Reasoning Zoom’s valuation 🤔

A more rational approach

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Today’s post is by Alex Hinch. Not only is he one of the smartest people I know, he’s a great friend with a witty sense of humor. He always has a refreshing take on companies.

Alex and I worked together at McKinsey. He joined WanderJaunt 3 years ago as an early employee where he leads operations.

Alex is bringing a way to think about stock prices, using Zoom as an example. For more context on Zoom, check out the bull / bear case from last week.


Sometimes I look at Twitter and wonder, is investing this simple?

In 2019 when Zoom was at $100/share, half of the internet was screaming that Zoom was a buy because of how great the product was. 

At the same time the other half of the internet was saying this was a terrible purchase because of how expensive the stock was.

Now Zoom is trading at $250/share and my feed seems to have the same opinions.

So I start to question, “what must be true for me to invest today?” Here’s what came to mind:

Broke: I’d never buy Zoom! Their stock has gone up so much it’s definitely going to crash.

Also, broke: Zoom is a great buy! The product works so well.

Bespoke: In order to believe that Zoom is a “buy” at today’s $77 billion valuation, I need to believe they can grow at a rate of X% over the next few years. I also need to believe that the market will value them at a Y revenue multiple in a few years time.

Let’s ignore the twitter stock pickers for the next few minutes...let’s go solve for X and Y ourselves.

Editor's note: Zoom’s (ZM) valuation was $77B at time of writing, $70B at time of publication. The takeaways herein still stand.

“The fundamental theorem”

How do we get from “broke” to “bespoke”? 

One way is to critically think about what the stock price will be five years from now. Here's a formula that I can promise will be true at all times...

Stock price = Revenue Multiple * Revenue

...meaning if we can estimate the revenue and revenue multiple in the future, we have a crystal ball of what the price can be.

Solving for X and Y

Revenue Multiple

A revenue multiple is the company's valuation divided by its revenue

They’re handy as we can use them to compare valuations across similar companies, and helps us think about the value of ZM stock as it grows.

For context, revenue multiples are high when small companies are valued mostly on hopes and dreams (i.e. their opportunity to grow). Revenue multiples shrink as companies mature - they have less space to grow and investors want revenue to translate into value.

We see this in reality:

Bigger companies (with presumably less room to grow) tend to have lower revenue multiples. For example, IBM has a revenue multiple of 2x, yet higher potential Slack is at 26x.

At the moment Zoom is trading at a ~90x revenue multiple!

To be clear, as Zoom grows, their revenue multiple will fall. It’s just a question of how much.

So how much? It depends largely on how big we think Zoom is going to be in 5 years. Skipping ahead a bit to our revenue projections (spoiler alert!), out of the choices above, to be a worthy investment, Zoom’s revenue has to be most similar to Salesforce. 

Salesforce has a revenue multiple of 10. For this equation, let’s use 10x as the FY2025 revenue multiple (FY means Fiscal Year).

Revenue

Now let’s project what we think the revenue will be at the end of FY2025. 

To start, I took Zoom’s revenue assuming they hit the lower end of their projected FY2021 revenue guidance. They estimated revenue of $1.775B for FY2021 back in June.

Given Zoom is a riskier investment, I assume we would need a 12% desired rate of return (above the expected market returns of 7-10%). 

From here, we can calculate the annual revenue growth rate Zoom needs to justify their valuation. 

We’ll find it using these assumptions (12% return, the 10x revenue multiple) and the magical excel solver.

Drumroll, please…

A 66% annual growth rate is needed in order to meet our expected rate of return. Here’s what that can look like over time:

In FY2025, that means ~$13.5 billion of revenue and a valuation of $135 billion (10x their revenue). 

What this comes down to

Putting into context

So whether or not Zoom is a “buy” or not crudely comes down to one thing: Do you think Zoom can grow their revenue to ~$13.5 billion in 2025?

In order to digest what that means, there’s two ways to look at it. 

  • One is, that's 8x the revenue they’re planning for this year

  • Another way is, how many paid subscribers will they need?

We can estimate the second by dividing the FY2025 revenue by the average revenue per paid. I guesstimate the average revenue per paid user is $12/month (a discount from their list price of $20/month). 

Doing the math (~$13.5B annual revenue /  $12/user/month), means Zoom would have to grow their subscriber count to ~93 million paid users for FY 2025. 

The authors take

Now that we’ve done this napkin math, I start to think, how plausible is this growth story?

Personally, I think getting to 93 million paid subscribers by 2025 is way too steep a hill to climb.

I consider this growth physically possible, but quite challenging when you consider the total size of the market and the competition.

Their market is largely limited to educated white collar workers (for reference there are about 60 million of those in the US). They’ve faced growth challenges with security-concerned clients, school districts, and in China, all of which will limit the size of their total addressable market.

Additionally, the competition in the space will be fierce. It’ll include free options (Google), options that are add-ons to services clients are using (Slack), and options that will come loaded on PCs out of the box (MS Teams).

Given all of that, to me, 93 million seems like a ton of paid accounts to chase after for a 12% return. In the words of Shark Tank:

Parting thought

Whether you agree or disagree with me, I hope you aren’t dogmatic in your view (i.e. there is some price at which you would consider both buying and selling this stock).

Buying companies that seem “great” without evaluating their price is silly - it’s not the way you would shop for anything else. Hopefully this will inspire you to think about growth stock prices more methodically.

Thanks for reading,

Alex


Editors note: If you have any comments or questions, feel free to reply to this email! I’ll forward it to Alex. 

Additionally, what do you think of guest posts? I’m thinking of experimenting with the format. Would you want to see these more often? Less often? Would you want to write one?

Note: This content is for informational purposes only. Neither Alex nor Anuj are financial advisors. This post should not be relied upon as legal, business, investment, or tax advice. Your use of the information contained here is at your own risk.