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 Five9, Inc. (NASDAQ:FIVN) 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).

Five9, Inc. (NASDAQ:FIVN)

Number of Hedge Fund Investors  in Q1 2024: 38

Analyst Average Share Price Target: $80.15

Upside: 83%

Five9, Inc. (NASDAQ:FIVN) is a cloud software provider that serves the needs of the call center industry. It provides a one stop solution for call center agents to use email, social media, and other platforms to communicate with customers. This makes Five9, Inc. (NASDAQ:FIVN) one of the few companies of its kind that is able to let call center companies off load their infrastructure costs to a third party and improve margins. However, a large portion of Five9, Inc. (NASDAQ:FIVN)’s customers are reliant on discretionary spending, and as the economy slows, the firm will find it difficult to sustain its recurring revenue growth. To counter this, Five9, Inc. (NASDAQ:FIVN) has to grow the share of enterprise customers within its revenue mix. Additionally, a key component of its hypothesis, which has also rattled investors and contributed to a modest 16% share price gain in 2023, is whether AI will disrupt call centers sufficiently to make Five9, Inc. (NASDAQ:FIVN)’s business redundant. The firm has responded to these concerns by deepening AI’s presence in its portfolio and offering products such as AI chatbots and allowing businesses to determine customer needs without relying on humans.

Brown Capital Management was aware of all these trends in its Q1 2024 investor letter. However, it remains bullish about Five9, Inc. (NASDAQ:FIVN) and shared:

Five9 is a leader in cloud-based contact center software, offering a comprehensive omnichannel solution that seamlessly incorporates inbound and outbound calling with email, chat, SMS and social media. With the growth of e-commerce, consumers are increasingly opting for digital interactions over physical visits, driving the need for world-class contact-center software solutions. These systems effectively become a virtual front door for customers, serving as indispensable, mission- critical gateways for customer engagement and support. Five9’s cloud-native platform is superior to traditional, on-premise legacy systems, offering lower costs, faster innovation and support for remote-working needs. These advantages are expected to significantly increase cloud adoption in the future, pushing it well above the current level of approximately 20%.

The company reported fourth quarter revenue results that were only modestly ahead of consensus expectations, with disappointing revenue-growth guidance for the first quarter of 2024. Management cited the macroeconomic impact of lower demand for services from the installed base, driven by headwinds within the consumer discretionary vertical, which is the company’s third-largest customer segment. In addition, there are ongoing concerns that new artificial intelligence (AI) technologies could disintermediate contact-center software and shrink the market for the company’s offering. However, AI also offers a significant opportunity for the company, a leader with eight currently marketed AI products that are providing a pricing uplift of as much as 2-3x. In addition, to fully leverage AI’s advantages, customers must first adopt cloud-based solutions, which should accelerate the shift to the cloud, benefiting Five9. The company has seen particularly strong adoption of AI solutions with larger enterprises, helping it expand beyond its earlier success with small and medium-sized customers. Despite the near-term headwinds, Five9 should have a healthy runway for durable double-digit long-term growth driven by industry-leading technology and market-share gains from legacy incumbents.

Overall FIVN ranks 1st 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 FIVN 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 FIVN 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.