SaaS Valuation: 10x Multiple Does Not Apply; 30x Sales Is The New Bar

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Includes: MDB, TEAM, TWLO, ZS
by: Rajesh Kumar
Summary

There is a paradigm shift in the new SAAS-based software companies and how they operate and create long-term value.

Understanding the moat of the company, substitutes available, switching cost, and the network effect is the key to valuation.

Choosing Founder-led companies helps in getting long-term winners.

Looking at forward growth and total addressable market (TAM), optionality is key to picking long-term winners.

As investors get excited with the paradigm shift in the investment philosophy for the new SAAS-based software companies, I remember Marc Andreessen's famous quote more than a decade back,

In short, software is eating the world - Why Software Is Eating the World

It's a world full of opportunities in the SAAS space, but a lot of these companies still have not proved their mettle for the common man on the street. In this article, I want to look at how we arrive at a sane decision and hold the butterflies in the stomach when a stock like MongoDB (NASDAQ:MDB) falls 15% on a single day because Amazon (NASDAQ:AMZN) is mentioned as entering the same field, or Atlassian (NASDAQ:TEAM) falls 10% because they just met expectations of 30% revenue growth, which they have been achieving for the last 12 quarters.

I can relate from my personal experience that it's difficult to spot a diamond in the rough because there isn't a lot of data available to compare and contrast this new breed of companies. If someone is able to successfully pull this off, one could retire a decade earlier than planned. Companies like Adobe (NASDAQ:ADBE) and TEAM have already shown the power of the SAAS model. In the past, investors used to talk about stocks as richly valued at 5X the sales or Enterprise value (EV), but now, we see companies in this space trading at 20-30x sales of EV or sales. So, instead of pondering on what is a good multiple to enter a stock, I would suggest making investment decisions based on fundamentals that are completely realigned. Let me try to outline how I look at this problem and make decisions.

The most important things to look at are the basic evaluation parameters like "how big is the moat of the company products or services", what substitutes are available, what is the switching cost, and what is the network effect being created. Let me take some examples to explain each of these:

  • Zscaler (NASDAQ:ZS) has a great SAAS-based security product that has no equivalent substitute in the new cloud tech economy, and they have been creating the network effect one client at a time. Each new client adds to its endpoint network analytics, and they are able to build analytical models to decipher security threats that benefit their entire client networks. In my mind, they are disruptors and redefine this category as no other company because they have redefined this space.
  • Twilio (NYSE:TWLO) provides the nuts and bolts infrastructure for the tech space used by over 25,000 clients to build their own services and products. This is an example of the classic switching cost moat. There may be substitutes, but very few dismantle their utility and plumbing just because they could get a substitute, unless it really is a game-changer. Twilio's products are entwined into every aspect of the cloud-based economy - an Uber (NYSE:UBER) connects through them, and an Airbnb (AIRB) gets its payments completed with Twilio's underlying infrastructure. Each new client that creates a new use or adds to its endpoint solidifies the moat for TWLO.
  • TEAM is an example of a company that defies conventional software sales models. They have created a viral network of techie aficionados (think Apple (NASDAQ:AAPL) in its early days), and these developers have become the de facto sales team for them, as they don't have a sales and marketing team on the ground in the traditional way B2B software companies do business. I am not sure what do we call this moat, but I can definitely see the network effect playing besides their ability to be nimble and agile and keep innovating the value they provide to their existing client base.

The next critical element is choosing Founder-led companies, and one would have seen and read a lot on how these founders stretch their companies' ability to deliver what the client needs. We have already seen how, in the services sector, companies like Amazon, Netflix (NASDAQ:NFLX), Alibaba (NYSE:BABA), and many more have redefined investment returns in the last decade, and this is spreading across the entire technology space. How could an investor recognize the strategies to find Founder-led visionary companies that are winners in the next decade could be an article in itself.

The next criteria would be evaluating the stock price vis-a-vis the forward growth rate and TAM. This is one of the trickiest parts of the decision-making process. As an investor in my early days, I would always look at buying a stock at its lowest point, until I realized my folly. Having missed a few multi-baggers, I learnt from experience that any stock would always have been lower at some stage. Trying to time the lowest price would be similar to the odds of winning a lottery ticket. Instead of trying to win the lottery, I started looking at what are the growth probabilities looking forward and analyzing how much could the stock price grow into, based on the TAM and growth rates. Hence, I suggest taking a bite-sized position and cost average the next few lots. The risk of sales multiple being a stretch is always imminent, but as a thumb rule, one should be okay with a multiple that is 1/2 to 1/3 times the growth rates + Op margins combined. Let me explain this with an example - a company like TWLO is growing 60% yoy and an ARR (the value of the contracted total recurring revenue components of the subscription revenue normalized to a one-year period) of 130% and with a solid expanding TAM (this can be seen from the increasing ARR). I would be okay paying a 20-30 times multiple for the initial lot because they are growing at 60% and are almost profitable on Op margins and then adjust the next lots to buy based on analysis of parameters like growth, Op margin expansions, competition, and other financial metrics that make sense.

Having optionality to grow into new areas is the next criteria, and let's take Intuitive Surgical (NASDAQ:ISRG) instead of a typical SAAS company. ISRG has redefined the medical equipment paradigm with a decade of success. They are also transforming their business into a recurring SAAS model, with their new leasing model and analytics offering. They built a great franchise starting with urology and gynecology and now have 5 areas, having, in the recent past, expanded into head and neck and lung. This has allowed ISRG to keep expanding their revenue sources (TAM), and as I stated earlier, a company with a high ARR from the same client increases the TAM and has a bigger runway to grow and excel. TWLO would be another great example of a company having started with an ARR of 120% and now in the 140% ranges. They are able to monetize the same client year over year (yoy), thus allowing them to increase the life time value of the client for the same marketing dollars that are spent to acquire the initial customer.

Summary

As the SAAS companies expand, no one is sure how to evaluate these new business models and price them as yet, but as one can see from the Zoom (NASDAQ:ZM) IPO, people are beginning to realize this. The traditional valuation models don't apply when a customer is acquired in the 1st year. But the company already spent all the marketing costs upfront, and profits are to be driven in the next few years from this customer. An investor needs to be comfortable to pay X times the sales as the company increases the value of this customer and the leverage kicks in. The revenue would grow 5X in the next 6 years from this same customer if the ARR is 130% and profitability begins to touch closer to the gross margins, minus the SG&A/R&D for this unit customer. If an investor is able to decipher the optimal multiple and leverage the volatility of the SAAS models (e.g. buying in multiple lots), they could make a good return from these SAAS companies.

Happy investing to the SAAS hunters.

The author runs an investment advisory to help clients manage portfolios and allocations and also helps clients identify and invest in early-stage startups through a startup fund.

Disclosure: I am/we are long TEAM,ZS, TWLO, MDB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.