On May 28, I wrote that Snowflake, the cloud-based data software platform company, had changed my mind. I forecast a higher value for SNOW stock. I projected that it would hit $300 based on my free cash flow (FCF) estimates and FCF yield metrics.
SNOW stock closed on Sept. 23 at $321.50. With close to a $97 billion market value, it is getting hard for me to see how SNOW stock is still undervalued. I certainly did not expect it to rise so fast.
In fact, since the stock troughed out at $188.24 on May 13, it has risen 70.8% in the space of just four and a half months. However, since SNOW stock started this year at $285.41, its year-to-date (YTD) performance is just 14.25%.
And so, despite my fear that the stock could be at full value, I have a sneaking suspicion that the market could pull it higher. In my model, the only way this could happen is if the company eventually produces a much higher FCF margin. Let’s look at this.
Consistent FCF Production
On Aug. 25, the Montana-based company produced its fiscal Q2 results ending July 31. The growth rates were impressive. Its revenue was up 103% on a year-over-year (YoY) basis, and 19% over the prior quarter’s revenue.
The latter implies an ongoing run-rate revenue growth rate of 100% (1.19^4 – 1 = 100%). This is consistent with what happened last quarter as well. In my prior article, I showed that the quarterly run-rate growth rate was 106.6%. It’s good to see that going forward, the company has plenty of growth potential.
One reason for this is that Snowflake has a very large Remaining Performance Obligations (RPO) of $1.5 billion. This represents potential sales in the future from contracts that have already been booked. In other words, it provides a base for sales each year and makes high sales growth even easier to achieve.
But even more importantly, Snowflake produced positive adjusted FCF for the third quarter in a row. The Q2 FCF was $2.8 million, with just a 1% FCF margin. However, the company provided an outlook for the year that assumes that FCF will start to shoot up. They forecast that FCF will hit an adjusted FCF margin of 7% for the full fiscal year.
This implies that FCF could hit $74.55 million if its revenue forecast of $1.065 billion is hit. This has huge implications going forward.
Estimating Future Value of SNOW Stock
Let’s assume that the FCF margin can at least double to 15% by the year ending Jan. 2026, when analysts project revenue will hit $5.85 billion. That implies that by then FCF will reach $877.5 million.
Next, assuming we use a 1% FCF yield ratio (the equivalent of a price to free cash flow multiple of 100) to value that FCF in the future results in a target market cap of $87.75 billion. This valuation is actually now below today’s market cap of $96.739 billion.
But as I pointed out in my earlier article, by that time, four and a half years in the future, the market will adjust. It will then be anticipating at least another 3 to 5 years of growth and pricing the stock accordingly. Part of the reason for this is the steady recurring sales that the company will have with its ever-growing RPO.
Where This Leaves SNOW Stock Investors
This means that it makes sense to use an even more favorable FCF yield — a lower ratio. So, for example, if we divide that $877.5 million target in 2026 FCF by 0.75% (which equals a P/FCF multiple of 133.3 times), the target market value works out to $117 billion. And at a rate of 0.5% (P/FCF of 200 times), then the target market value is $175.5 billion. Both of these targets are substantially higher than today’s market value.
Assuming a 0.75% FCF yield, the implied gain is 20.9% over today’s market value of $96.739 billion. And the 0.50% FCF yield produces an 81.4% upside. The average of these two is a 51.15% upside.
Therefore, I can still see a 51% potential upside in SNOW stock, albeit the most likely return is a 20.9% gain. This means that SNOW stock has a value of between $388.69 (20.9% higher than $321.50 today) and $485.94. The latter is a long-term projection and could take up to 2 to 3 years.
So, despite SNOW stock having reached my target price earlier than expected, I can still see some upside for most investors. Keep in mind, though, that these are nosebleed valuations, and carry a lot of downside risk, especially if the market turns down.
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.