A Top Down Apprach to Understanding SaaS Value Creation
Software as a Service (SaaS) stocks are all the rage at present. The 53 companies in the Bessamer Venture Partners (BVP) Cloud Index have a median market cap of US$2.4bn. However, only 17 are profitable at the EBITDA line and these trade on a median EV/EBITDA multiple of >50. On traditional metrics this screams Bubble. Maybe, maybe not.
In this series of posts we will examine the Value Stories that are told by investors about how SaaS companies create value. Like all growth companies, these stories centre around the ability of the company to create value by investing capital at positive rates of return. However, because high growth software firms often tend to have low or negative levels of profitability, analysing value creation through accounting earnings is usually ineffective. Instead, the shorthand approach of most investors is to value such stocks based on both the level and rate of growth of sales. Is this reasonable?
The Importance of Sales
Whilst its important to be sceptical of valuation metrics that don’t relate to free cash flow, for software companies there are some good reasons why sales and sales growth can be linked to this ultimate objective:
- Software operations generally involve high fixed costs of software development and platform administration offset by high gross margins. Therefore sales growth is a proxy for incremental cash flow growth; and
- The costs of growth, R&D and Customer Acquisition Costs, are usually expensed as incurred. This depresses short term accounting profits and measurement of return on investment, even where the true return on investment is very favourable.
With this is mind, how do we understand the twin pillars of opportunity to deploy capital and the return the company will generate on that capital.
Step 1 – The Ability to Deploy Growth Capital