On Monday, Jim Cramer revealed ‘quick and dirty’ tricks that investors may use for assessing enterprise software stocks like a Wall Street expert.
In recent weeks because of the rotation from secular to cyclical investments high-flying cloud equities have taken double-digit. Thus, the ‘Mad Money’ host warned that it’s time to be ‘more selective.’
He said, ‘When you make these types of decisions, you need to be ruthlessly reasonable, not emotional. We’re in triage form, and that means we must be as objective as possible.’ ‘Through these two filters, we’re going to run our entire cloud universe, one is for fundamentals and another is for valuation. Whatever thing that passes both filters, well then you’ve got my blessing to obtain down here after the big sell-off.”
The first tool that Cramer broke down is called as the rule of 40, where the revenue growth and profit margin of a company must add up to 40% or more. Hedge funds and venture capitalists use the rule for calculating the tradeoff in profitability and growth. For a stock portfolio, anything below that threshold is a red flag.
A combination of a 20% profit margin and a 30% revenue growth profit margin passes the screening. A valuation of 70% revenue growth and a negative 20% profit margin is also a passing evaluation, but a negative 15% margin and 50% growth is a failing mark.
Using EBITDA, adjusted earnings before taxes, interest, amortization and depreciation for profit margin, Cramer determined that all 7 stocks in his ‘Cloud Kings’ bucket pass, led by Adobe and Twilio with scores of 68% and 82%, respectively. Among his riskier ‘Cloud Prince’ group, both Okta and New Relic come up short.
Another test suggested by Cramer to investors to run the cloud names through is valuation. Stocks that deal above 10-times sales fail, he said ‘unless we can come up with a very good excuse’.
He further added, ‘When you endeavor to be objective about the cloud stocks, the ones that you to keep are Salesforce, Workday, Adobe, RingCentral, Dynatrace, HubSpot, Twilio, Splunk, Five9, VMware and Zendesk. ‘Everything else, you need to be a lot more careful.’