NOW Stock Analysis: Why ServiceNow Remains a Top Tech Investment

Posted by Admin August 14, 2024 Tech

If somebody told you that you could generate a 37.4% annual return from an IPO over the next 12 years, most investors would sign up for that opportunity. That’s what happened to longtime ServiceNow NOW shareholders who bought NOW stock in the IPO and are still holding.

I’m not sure if I’ve ever written about the company. Its digital workflow automation platform helps over 8,100 global companies transform their businesses, including approximately 85% of the Fortune 500.

In 2024, its shares are up nearly 18%, which is 529 basis points better than the S&P 500 but considerably less than its 12-year performance.

As I said, I’m a neophyte regarding ServiceNow’s business. Perhaps its growth is shot. I really couldn’t tell you.

But considering its track record, I really want to find out whether that’s true or investors are just staying away from most tech because they view valuations as stretched even with the latest correction – the Nasdaq 100 down nearly 9% – over the past month.

Here are my thoughts.

A High Return on Invested Capital

I recently wrote about three stocks with high returns on invested capital, defined as the company’s profit divided by the sum of its common stock’s carrying value (book value on the balance sheet), preferred stock, long-term debt and capitalized lease obligations.

According to Morningstar.com, ServiceNow’s five-year average ROIC is 10.31%, which makes the cut, but barely. In the trailing 12-months ended June 30, it’s 8.59%.

However, it’s essential to remember that ROIC isn’t nearly as important for software companies as it is for more capital-intensive businesses – further, ServiceNow’s after-tax income changes occasionally because of a valuation allowance against its deferred tax assets.

“The income tax benefit was $723 million for the year ended Dec. 31, 2023. The income tax benefit was primarily attributable to the release of the valuation allowance of certain U.S. federal and state deferred tax assets,” states pg. 46 of its 2023 10-K.

Its pretax income, which excludes the tax benefit, was still $1.01 billion in 2023, 153% higher than in 2022. Through the first two quarters of 2024, its pretax income was $759 million, double what it was in 2022.

What’s important is that its revenues and profits continue to grow.

Free Cash Flow and NOW Stock

One metric I use for valuation purposes is free cash flow yield. That’s defined as free cash flow for the trailing 12 months divided by enterprise value. Its FCF in the trailing 12 months through Q2 2024 is $3.05 billion.

Based on an enterprise value of $163.81 billion, its FCF yield is 1.9%. On the surface, that’s not a great yield. Anything under 4% is an overvalued territory.

However, when you consider that its free cash flow has never been higher – in 2018, it was $587 million – growing by 35% compounded annually over the past 5.5 years, it’s much easier to accept the valuation.

Further, considering that it expects subscription revenue of $10.58 billion in 2024 and a free cash flow margin of 31%, its 2024 free cash flow should be $3.28 billion, 21% higher than $2.70 billion in 2023.

As long as it continues to grow its annual revenues by 20% or more, the free cash flow will continue to grow.

At the end of Q2 2024, it had $18.6 billion in RPOs (remaining performance obligations), with the current RPOs expected to keep growing at 20% or more, providing at least a year or two of future revenue.

These seem healthy from where I sit as a relative newbie to NOW stock.

Bill McDermott is a Quality CEO

As soon as I saw Bill McDermott’s name in the Q2 2024 news release, I remembered that I’d written about him and ServiceNow in March 2023.

McDermott had just sold 54,000 shares of NOW stock for $25 million to pay for some real estate. That’s some real estate. Investors often make a big deal about CEOs selling stock.

I believe stock sales are done for many reasons, few, if any, related to the CEO’s opinion of the share price or valuation. At the time, the company said McDermott was bullish about NOW stock.

According to McDermott’s Form 4, the CEO held 1,667 shares directly and 1,933 indirectly after the February 2023 stock sales. As of McDermott’s most recent filing on Aug. 9, he had 3,051 directly and 17,177 indirectly, nearly 6x what he owned 17 months ago.

Clearly, he continues to believe in the company and NOW stock. With over 100,000 shares beneficially owned that have yet to vest or have vested but not yet been exercised, McDermott has millions of reasons to keep pushing ServiceNow’s growth.

He’s exceptionally well compensated, but NOW has significantly outperformed the S&P 500 and Nasdaq 100 during his five-year tenure.

As long as he’s CEO, ServiceNow is a buy.

On the date of publication, Will Ashworth did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.comPublishing Guidelines.

On the date of publication, the responsible editor did not have (either directly or indirectly) any positions in the securities mentioned in this article.

Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia.