Call me old fashioned, but when I buy part of a company I want to be reasonably sure that at some point, that company will be able to pay me back the cost of my investment in capital returns. The alternative to this is to rely on capital gains, however these are driven over the long term by the ability of the company to generate free cash flows, and so ultimately amount to the same thing.
In the short term of course, sentiment can drive share prices higher but then we are playing the "greater fool" game which is very risky and not at all what investing is about.
So ultimately, for value investors, the decision to buy a stock comes down to whether the underlying company is able to generate sufficient cash per share over its life to exceed the price of those shares adjusted for the time value of money.
The trouble is that it is very difficult to predict cash flows for the next year, let alone 10 or 20 years in the future. To overcome this problem I am extremely conservative with my estimates and personally will not buy a stock in a company that isn't already profitable and even if it is profitable, the price of the stock must imply minimal profit growth.
With 136,107,864 shares on issue and a share price of $15.93, XERO FPO NZ (ASX: XRO) has a market capitalisation of $2.2 billion. As a rule of thumb, I often refer to the mathematical fact that if a business generates the same free cash flows each year for ever, then using a discount rate of 10% that business is worth exactly 10x its annual cash flows. Now, some may argue that a 10% discount rate is too high given interest rates are much lower. I would counter that by saying that interest rates will not always be so low and that a business with an unlimited lifetime is a generous assumption to compensate for such a demanding discount rate.
Clearly, Xero is rapidly growing and not a stable business as my rule of thumb requires. However all companies stop growing at some stage and so for its current share price to be in the right ball park, Xero needs to produce roughly $220 million in profit per year at some point in the future, equating to one tenth of its current market capitalisation. For it to be worth more than $2.2 billion, it needs to reach a profit level far in excess of $220 million to account for the years leading up to it reaching this point, which have a greater weighting in the discounted cash flow model thanks to the time value of money.
Xero has 540,000 subscribers, 1,200 employees, 16,000 partners and has processed $300 billion of transaction value in the last 12 months. These are impressive numbers – no wonder they make it to the front of the latest investor presentation. In particular, the $300 billion transaction value number sounds great but unfortunately has very little meaning. A more useful figure would be the number of transactions processed, since it takes the same amount of work to process any transaction regardless of its value. Even that wouldn't tell us much since Xero don't charge per transaction, but per subscription. I guess the main point of including such a number is that it is impressively large, which conveys the impression that Xero is also an impressively large company.
The numbers that matter
In the 2015 financial year, Xero generated NZ$123.9 million operating revenue up from NZ$70.1 million in 2014. This represents strong growth, but revenues are still only around half what Xero's profits needs to be for the current share price to make any sense at all.
As a software company, you would expect Xero to have low variable costs and therefore profit to rise faster than revenues but this is not the case. In fact, Xero delivered a loss after tax of NZ$69.5 million, much worse than the NZ$34.7 million loss incurred in 2014.
Admittedly, part of the increase in losses was due to additional marketing spend which some may argue is an investment in the future of the company (incidently, I would not be among them). Generously stripping out all marketing and sales costs for each year, Xero would have made a profit of NZ$24 million in 2015 compared to NZ$20 million in 2014, a rise of just NZ$4 million versus a NZ$54 million uplift in revenues!
Foolish takeaway
Here are the two key assertions that in my opinion show that Xero is massively overpriced.
- It is currently heavily loss making, having made a loss of NZ$69.5 million last year.
- Its current revenues are only about half what its profits need to be before its market capitalisation starts to make sense.
No doubt some would say that I am using the wrong valuation method and that revenue growth or some other metric is more applicable for technology shares. My view is that there is only one definition of a company's value and that is the current value of its future cash flows. Dubious valuation techniques tend to gain popularity in order to justify extremely high share prices and for me their use is a strong sign of danger. I cannot predict the future sufficiently well to be sure if Xero will achieve the exceptional growth required for current prices to offer good value, can you?
