However, despite the earnings beat in its first report since the initial public offering, I believe FROG stock is set to fall further. This is because, as I wrote earlier, the insider lockup on share sales is not due to be lifted for another four months, on March 16. (By the way, you can track recent restriction periods on Marketbeat’s IPO Lockup Restrictions site.)
The bottom line is that the valuation is not going to drop to a reasonable level without a drop in the stock price.
Earnings and FROG Stock Valuation Issues
The problem is that nothing in the Nov. 4 Q3 earning release changed how overpriced these shares have become. For example, although revenue rose 40% to $35.7 million for the quarter, it still showed losses on both an operating and net income basis.
Moreover, as I pointed out last time, the price-to-sales ratio for this stock remains exorbitantly high. For example, even though JFrog said it now expects 2020 full-year revenue to be between $149 million and $150 million, the stock has a market capitalization of $5.65 billion. So, do the math. That means it’s trading at an astounding 37.7 times revenue.
This is the kind of multiple that most public companies would love to have for the net income ratio, not their revenue multiple. For example, a typical price-to-sales ratio for many stocks is well below 5x.
Estimating 2021 Revenue and Future Value
In addition, analysts seem to think that 2021 will not show that great a jump in revenue. At Seeking Alpha, the survey of analysts shows a $195.35 million forecast. Yahoo! Finance shows almost the same exact 2021 revenue forecast. That is a 30% growth rate over 2020 revenue.
However, that still puts FROG stock on a forward price-to-sales multiple of 29 times revenue. Think about that. That means if you owned 100% of the shares by taking over the company for $5.7 billion, you would have to wait 29 years before the amount of revenue piled up to the amount of the purchase. And that does not include earnings, which could take longer.
Obviously, the market thinks JFrog will grow fast and hence lead to a lower multiple within several years.
For example, let’s assume it grows revenue by 30% annually over five years. That works out to 3.71x that $150 million, or $556.9 million in revenue in five years.
Therefore, the price-to-revenue multiple will still be over 10x at that point, which is considered high.
Moreover, even if net income turned positive by then and was at a bare minimum of 10% margin, the profits would be just $55 million. That implies a price-to-earnings (P/E) metric of 103x (i.e., $5.7 billion divided by $55 million).
In other words, the company is going to have to make at least a 25% margin, or $139 million (i.e., 0.25 times $557 million), for FROG stock to have a reasonable value. That would put its P/E ratio at 41x, which again would be high, but more reasonable.
What To Do With FROG Stock
At this point, most cautious investors would like to see either more growth, a better profit outlook, or a lower price before investing.
In addition, they might also consider waiting until the insiders’ lockup restrictions on selling their shares after the IPO expires. That will relieve some of the selling pressure on the company.
Another hidden risk is that the company likely knows that its stock is too high. Many companies do secondary offerings of shares shortly after their IPOs to take advantage of this situation. They will issue another 10% or 20% of the shares they have outstanding in order to raise capital when they can. It also helps them get through a period when they won’t have enough cash or cash flow to cover losses.
However, JFrog is not in too bad of a situation in terms of this risk. For example, its cash flow from operations was positive $16.6 million in the first nine months of 2020, as seen on page 9 of its 10-Q. In addition, free cash flow was positive $14.4 million.
Moreover, the company has $578 million in cash and securities as of Sept. 30, with no interest-bearing debt. So it is in a good position to wait until profits start to appear on a large scale.
It’s just that at this price, FROG stock still looks too richly priced for most value-oriented investors.
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.