A Hero Couldn’t Even Rescue Cloudflare From Overvalued Territory Now

Ever since Cloudflare (NYSE:NET) released its Q2 earnings on Aug. 5, analysts have been hiking their projections for next year’s revenue forecasts. As a result, NET stock has kept drifting higher. This is despite the losses the company reported last quarter. Nevertheless, I am not yet ready to change my mind about how high the stock is valued.

Close up of Cloudflare logo at the Company's headquarters

Source: Sundry Photography / Shutterstock.com

For example, on Aug. 6 I wrote that NET stock was likely to fall 30% to $83 from $118.82. But as of Friday, September 17, the stock is actually up 10.6% in the past month to $131.41 per share.

In fact, now I suspect that analysts’ revenue forecasts could keep rising. If so, there is a good possibility that Cloudflare could end up making positive free cash flow (FCF). That could be one reason why NET stock is still rising, despite its losses.

But the problem is Cloudflare is simply too expensive, even with incrementally higher sales prospects.

Where This Leaves Cloudflare

As it stands, the company has indicated that it expects revenue for 2021 to reach between $629 million to $633 million. Seventeen analysts tend to agree with this so far and on average project $632 million for 2021. This is according to a Seeking Alpha survey as well as at Yahoo! Finance, which uses Refinitiv analyst survey data.

But for 2022 those seventeen analysts now project that Cloudflare will make $845.14 million, according to Seeking Alpha, and $842.64 million at Yahoo! Finance. This is higher than last month when they projected $818.47 million, as I wrote last month. So, in other words, instead of expecting an increase of 29.5% over 2021, analysts now expect gains of 33.3% in 2022.

And I suspect that analysts’ forecasts are likely to continue to rise. For example, Cloudflare recently announced that its high-speed cloud network and servers are in 250 cities in the U.S., up 25% over the last 2 years. As a result, Cloudflare can bring a faster and more reliable internet experience to users and potential customers for its security and reliability software and services.

I think that will mean its sales forecasts will keep rising.

Valuing Cloudflare Stock

Let’s assume that by 2022 Cloudflare can start making positive FCF. If we assume that the company can make a 20% FCF margin. This works out to FCF of $168.8 million, based on an average revenue estimate of $843.89 million for 2022.

Therefore, if we use a 1% FCF metric and divide $168.8 million by 1%, the resulting target market value is $16.88 billion. But that is still less than half of today’s market value of $42.02 billion.

I suspect that the market is looking out for its 2023 revenue prospects. For example, Seeking Alpha shows that revenue prospects for 2023 are $1.09 billion. Assuming a 20% margin by then, the FCF will reach $218 million. But again, even at a 1% FCF yield, the target market value is just $21.8 billion. This is still just half of today’s market value of $42 billion.

The only way today’s valuation makes any sense is to use an ultra-high valuation metric of 0.5% FCF yield. That is the equivalent to a price-to-FCF metric of 200 times (i.e., 1/0.005 = 200). That implies a valuation of $43.6 billion, or slightly over today’s $42 billion market value.

Another way to value the stock is to use a price-to-sales (P/S) metric. For example, at today’s $42 billion market value its 2022 sales of $843.89 million put NET stock on a P/S value of about 50 times sales. This is also a very high valuation metric.

What To Do With NET Stock

As I pointed out last month, analysts still see Cloudflare as overvalued. According to Seeking Alpha, the average of 18 analysts is that NET stock is worth $125.47, or 4.5% below Sept. 17’s price of $131.41. Moreover, TipRanks indicates that the average of 12 analysts who’ve written on the stock in the last 3 months is $128.90, or 1.91% below Friday’s price.

In other words, just as I have shown, NET stock is probably near a full valuation. Unless sales move dramatically higher, then I don’t see the stock moving significantly higher. This is not really the best way to buy a growth stock. It’s better to wait for a bargain entry point, with a price that gives a margin of safety.

On the date of publication, Mark R. Hake did not (either directly or indirectly) own any of the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Mark Hake writes about personal finance on mrhake.medium.com and runs the Total Yield Value Guide which you can review here.


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