CNBC's Jim Cramer on Monday revealed "quick and dirty" tricks that investors can use to assess enterprise software stocks like a Wall Street expert.
High-flying cloud equities have taken double-digit hits in recent weeks due to the rotation from secular to cyclical investments. Because of this, the "Mad Money" host warned it's time to be "more selective."
"When you make these kinds of decisions, you need to be ruthlessly logical, not emotional ... We're in triage mode, and that means we need to be as objective as possible," he said. "We're going to run our whole cloud universe through these two filters — one is for fundamentals, one is for valuation. Anything that passes both filters, well then you've got my blessing buy down here after the big sell-off."
The first tool that Cramer broke down is what's called the rule of 40, where a company's revenue growth and profit margin should add up to 40% or more. Venture capitalists and hedge funds use the rule to calculate the tradeoff in growth and profitability. Anything below that threshold 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 negative 20% profit margin is also a passing grade, but 50% growth and negative 15% margin is a failing mark.
"I like this rule of 40 because it recognizes that there are two ways to win," Cramer said. "The healthiest cloud stocks are either growing very rapidly and losing money or their growth is slowing, but they've got increasingly strong earnings."
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' bucket pass, led by Twilio and Adobe with scores of 82% and 68%, respectively. Among his riskier 'Cloud Prince' group, both New Relic and Okta come up short.
A second test that Cramer suggested investors run the cloud names through is valuation. Stocks that trade above 10-times sales fail, "unless we can come up with a very good excuse," he said.
The host gave Adobe, which sells for 10.4-times 2020 sales estimates, a pass because of its profitability. However, ServiceNow at eleven times its 2020 forecast did not make his cut.
"When you try to be objective about the cloud stocks, the ones that you to keep are Adobe, Salesforce, Splunk, Twilio, VMware, Workday, HubSpot, Five9, RingCentral, Zendesk and Dynatrace," Cramer said. "Everything else ... you need to be a lot more cautious."
Disclosure: Cramer's charitable trust owns shares of Salesforce.com and Twilio.