Salesforce (NASDAQ:CRM) is a company that develops enterprise cloud computing solutions with a focus on customer relationship management worldwide. The stock has been on a terrific run so far this year. However, in my view, the firm doesn’t have a concrete edge over its competitors, and the market may be overestimating its value. Hence, my take on CRM stock is neutral.
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Evaluating Salesforce’s Competitive Advantage
Let’s talk about how to evaluate a firm’s edge over rivals. We can discern this through its income statement using two methodologies. The first one revolves around the concept of earnings power value (EPV).
EPV refers to the after-tax adjusted EBIT divided by the weighted average cost of capital. You can gauge the reproduction value via the total asset value. A firm is considered to have a competitive edge if its EPV exceeds its reproduction value. The calculation is as follows:
Salesforce’s average EBIT margin in the past five years was 3.4%. Using its revenue for the last 12 months, its adjusted EBIT is:
- $32.18 billion x 0.034 = $1.094 billion
Using a corporate tax rate of 21%, the after-tax adjusted EBIT is:
- $1.094 billion x (1 – 0.21) = $864 million
Salesforce’s weighted average cost of capital is 10.5%. Therefore, the earnings power value is:
- $864 million / 0.105 = $8.228 billion
Considering Salesforce’s total asset value of $93.5 billion, it may lack a competitive edge with its current numbers. However, it’s important to note that some further adjustments need to be made. In fact, we need to create a scenario where the company shifts its focus from growth to profitability. This would require estimating its maintenance operating expenses which, as the name implies, is the minimum amount of investment the company would require to maintain its current revenue.
This is difficult to do, so instead, I will reverse engineer the amount of spending reduction needed to generate $93.5 billion in earning power by multiplying it by the weighted average cost of capital and subtracting its average EBIT:
- $93.5 billion x 0.105 = $9.8175 billion
- $9.8175 billion – $1.094 billion = $8.7235 billion
Thus, this means that Salesforce would need to cut spending by more than $8.7235 billion to have an EPV greater than its total asset value. Considering that it has total operating expenses of more than $20 billion, it does seem that CRM has the potential to have a competitive advantage. However, it remains difficult to know for certain how such drastic spending cuts would actually impact the business.
The second approach to assessing a firm’s edge involves analyzing its gross margins, which reflect the excess amount customers are willing to pay over a product or service’s cost.
When a firm’s gross margin expands, it signals the presence of a sustainable competitive edge. Without such an edge, newcomers to the market could potentially chip away at the existing firm’s market share, resulting in shrinking gross margins due to ensuing price wars to stay competitive.
Salesforce’s gross margins have basically remained flat in the past five years. However, these levels are lower than its gross margin in 2012 (78.4%). The company saw a steady decline from 2012-17 and has also been declining over the past three years. As a result, its gross margins indicate that a competitive advantage is not present in this regard either.
Salesforce Stock Might be Overvalued
Salesforce has had a strong run on a year-to-date basis, rallying over 57%. However, this run has likely pushed the stock into overvalued territory.
To value Salesforce, I will use the H-Model, which is similar to a three-stage DCF model. The H-Model assumes that growth will decelerate linearly over a specified period of time. I believe this is a reasonable assumption as companies gradually slow down as they mature.
The formula is as follows:
Stock Value = (CF(1+tg))/(r-tg) + (CFH(hg-tg))/(r-tg)
Where:
- CF = cash flow per share
- tg = terminal growth rate
- hg = high growth rate
- r = discount rate
- H = half-life of the forecast period
For Salesforce, I used the following assumptions:
- CF = $7.22 per share
- tg = 3.87% (set as the 30-year U.S. Treasury yield)
- hg = 23.4% (five-year FCF CAGR)
- r = 10.8%
- H = five years (I am assuming it will take 10 years to reach terminal growth)
As a result, I estimate that the fair value of Salesforce is approximately $209.92 under current market conditions.
Is Salesforce a Buy or a Sell?
Turning to Wall Street, analysts have a Moderate Buy consensus rating on CRM stock based on 22 Buys, 10 Holds, and one Sell assigned in the past three months, as indicated by the graphic below. In addition, the average price target of $239.10 per share implies 12.97% upside potential.
Takeaway: The Market May be Overestimating Salesforce
While Salesforce is undoubtedly profitable and continues to grow, it doesn’t possess a discernible competitive edge compared to other firms. Furthermore, its intrinsic value appears to be lower than its current price, which suggests to me that analysts might be overly optimistic in their price projections.
