On Monday, CNBC's Jim Cramer unveiled "quick and dirty" tricks that investors can use to value corporate software stocks as a Wall Street expert.
High-level cloud stocks have hit double digits in recent weeks due to the shift from secular to cyclical investments. Because of this, the "Mad Money" host warned that it is time to be "more selective."
"When you make that kind of decision, it has to be relentlessly logical, not emotional. We're in sorting mode, and that means we need to be as objective as possible," he said. "Let's go through our entire cloud universe through these two filters – one is for fundamentals, one is for evaluation. Anything that passes both filters, well, so you'll have my blessing here after the big sale." "
The first tool Cramer broke is the 40 rule, where a company's revenue growth and profit margin must reach 40% or more. Venture capitalists and hedge funds use the rule to calculate the growing tradeoff and profitability. Anything below this limit is a red flag for a stock portfolio.
A combination of 30% revenue growth and 20% profit margin passes the screening. A measure of 70% revenue growth and a 20% negative profit margin is also a positive note, but 50% growth and a 15% negative margin are a flaw.
"I like this 40 rule because it recognizes that there are two ways to win," Cramer said. "Healthier cloud stocks are growing too fast and losing money or their growth is slowing, but they are getting stronger gains."
Using EBITDA – adjusted earnings before interest, taxes, depreciation and amortization – for profit margin, Cramer determined that all seven stocks in his so-called Cloud Kings pass, led by Twilio and Adobe, with scores of 82% and 68% respectively. Among Cloud Prince's riskiest group, New Relic and Okta fall short.
A second test by which Cramer suggested investors look at cloud names is the assessment. Shares that trade above 10 times sales fail, "unless we can make up a very good excuse," he said.
The host gave Adobe, which is sold by sales estimates 10.4 times in 2020, a pass because of its profitability. However, ServiceNow, eleven times the forecast for 2020, has not made its cut.
"When you try to be objective about cloud stocks, the ones you keep are Adobe, Salesforce, Splunk, Twilio, VMware, Workday, HubSpot, Five9, RingCentral, Zendesk and Dynatrace," said Cramer. "Everything else … you need to be much more cautious."
WATCH: Cramer explains how to evaluate cloud stocks
Disclosure: The charity Cramer owns shares of Salesforce.com and Twilio.
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