NET Price Drops. What Do the Numbers Tell Us?

One of the biggest losers as of today's morning session is software company Cloudflare, whose shares are down -3.7%, underperforming the Nasdaq by -3.0%.
At $67.63, NET is 17.58% above its average analyst target price of $57.52.

The average analyst rating for the stock is buy. NET underperformed the S&P 500 by -4.0% so far today, but outpaced the index by 38.0% over the last year with a return of 55.0%.

Cloudflare does not release its trailing 12 month P/E ratio since its earnings per share of $-0.56 are negative over the last year. But we can calculate it ourselves, which gives us a trailing P/E ratio for NET of -120.8. Based on the company's positive earnings guidance of $0.42, the stock has a forward P/E ratio of 161.0. The average trailing Price to Earnings (P/E) ratio of US-based technology companies is 27.16 as of first quarter of 2023. In contrast, the S&P 500 average is 15.97. The P/E ratio is the company's share price divided by its earnings per share. In other words, it represents how much investors are willing to spend for each dollar of the company's earnings (revenues minus the cost of goods sold, taxes, and overhead).

NET’s price to earnings ratio can be divided by its projected five-year growth rate, to give us the price to earnings, or PEG ratio. This allows us to put its earnings valuation in the context of its growth expectations which is useful because companies with low P/E ratios often have low growth, which means they actually do not present an attractive value.

When we perform the calculation for Cloudflare, we obtain a PEG ratio of 3.2, which indicates that the company is overvalued compared to its growth prospects. The weakness with PEG ratios is that they rely on expected growth estimates, which of course may not turn out as expected.

To better understand the strength of Cloudflare's business, we can analyse its operating margins, which are its revenues minues its operating costs. Consistently strong margins backed by a positive trend can signal that a company is on track to deliver returns for its shareholders. Here's the operating margin statistics for the last four years:

Date Reported Total Revenue ($ k) Operating Expenses ($ k) Operating Margins (%) YoY Growth (%)
2022-12-31 975,241 943,834 -20.63 -6.07
2021-12-31 656,426 636,976 -19.45 21.48
2020-12-31 431,059 436,772 -24.77 34.14
2019-12-31 287,022 331,545 -37.61 n/a
  • Average operating margins: -25.6%
  • Average operating margins growth rate: 13.9%
  • Coefficient of variability (lower numbers indicate less volatility): 32.5%

Another key to assessing a company's health is to look at its free cash flow, which is calculated on the basis of its total cash flow from operating activities minus its capital expenditures. Capital expenditures are the costs of maintaining fixed assets such as land, buildings, and equipment. From Cloudflare's last four annual reports, we are able to obtain the following rundown of its free cash flow:

Date Reported Cash Flow from Operations ($ k) Capital expenditures ($ k) Free Cashflow ($ k) YoY Growth (%)
2022-12-31 123,595 -163,364 -39,769 7.71
2021-12-31 64,648 -107,738 -43,090 53.21
2020-12-31 -17,129 -74,962 -92,091 4.27
2019-12-31 -38,917 -57,279 -96,196 n/a
  • Average free cash flow: $-67786500.0
  • Average free cash flow growth rate: 19.8%
  • Coefficient of variability (the lower the better): 45.0%

If it weren't negative, the free cash flow would represent the amount of money available for reinvestment in the business, or for payments to equity investors in the form of a dividend. While a negative cash flow for one or two quarters is not a sign of financial troubles for NET, a long term trend of negative or highly erratic cash flow levels may indicate a struggling business or a mismanaged company.

Another valuation metric for analyzing a stock is its Price to Book (P/B) Ratio, which consists in its share price divided by its book value per share. The book value refers to the present liquidation value of the company, as if it sold all of its assets and paid off all debts. As of the first quarter of 2023, the average P/B ratio for technology companies is 6.23. In contrast, the average P/B ratio of the S&P 500 is 2.95. Cloudflare's P/B ratio indicates that the market value of the company exceeds its book value by a factor of 34, so it's likely that equity investors are over-valuing the company's assets.

Since it has a negative P/E ratio, an elevated P/B ratio, a pattern of improving cash flows with an upwards trend, Cloudflare is likely overvalued at today's prices. The company has mixed growth prospects because of a negative PEG ratio and consistently negative margins with a positive growth rate. We hope you enjoyed this basic overview of NET's fundamentals. Make sure to check the numbers for yourself, especially focusing on their trends over the last few years.

The above analysis is intended for educational purposes only and was performed on the basis of publicly available data. It is not to be construed as a recommendation to buy or sell any security. Any buy, sell, or other recommendations mentioned in the article are direct quotations of consensus recommendations from the analysts covering the stock, and do not represent the opinions of Market Inference or its writers. Past performance, accounting data, and inferences about market position and corporate valuation are not reliable indicators of future price movements. Market Inference does not provide financial advice. Investors should conduct their own review and analysis of any company of interest before making an investment decision.