this:
Data source: Cloudflare and Yahoo! Finance. Chart by author.
That would value Cloudflare’s stock at 6.2 times 2026’s hypothetical sales. Compared to more mature companies, like Microsoft (8.9 times sales) and Adobe (9.3 times sales), 6.2 times 2026 sales seems relatively close. But if you value Cloudflare’s stock at the midpoint, 9.1 times sales, Cloudflare’s stock would need to have a 10% compounded annual growth rate from today’s price to reach that valuation with the growth projected above.
Now 10% returns are pretty much the market average. But it all depends on Cloudflare’s growth rate. If the company grows faster than the projections above, it can produce a much higher rate of return (especially if it maintains its near-50% growth rate). On the other hand, if it grows more slowly, the stock could lose to the market.
I think the above projections are conservative, indicating the stock could handily beat the market in the coming years. However, the key is to hold on to the stock over the next three to five years. Without the long-term holding period, the effects of compounding growth are lost. Despite looking expensive now, Cloudflare’s stock remains cheap from a long-term perspective.

Keithen Drury has positions in Adobe Inc. and Cloudflare, Inc. The Motley Fool has positions in and recommends Adobe Inc., Cloudflare, Inc., and Microsoft. The Motley Fool recommends the following options: long January 2024 $420 calls on Adobe Inc. and short January 2024 $430 calls on Adobe Inc. The Motley Fool has a disclosure policy.
*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.
Market-beating stocks from our award-winning analyst team.
Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 11/22/2022.
Discounted offers are only available to new members. Stock Advisor list price is $199 per year.
Calculated by Time-Weighted Return since 2002. Volatility profiles based on trailing-three-year calculations of the standard deviation of service investment returns.
Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool’s premium services.
Making the world smarter, happier, and richer.

Market data powered by Xignite.

source

- Advertisement -

LEAVE A REPLY

Please enter your comment!
Please enter your name here

Share post:

Subscribe

ADVERTISEMENT

Popular

More like this
Related