The bit about gross margin concerns me. Let me go back to basics a bit to help explain:
Let’s say that our conventional company has a 23% gross margin. That means it keeps $23 out of every $100 of revenue to cover operating expenses and profit.
Implicit in that statement is that the COGS (Cost of Goods Sold) has been subtracted out in the calculation.
Gross Margin = (Net Revenue - COGS)/Net Revenue
One problem becomes classifying what is a COGS and what isn’t. Typically, anything that scales the more of the thing/service you sell should be considered a COGS. If you make cars, then the steel you buy is a COGS. If you provide SaaS on top of AWS, then you should definitely consider your AWS charges as a COGS.
Here’s an article on the subject: https://www.founderviews.com/cogs-in-saas/
It gets more complicated if, say, your SaaS company hosts its own servers (ZScaler?). Now, when you add a new customer, you probably don’t run out and buy more servers. (But, at some point, you do. Under GAAP rules, you’re supposed to account for that via “absorption costing,” which would spread out the cost of buying and running servers (eg, electricity and support personnel) across all your sold things/services as contributing to COGS. But, the Gross Margin often discussed for investing purposes is the non-GAAP version that doesn’t include overhead, since that tells you something about how much the company can make by incrementally selling more, or what it needs to sell to cover its overhead, etc.)
Obviously, Gross Margin for software companies will be high. This is nothing new. In the old days, when you bought Microsoft Office, the COGS was a DVD (CD or even floppies if you’re really old :^)), a manual, and a box. Today for some software there is no COGS - the customer downloads a file, then runs it and enters a supplied serial number. That’s literally 100% Gross Margin assuming the server hosting the downloadable file and generating serial numbers doesn’t cost you more as you sell more product. But, that doesn’t guarantee profitability by itself.
With software companies, what you have to watch out for are things like development costs. How many software architects, programmers, testers, etc. do they need to hire and for how long and what equipment and environment are needed to support them? The fixed costs for developing software are not to be overlooked. While a company like Ikea that sells furniture can sell the same table design for years and years (which means development costs are one-time and low), companies that sell software are constantly improving and updating the software. So, Ikea has relatively high COGS (particle board, dowels, etc.), with low development costs (designer for a week), while Microsoft had relatively low COGS (a cardboard box with a DVD and manual), but high development costs (thousands of highly paid programmers in Seattle).
As a result, a startup software company might have a super high Gross Margin, but if sales are minimal and development costs are high, that company could be burning cash at a very high rate and losing a ton of money overall.
What’s important here is total revenue and, yes, Revenue Growth. As Saul said, one great thing about a business with a low COGS/high Gross Margin is that when it sells more, more of that revenue goes to cover operating expenses and when that’s covered (and depreciation and taxes also, as in EBITDA), then the rest is profit. And also as Saul said, when a SaaS company’s business model has recurring revenue (customers pay monthly or quarterly or yearly for the service), then it’s not like a car company that has to find new car buyers literally every day because it might be several years before someone who bought a car looks to buy another. So, sales costs can be lower and revenue can be more predictable.
What this diatribe is leading to is that I disagree with Saul on this statement:
We have Factor One – that a company with a higher percentage of gross profit, takes home more dollars out of each $100 of revenue, and thus, by definition, is worth a higher EV/S, even without considering the higher rate of growth.
A software or SaaS company without a high rate of growth that is not yet profitable may take a long time to become profitable, and even if it is profitable may not grow to be much more profitable. Just because a company has a high Gross Profit doesn’t mean that profit is covering expenses - which as discussed can be considerable and ongoing for software - and without a high rate of growth that company may go nowhere for a long time. So I don’t think just having a high GM demands a high EV/S just by itself.
Saul also says:
Any company with 75%, 85% or 95% gross margins can make a profit whenever they decide to!
Again, I disagree. Since R&D costs for developing software aren’t included in COGS, the Gross Margin for software will always be super high, yet if sales aren’t sufficient in quantity then the company will lose money paying hundreds or thousands of software engineers to develop/improve/maintain that software. If they can’t find enough buyers they won’t turn a profit. If they fire the software engineers to reduce overhead costs then their product will probably become less attractive to potential buyers, and maybe quickly. So, even though development costs aren’t considered in calculating Gross Margin, they need to be considered. This is why my parenthetical section above about GAAP and Gross Margin exists, but companies talking Gross Margin aren’t talking GAAP for very valid reasons. It’s not accurate to say that all companies with a high GM can “make a profit whenever they decide” - they have to have a product/service people want to “buy” at a certain price point that results in them covering expenses and such.
Let’s say a SaaS company has a product with a GM of 95%. That company may go bankrupt in short order while another SaaS company has a product with a GM of 99% may make money hand over fist. How’s this possible for just a 4% increase in GM? What considering Gross Margin alone misses is that the first company is selling their SaaS for $100/month with a COGS of $5 while the second company is selling their SaaS for $10,000/month with a COGS of $100. If the costs of developing the software for the two SaaS products is similar, the first company may struggle to survive - with a GM of 95%!
So, I don’t see how Factor One can be considered on its own, unless we’re talking GAAP Gross Margin, in which case I’m wrong here, but I don’t think the Gross Margin numbers being tossed about are calculated under GAAP rules with absorption costing.