We recently compiled a list of the 11 Best Cloud Stocks to Buy According to Analysts. In this article, we are going to take a look at where Fastly, Inc. (NYSE:FSLY) stands against the other cloud stocks.
The surge in internet speed and usage has created a plethora of new industries in its wake such as eCommerce, social media, and online streaming. On the business side, one of the biggest beneficiaries of advances in communication is cloud computing. Cloud computing in its simplest terms is the use of computing resources virtually, where companies host expensive hardware and data servers and sell this capacity to customers.
Naturally, it’s unsurprising that some of the biggest companies in the world either directly offer cloud computing software products or the hardware that powers these systems. In fact, out of the five most valuable companies in the world in terms of market capitalization, three have leading cloud computing divisions (Google Cloud, Amazon AWS, and Microsoft Azure) while the other is a hardware company that is Wall Street’s AI darling.
In fact, cloud computing is so valuable that research from Bloomberg shows that AWS alone can reach a whopping valuation of $3 trillion. To wit, only the world’s biggest companies have crossed this metric, so this figure shows the potential that’s present in this industry. This isn’t the only time that a trillion dollar figure has been chosen to describe cloud computing’s potential. One of the biggest benefits of cloud computing is that it allows businesses to save on costs by outsourcing their hardware procurements.
These benefits will be worth quite a bit as research from McKinsey shows that by 2030, they can enable cloud computing companies to capture up to $1 trillion in run rate operating income (EBITDA) from Fortune 500 firms. Run rate EBITDA is a key metric in cloud valuation, as it projects current earnings into the future to make an estimate of value. Another mention of the enticing trillion dollar valuation comes in the form of market research. This suggests that the global cloud computing market was worth $484 billion in 2022, and from 2023, it can grow at a compounded annual growth rate (CAGR) of 14.1% to be worth $1.5 trillion.
Looking at these estimates, it’s clear that there’s at least some value in cloud computing stocks. The next question to ask is, how does one pick out the right cloud computing stocks? On this front, there are several valuation metrics that can be relied upon. Standard models such as the discounted cash flow (DCF) often do not capture the potential of cloud computing stocks since there are few reasonable estimates to measure their growth. These stocks differ from traditional companies since they don’t have to fork out massive capital to buy equipment and prime themselves for growth. Instead, software development is a margin heavy business with low development costs and stable, recurring revenue. This makes management focus on growing market share, and since this also leads to higher operating costs, many cloud computing stocks remain unprofitable for years.
The direct implication of this fact on valuation is that cloud computing stocks cannot be valued by traditional metrics such as the price to earnings (P/E) ratio. Instead, the enterprise value to sales is used as it captures the market and debt value minus cash and compares its scale with the revenue that the firm generates. Investors also have to nevertheless measure the ‘value’ a firm is generating even though it’s unprofitable. This is captured through the free cash flow. One of the most well known cloud computing stock valuation metrics is the Rule of 40. This combines the FCF with the revenue growth rate to evaluate the margins that such firms achieve. The logic is that the revenue growth rate plus the FCF margin (FCF divided by revenue) should be greater than 40 for a cloud computing firm to be sustainable. Combining these together, the ideal cloud computing stock should have a high Rule of 40 scores but a low EV/Sales, as this principle shows that a sustainable business is available at a cheap entry price.
Looking at the data, the EV/Sales multiple varies with a firm’s growth rate, and those with higher growth naturally command a higher multiple. For instance, as of recent market close, data shows that stocks with a Rule of 40 score greater than 40 and a revenue growth rate greater than 30% (Category 1) have a median EV/Sales multiple of 12.5x. On the flip side, those that fall below both of these have a median multiple of 5.1x (Category 2). Crucially, though, the category of stocks that have a growth rate higher than 30% but a Rule of 40 scores lower than 40 (Category 3) have a median EV/Sales ratio of 12.2x in today’s market which implies that investors are valuing growth more than profitability.
Why do we say “today’s market”? Well, when we compare this to the era of low interest and inflation rates in, say October 2021, the picture is different. Back then, Category 1 firms had a median EV/Sales ratio of 27.7x (!) while Category 3 firms had a ratio of 24.9x. This difference was even sharper in September 2020, with a ratio of 42.3x for Category 1 stocks and a value of 29.1x for Category 3 firms. To conclude, it appears that investors place a higher premium on growth than profitability when inflation tightens the belt and higher rates place a premium on attracting business spending for cloud computing stocks.
Our Methodology
To make our list of the best cloud stocks according to analysts, we ranked the holdings of First Trust’s cloud ETF by their average analyst percentage share price upside and picked out the stocks with the highest upside.
We also mentioned the number of hedge funds that had bought these stocks during the same filing period. Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points (see more details here).
A technician pointing at a projection of the company’s geolocation software.
Fastly, Inc. (NYSE:FSLY)
Number of Hedge Fund Investors in Q1 2024: 23
Analyst Average Share Price Target: $10.17
Upside: 37%
Fastly, Inc. (NYSE:FSLY) is a content delivery and application development focused cloud company. As is with other cloud stocks, central to its hypothesis is Fastly, Inc. (NYSE:FSLY)’s ability to grow its customer base, grow revenue, and retain customers. It has to consistently match Wall Street’s revenue growth expectations, and any misses are punished heavily, particularly in today’s high rate environment that has increased the risk premium. At the same time, Fastly, Inc. (NYSE:FSLY) also depends on the source of its traffic for its revenue. Certain countries lead to high value traffic, and if this source shifts, then Fastly, Inc. (NYSE:FSLY) experiences a growth slowdown. This led to a 31% share price drop in February when the firm’s $138 million in Q4 revenue sat at the lower end of its guidance as international traffic fluctuations impacted the top line. Fastly, Inc. (NYSE:FSLY)’s shares fell another 32% in May when its calendar year revenue growth guidance of 6% to 9% marked a significant drop over the earlier guidance of 15% to 17%.
Customer deals were at the heart of the revision, and during the earnings call, Fastly, Inc. (NYSE:FSLY)’s management shared:
There are a few factors that contributed to a challenging short-term environment. The biggest factor is a reduction of revenue from a small number of our largest customers. The first-quarter revenue from our top 10 customers dropped from 40% to 38%. Many of the top 10 accounts run a multi-vendor strategy. And we did see significant volatility here. And there are a few reasons for that. Firstly, historically, Fastly has gradually won greater traffic share in our largest accounts. But with the timing of rate and volume changes, we saw increased volatility this quarter. To be clear, we have not been removed from any of our largest customers and we remain in a strong strategic position, each of them long term.
Overall FSLY ranks 6th on our list of the best cloud stocks to buy. You can visit 11 Best Cloud Stocks to Buy According to Analysts to see the other cloud stocks that are on hedge funds’ radar. While we acknowledge the potential of FSLY as an investment, our conviction lies in the belief that some AI stocks hold greater promise for delivering higher returns and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than FSLY but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.
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Disclosure: None. This article is originally published at Insider Monkey.
