I have wanted to opine on this thread, but I’ve been very slow in collecting my thoughts. Unfortunately it’s veered into a GAAP / COGS discussion, but maybe we can get it back.
You see, it’s not about Gross Margin. That’s one component of the value of SaaS companies: they are software companies. But it’s not the only component, or even the most important. So let’s not dwell on it. What Saul has laid out is a cumulative case. It explains why these companies are valuable. I think we all believe that is true.
One way to look at this, as some have pointed out before, is the LTV to CAC ratio. With all SaaS companies, the LTV (life time value) of a customer is (or at least should be) several times that of the CAC (Cost of Acquiring a Customer). So we need to consider the LTV of a customer. Will the customer spend more in the future? SaaS customers usually do. Will they remain a customer for the foreseeable future? SaaS customers often do.
Also, there are other levers SaaS companies can pull, the most obvious being reducing OpEx and thereby increasing profitability. Just a few minutes ago Dreamer pointed to VEEV and the profits they are generating. Most SaaS companies focus on maximizing revenue growth, but apparently revenue growth in the 20’s and rapidly growing profits works too. The key is how long the revenue will be able to grow into the future, and how much leverage the company still has to drive more and more profit to the bottom line. This method has worked for PAYC too.
I guess I just take what I consider to be a common sense approach. Yes, our SaaS companies are amazing. Yes, they will probably continue to be. But yes, they are also about twice as expensive on average than they were two years ago. Maybe they are more fairly valued now than they were then. But they are certainly less of a bargain. So the issue is how much future growth you have to pay for now. In short, I very much agree with what Dreamer just said:
Whether AYX, ZS, ESTC, SMAR and others can get to $1b-2b/yr runrate is a separate question, but I think the market is modeling a future state that looks something like what they see from CRM, NOW, VEEV and other more mature companies. [Larger companies with a SaaS model have shown] how dramatically their profitability can grow as they scale, whether you look at it as profit dollars or profit %.
My quibble is just in how far-future-baked some of these valuations are, like with ZM. If you go into a stock hoping to get an eventual double or triple over X amount of years, and the starting point is $20b mkt cap at 60 P/S, that just seems a lot less likely to happen vs a $5-10b mkt cap at 16-30 P/S.
My common sense approach is to own some that are growing like weeds, but with PS ratios in the 20s, and some growing not as fast, but with PS ratios in the low to mid teens. (If I could find companies growing like weeds with PS ratios in the low to mid teens, obviously I’d prefer that…but those don’t seem to exist right now.) What I don’t seem to be able to convince myself to do is to own companies with a PS over 30 or 40 or 50 or 60. There are just too many other good companies on offer where you aren’t paying for so much future growth, even though I’m still expecting the growth (MDB, AYX, TWLO, ESTC, etc).
Just another Fool’s perspective. Good discussion, Saul.
PS As JAF pointed out, Fish’s reminder is crucial: If you invest like [Saul] you need to be on top of things. Having a concentrated portfolio does not allow you to sit back and buy and forget. Please remember this. You can’t just buy companies we discuss and hold them. You can’t even just buy what Saul is in. You have to evaluate your holdings daily.
I consider my method very similar to Saul’s, except that I have taken to holding some cash as valuations of all our companies have risen. There’s no shame in trimming a position as it grows over 10% or 15% and then considering buying some back if it drops. If it just keeps going up, you’ll still have enough. Trust me – that’s what’s been going on since late 2016.