JFrog Ltd (NASDAQ:FROG) went public on Sept. 16 at an IPO price of $44 but closed its first day at $67.99, up 54.5%. Now FROG stock is priced at more than $85, or 94% better than its IPO price.
But investors should beware the market is highly overvaluing this stock on any sort of reasonable basis.
This is somewhat of a surprise since its prospectus says on the very first page that the expected price would be between $39 and $41 per ordinary share.
The high price for the stock now seems out of place for a company that makes no profits. It is also priced at a very multiple of its sales.
High Price-Sales Ratio
For example, JFrog, which produces development software for the management and release of software updates, made just $104.7 million in revenue in 2019. That was up 64.8% over 2018.
But the problem is that JFrog now has a huge market capitalization. The company sold 8 million shares and selling shareholders sold 3.568 million shares. The company raised $352 million before expenses. All told there are now 90.41 million shares outstanding. At $85.47 per share, it has a market cap of $7.58 billion.
But think about this. That means that investors altogether are paying $7.58 billion for a company with $105 million in sales last year. That is 72x revenue. That is normally a ratio level that most investors would consider high for a company’s price-earnings.
But revenues in the first half of 2020 rose to $69.3 million from $46.1 million. The growth rate slowed to 50.3%, but it still implies that revenue could reach $140 to $150 million this year.
That lowers the price-sales ratio to 50.3 times revenue. Just for giggles, let’s assume that revenue grows 50% over the next three years. That would put it at $506.3 million by 2023. If FROG stock stayed at the same price it would still have an incredibly high multiple of 15.1x revenue.
And we haven’t even yet talked about profits.
Estimated Price-Earnings Ratio
Even though software companies are typically very profitable, this one isn’t.
For example, in the first half of 2020, JFrog lost $430,000. This was down from a $2 million loss in the first half of 2019 and a loss of $5.4 million in 2019.
So, the trend looks promising but again the stock price seems to have discounted earnings at least two or three years in the future. For example, let’s assume it makes a 30% margin in 2023. that would put its net income at $150 million.
Therefore, the stock trades for a price-earnings multiple of 45.6 times earnings three years in the future with an assumed 30% net income margin.
But that is a lot of assumptions and we have no guidance from the company to even forecast this. Neither are there any analyst predictions or estimates.
The company claims that it has 286 clients with over $100,000 or more per client of annual recurring revenue (ARR). That implies that its ARR is more than $28.6 million. That is nowhere near its 2019 $105 million in revenue. I do not understand why they would use that statistic.
This highlights one of the fundamental problems with the IPO process. The companies never give any kind of estimates for their future revenue and profits.
However, recent SPAC (special purpose acquisition companies) mergers are providing this kind of information. They are more upfront with investors about the multi-year outlook for the combined companies. That is why I prefer SPAC mergers over IPOs.
What To Do With FROG Stock
Investors seem to really want to overpay for these subscription-as-a-service (SaaS) software companies. Recently Snowflake (NYSE:SNOW) went public through an IPO and investors have now overbid that stock as well.
That stock trades at a ridiculous valuation of 76x sales. This is simply not sustainable in the long run. Once the company’s lock-up restrictions are up the stock is likely to sell-off. Snowflake will allow management to sell more of their shares in a short 91 days after its IPO, in early December.
JFrog has a more traditional lock-up period of 180 days. I suspect that many of the insiders are going to want to sell their shares at these high prices.
I always believe that investors should never consider purchasing a recent IPO stock until the lock-up period has long passed. That allows sufficient time for the stock to settle into a reasonable valuation, and also allows sell-side analysts to comb through the valuation issues related to the stock.
Therefore, I suspect most investors will do well to wait for at least six months before looking at FROG stock.
On the date of publication, Mark R. Hake did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.