Last week, DocuSign Inc. (DOCU, Financial) experienced a significant 13% increase in its stock price in a single trading day, triggered by rumours of a potential sale. The share price, which had dropped to $38.10, has seen a remarkable rebound, rising by approximately 66% to $63.20 at the time of writing.
Despite this surge, the current price remains only 20% off its all-time high of $310, which was reached in September 2021. Determining the fair value of DocuSign is a complex matter that merits further analysis.
Consistently high growth and positive operating cash flow
DocuSign is a market leader in e-signature solutions, allowing users to sign various documents, including contracts, across different devices. The company boasts an extensive network, with over 400 partners, 1.3 million customers and a billion users in more than 180 countries. Its client base spans a broad spectrum, serving multinational corporations, non-profits and government organizations. Beyond e-signature products, DocuSign has diversified its product range to enhance the customer experience in agreement management. This expansion includes Contract Life Cycle Management, Liveness Detection for ID Verification and DocuSign Monitor.
What investors like about DocuSign is its consistent top-line growth over the years. Since 2016, the company has kept growing at double-digit rates, increasing from only $280.5 million in 2016 to more than $2.5 billion in 2023. However, because of the growing operating expenses, DocuSign has kept producing losses. Despite the operating losses, however, the cash flow from operations has been positive since fiscal 2018.
Stock-based compensation is a huge expense
Like many high-tech businesses experiencing growth, DocuSign's significant discrepancy between operating income and operating cash flow can be attributed to substantial stock-based compensation. While investors often overlook stock-based compensation because it doesn't immediately result in cash outflows, it dilutes current shareholders' value through the issuance of stocks at prices below market value. Warren Buffett (Trades, Portfolio) has previously offered insight on perceiving stock-based compensation, noting:
"It has become common for managers to tell their owners to ignore certain expense items that are all too real. 'Stock-based compensation' is the most egregious example. The very name says it all: 'compensation.' If compensation isn't an expense, what is it? And, if real and recurring expenses don't belong in the calculation of earnings, where in the world do they belong?"
Since 2016, the total stock-based compensation at DocuSign has reached a considerable sum of $1.95 billion. This amount represents more than 15.6% of the company's total market capitalization, which is $12.8 billion at the time of writing. This figure is far from negligible, highlighting the substantial impact of stock-based compensation on the company's financials.
Growing quarterly performance amidst rule of 40 challenges
DocuSign recently reported robust earnings for the third quarter of fiscal 2024. The company's total revenue saw a 9% increase, reaching $700.4 million on the back of 9% growth in subscription revenue. There was a notable improvement in net income per share compared to the same period in the previous year. In the prior-year period, DocuSign reported a loss of 15 cents per diluted share. However, DocuSign began to generate increasing profits in the fourth quarter of 2023, with 2 cents per share in earnings. In the third quarter of 2024, DocuSign's earnings reached 19 cents per share.
For SaaS companies like DocuSign, the Rule of 40 is an essential metric for assessing its health and scalability. This rule considers both revenue growth and profit margins. Companies meeting or surpassing the Rule of 40 thresholds typically exhibit the capacity for growth while maintaining sound financial health, making them attractive investment options.
I calculate the Rule of 40 using the net free cash flow margin, adjusted for stock-based compensation. Under this criterion, DocuSign's prospects appear less favorable. The company exceeded the 40% threshold only in 2021 and 2022. In other years, it fell short of this mark, with a particularly low Rule of 40 ratio of just 15% in 2023. This low ratio is primarily attributed to consistently high stock-based compensation, adversely affecting free cash flow and its free cash flow margin.
Source: Author's table
Potential 60% upside
DocuSign's current valuation stands at 4.47 times its enterprise value/revenue, which surpasses the sales multiples of competitors like Dropbox (DBX, Financial) and Box (BOX, Financial). Currently, Dropbox is slightly lower at 4.45 times, while Box has the lowest of the trio at 4.14 times. Despite this, DocuSign's valuation remains relatively inexpensive compared to its historical figures. Over the past five years, its average sales multiple was around 15 times, influenced significantly by the 2020–21 period, when valuations soared between 30 and 37 times.
Research from Aventis Advisors indicates the median enterprise value/revenue multiple for public companies in the software-as-a-service industry averages around 7.7 times.
Looking ahead to full fiscal 2024, DocuSign is projected to generate approximately $2.75 billion in revenue. Using a conservative estimate of 7 times the multiple, the company's enterprise value could reach about $19.25 billion, representing a 60% increase from its current market price.
Key takeaway
While the recent spike in DocuSign's stock was triggered by news of a potential sale rather than reflecting its fundamental market position, the company's overall financial health and growth prospects remain key considerations for investors. Despite challenges such as high stock-based compensation and variable performance against the Rule of 40, DocuSign has demonstrated strong top-line growth and is transitioning toward profitability, as evidenced by its positive earnings per share in recent quarters. Considering the industry's average enterprise value/revenue multiple and DocuSign's projected revenues, there's an indicated potential for 60% upside in its valuation. This assessment suggests DocuSign might be undervalued, offering a significant opportunity for investors. However, this optimistic projection must be balanced against market volatility, the impact of stock-based compensation and other financial metrics to form a comprehensive view of its long-term value and sustainability.
