Picking the right SaaS companies to add to your portfolio can feel like a daunting task. There are so many to choose from, and many of them are considered grossly overvalued by most valuation standards.
- Fast revenue growth showing strength of the business
- Improving margins showing scalability
- High insider holdings showing commitment from leadership
- Positive cash flow showing sustainability
- Undiscovered companies based on trading volume
- Under-followed by Wall Street
- Outstanding management teams (based on Glassdoor reviews)
- Appreciating stock price (winners tend to keep on winning)
It's rare to find a company that will satisfy all criteria, even more so at a valuation that appears reasonable.
As I keep refining my screening process before deciding where to invest next, I have come to realize that my biggest winners have an important trait in common: they tend to satisfy the rule of 40, the principle that a software company’s combined growth rate and profit margin should exceed 40%.
As explained by Thierry Depeyrot and Simon Heap, partners at Bain & Company:
"The Rule of 40 [...] has gained momentum as a high-level gauge of performance for software businesses in recent years, especially in the realms of venture capital and growth equity. Increasingly, software industry executives are embracing the Rule of 40 as an important metric to help measure the trade-offs of balancing growth and profitability."
As I looked into the health of the SaaS businesses I either already own or have placed on my watch list, I started to see a clear correlation between their performance as a stock and their efficiency score based on the sum of their revenue growth and profitability.
To be clear, the rule of 40 is not an end-all-be-all kind of score and I think you can find future winners in companies that fail to reach a satisfactory efficiency at a given time. Similarly, a high efficiency score doesn't guarantee a winner either. That's particularly true of fast growers that can see their profile evolve fast.
After playing around with graphs, I've found the following two-step process to be enlightening and visually helpful to educate my next investment decision:
- Create a "rule of 40 map" to visualize the efficiency of SaaS businesses.
- Pit the efficiency score against valuations to see if quality justifies the price.
Let's review and see what conclusions we can reach.
1) Position SaaS businesses on the Rule of 40 map
I have built the SaaS "Rule of 40 map" below using the following criteria:
- Sales growth (yoy) from most recent quarter.
- Operating profit from most recent quarter.
- Selected SaaS companies that I follow and consider part of the App Economy Portfolio "universe" based on extensive research and the criteria detailed in the beginning of this article. Companies selected: MongoDB (MDB), Paycom Software (PAYC), Veeva Systems (VEEV), Adobe (ADBE), The Trade Desk (TTD), Alteryx (AYX), Baozun (BZUN), Square (SQ), Twilio (TWLO), Shopify (SHOP), Elastic (ESTC), AppFolio (APPF), ServiceNow (NOW), Salesforce (CRM), Atlassian (TEAM), HubSpot (HUBS), Five9 (FIVN), Okta (OKTA), New Relic (NEWR), Workday (WDAY), Axon (AAXN), Dropbox (DBX), Zendesk (ZEN), Yext (YEXT), 2U (TWOU), Wix (WIX), BlackLine (BL), Q2 (QTWO), Upwork (UPWK), Box (BOX), DocuSign (DOCU), Splunk (SPLK), Zuora (ZUO), Appian (APPN), Tableau (DATA).
- Important Note: This list doesn't pretend to be a complete view of the public SaaS companies out there, and I would love to hear your feedback if you think some key software companies are missing from the chart.
Source: Data from YCharts. Graph from App Economy Insights. Bubble size based on market capitalization as of 5/27/2019.
Let's look at the map and see what we can learn.
A total of 35 SaaS companies were selected:
- 26% have an efficiency score above 40
- 31% have an efficiency score between 20 and 40
- 43% have an efficiency score below 20
It has been very helpful for me to realize where some of these companies end up appearing on the map. Most of them have yet to turn a profit, but they all have very different stories once you look at their profitability respective to their sales growth.
I identified three categories of interest.
Source: App Economy Insights
1. Proven winners:
The map made me realize how impressive the performance of Paycom Software, Adobe and Veeva Systems (hidden behind Adobe on the map) really is. The three of them are still growing their sales above 25% while delivering outstanding profit margins above 25% as well. These three companies are outstanding performers.
2. Scaling champions:
Many of my favorite and most successful investments end up being very close to the center of the map. They are in a phase focused on the scalability of their business: continued very high sales growth around 40% with profitability close to equilibrium. That includes companies like The Trade Desk, Square, HubSpot, AppFolio or Baozun. Several of them are among the best performers of the App Economy Portfolio.
3. Super-fast growers:
I had not fully realized how astonishing the current growth of Twilio, Elastic and MongoDB really is. They stand out on the map, with MongoDB presenting the most impressive margin profile of the three. These companies are emerging forces in their respective fields and likely to deliver outstanding returns for the years to come. They present a riskier profile since there are more uncertainties around the sustainability of such an impressive growth.
Laggards (efficiency score under 20):
Companies like DocuSign, Tableau, Splunk or even Zendesk are not growing fast enough when you consider their current profitability. I'm less concerned about Zuora or Appian since they are still very small companies under $2.5 billion market cap. Things could improve over time, but they are clearly lagging behind their peers. They present a good opportunity only if you think they can turn things around over the long term and offer a good entry point.
All nine companies that score above the 40 efficiency threshold have completely crushed the market over the years.
If we focus on companies that have IPO'd over the last three years, the difference in performance is staggering:
- SaaS companies above 40 in efficiency score have delivered massive multibagger returns since their IPO.
- SaaS companies below 20 in efficiency score have been disappointing comparatively.
Overall, it appears wise to build core positions in companies that can maintain a high efficiency score over time.
Now that we have identified who the winners are and where they are positioned on the map, the next step is to understand their corresponding valuation and to what extent you have to pay up for excellence.
2) Pit the rule of 40 against valuations
Source: Data from YCharts. Graph by App Economy Insights. Bubble size based on market capitalization as of 5/27/2019.
Given that the vast majority of these software companies have yet to turn a profit, the only way to pit them all against a comparable valuation metric is to use Enterprise Value to Sales ratio.
I really enjoyed seeing this chart coming to fruition. I added a trendline to illustrate the correlation between efficiency score and valuation.
Before considering a company as over or under-valued, it seems relevant to compare it to similar performers.
If we assume that the trendline represents what a "fair" valuation could be among this set of 35 SaaS companies, the companies that are overvalued are above the trendline, while the companies that are undervalued are below the trend line.
- Companies like Zuora, AppFolio or Alteryx appear fairly valued.
- Companies like Okta and Atlassian appear overvalued.
- Companies like Salesforce, Adobe or Baozun appear undervalued.
Here are immediate actions I took from the chart:
- I would rather add to companies that are below the trendline.
- Focusing on companies that are winners of the rule of 40 (in green), my SaaS watch list should be narrowed to a selected few: Paycom Software, Adobe, Square, The Trade Desk, Baozun and Alteryx.
- While I really like both companies, I am not considering adding to Okta or Atlassian in the near future given their extremely stretched valuations.
The process of choosing the right SaaS to buy next is not an easy one. But with the help of a clearly laid out approach and using the right KPIs, I believe you can make better decisions.
A thorough review of efficiency scores and how they translate into valuations is a great way to gauge the price and quality of a SaaS business. One way among many others to prioritize your watch list and educate your strategy.
- What do you think of the rule of 40 map and how efficiency scores compare to valuations?
- Does it change the way you look at some of these companies?
Let me know in the comments!
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The rise of the App Economy is disrupting many industries: retail, entertainment, financials, media, social platforms, healthcare, enterprise software and more.
While keeping in mind some of the best recommendations from experienced gurus of Wall Street such as Warren Buffett, Peter Lynch, Burton Malkiel or Philip Fisher, I am trying to beat the S&P 500 index by a significant margin.
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Disclosure: I am/we are long MDB PAYC TTD BZUN SQ SHOP APPF HUBS ZUO APPN. 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.