Warren Buffett, a Snowflake (SNOW -0.91%) investor, once said, “It’s better to buy a great company at a fair price than a fair company at a good price.” The logic behind this quote is that you won’t get low prices on the best companies on the market, and these companies will continue to outperform decent companies whose stocks are cheaper.
But what about good companies at high prices? That’s exactly what Snowflake investors are looking for.
While the company just reported another quarter-smashing expectations, the stock is relatively expensive. But is it? too expensive? Lets find out.
Blowing away management expectations
Snowflake’s data cloud software allows its customers to store massive amounts of data from multiple sources (even unstructured data that doesn’t easily fit into a standard “rows and columns” format). That data can then be used to provide information for cybersecurity, feed machine learning models, or be integrated directly into applications to improve business outcomes.
In addition, Snowflake only charges customers for the storage or computational power they actually use, a win-win for both customers and Snowflake. This ensures that customers will not pay for unnecessary resources, while the company will, in turn, efficiently allocate cloud resources.
But a usage-based model can cut both ways, as customers can reduce their usage during tough economic times like many businesses experienced in Q2. But this slowdown did not affect Snowflake. Instead, its net profit retention rate is an amazing 171%, meaning existing customers spend $171 for every $100 they spent last year.
This expansion helped accelerate revenue, with product revenue growing 83% year over year to $466.3 million compared to management’s Q2 projection of $437.5 million. However, this does not reflect what management thinks of their total addressable market. Using third-party GartnerIn Snowflake’s research, its total addressable market will be $248 billion by 2026.
However, if Snowflake runs out of money before 2026 due to its profitability, this is a moot point. Fortunately for Snowflake investors, the company was free-cash-flow positive, generating $53.8 million in the quarter (an 11% margin). So while its earnings per share may be negative ($0.70 loss in the quarter), Snowflake’s cash balance is increasing.
For a young and growing business, investors couldn’t ask for more than one quarter, which is why the stock jumped 23% the day after the company reported earnings. But does that make the stock too expensive?
How long does Snowflake need to grow to achieve a reasonable valuation?
Snowflake’s stock now trades at 37 times sales. While this marks a significant drop from the 150 times Snowflake’s sales used to trade, it’s still expensive.
However, a dichotomy occurs in rising sales and valuations. If Snowflake’s sales stagnate, the denominator of the price-to-sales (P/S) ratio will remain the same. That said, the numerator (price) will decrease because of a struggling business, dragging its valuation lower.
On the other hand, if Snowflake’s business continues to grow rapidly, the denominator will increase and the value will decrease. However, the latter scenario does not occur in a vacuum. If Snowflake’s business continues to execute and grow, its stock price will likely increase, so its value will not decrease. This back-and-forth is why looking at valuations helps to determine whether the price you’re paying now might be reasonable in the future.
If Snowflake can maintain a 50% annual revenue growth for three years (a lofty goal, but Snowflake has grown faster than every quarter it has gone public, and it has a tremendous opportunity to market), that would put its trailing-12-month total revenue at $5.53 billion in 2025, resulting in 11.4 times estimated 2025 sales.
The 50% revenue growth goal is not a hard-and-fast projection; it’s just a number used to illustrate how fast Snowflake has grown to get back to the same valuation level as other similar software companies. Adobe (10.9 times sales) and Service Today (13.7 times sales). This exercise illustrates the high prices investors would have to pay for Snowflake if they bought the stock now. Remember, that projection also assumes zero price appreciation or shareholder dilution due to stock-based compensation. Plus, if Snowflake is still growing at a pace of 50% or more over three years, its valuation is unlikely to drop to Adobe’s or ServiceNow’s level.
I am a Snowflake shareholder and believer, but I added to my position because I know it is a long-term holding. I used a three-year growth projection, but if the company grew rapidly for my ideal holding period of about a decade, the price I would pay now would be irrelevant due to a compounding effect .
Snowflake stock is expensive, but I’d rather be a shareholder and have some short-term losses than sit on the sidelines and not own one of the fastest growing tech companies on the market. I think Snowflake is a buy if you have a long timeline like me. However, if your horizon is shorter, Snowflake may not be your stock.