Enterprise Software Company Stocks Datadog (DDOG 6.84%), MongoDB (MDB 4.29%)and Twilio (TWLO 1.75%) rebounded this week, up 25.5%, 21.4% and 18% on the week to Friday, respectively.
There wasn’t much company-specific news this week. However, each is a very high growth stock, with much of its earnings far in the future. Thus, they are extremely sensitive to long-term interest rates. After six months of sluggish but seemingly rising long-term yields, yields have pulled back significantly this week. High-growth stocks, which began falling last November before the indices, rebounded strongly in response.
The enterprise software sector is, all other things being equal, a very attractive sector. These tools help businesses run and become more productive, and they tend to be “sticky” products. After all, it’s a pain for companies to switch and retrain their entire workforce on a new software system, and you’re not going to stop using software if the economy is in a downturn. Meanwhile, recurring subscription revenue is quite attractive, especially during lean times or recessions.
Yet many enterprise software stocks trade at very high earnings multiples. In the case of these three companies, there are still no profits to speak of, although Datadog is marginally profitable. Datadog and MongoDB are trading at very high sell multiples, although they are well below their highs. Although Twilio trades at a more reasonable price-to-sales ratio of 5.6, it also generates massive losses on its bottom line that the other two companies do not generate.
Since most of the value of these companies is far in the future, the discount rate used by investors to discount these future earnings into present value terms is very important. This discount rate is usually based on a premium added to the long-term risk-free rate, for which many investors use the yield on 10-year Treasury bonds as a proxy.
After the Federal Reserve raised the federal funds rate by 75 basis points in the previous week, long-term rates fell in anticipation of an economic slowdown. Since hitting a high around 3.48% on June 14, the 10-year rate ended this week at 3.12%. That’s a pretty big reversal in a short period of time and has proven to be a boon for high-growth software stocks.
Additionally, the University of Michigan’s June consumer survey of inflation expectations over the next five years was revised down to 3.1% on Friday from 3.3% reported earlier. in the month. This may have signaled that inflation expectations are not as entrenched as some thought at the start of the month, so the economy may not need much higher interest rates to rein in. inflation.
Even though these stocks had a nice rebound this week and each company is doing well, these stocks are still quite expensive. Although high-priced growth stocks have performed phenomenally over the past few years, it is unclear whether interest rates will return to the extremely low levels seen during the pandemic.
Plus, these companies already have significant growth in their stock prices, and it becomes harder to grow the bigger you get. All three appear to have bright futures, but a high valuation leaves relatively little room for error. So while these companies may be back to all-time highs, I still wouldn’t call them “cheap” even after their massive sales this year.
Datadog and MongoDB seem to be particularly disruptive products with large addressable markets, so they are on my watch list. However, they are only suitable for young investors in high-growth stocks who can tolerate large short-term declines, and not for older investors nearing retirement.