Software as a Service Company (SaaS) has been the growth engine of the software industry for the past 20 years.

However, few investors fully understand this business model and some may be shocked by the high P/E ratio of SaaS equities.

Does that mean SaaS companies are overrated?

In this article, we will go into detail about the SaaS industry and introduce some key metrics for evaluating SaaS companies.

SaaS Industry Overview

The SaaS model has changed the way the software industry does business.

In the past, traditional software companies offered self-hosted solutions where users buy and install software on their own servers or devices, and then pay a one-time fee to use the software indefinitely.

With the rise of SaaS, now software companies put services in the cloud, where users can access the software from anywhere with an internet connection and continue to pay subscription fees to use the software.

Innovation in the business model benefits both users and software companies. Customers can use their software across multiple devices without paying higher upfront fees. SaaS companies received stable cash flow from subscription revenue.

Many SaaS companies experienced significant growth in the 2010s and 2020s as more companies adopt SaaS software to increase efficiency, scalability, and agility.

SaaS stocks were generally strong during COVID-19 due to accelerated demand for telework and digital transformation. The demand for companies such as Zoom, Microsoft, Salesforce, and Adobe has increased in general.

Key metrics for a SaaS company

Due to the uniqueness of the subscription-based business model, SaaS companies have a series of new metrics to assess operational efficiency.

Here are some of the key metrics to assess the overall health of SaaS companies.

• Customer Acquisition Cost (CAC)

• CAC is how much money the company has spent acquiring a new user.

• For example, if a company has invested $1 million in marketing and gets 5000 new customers, the CAC can be calculated by dividing the total marketing cost by the number of new customers, i.e. $1 million ÷ 5000 = $200. So the cost of each new customer acquisition is $200.

• Customer Life Cycle Value (LTV)

• LTV is the total value generated by customers throughout the entire service period of a SaaS enterprise.

• The LTV/CAC ratio is one of the ways to measure the competitiveness and profitability of SaaS companies.

• For example, if LTV is $500 and CAC is $200, LTV >CAC, it indicates that the business model of operation is healthy and profitable. If LTV is $100 and CAC is $200, LTV<cac, which indicates that the business is operating at a loss.< p></cac,>

• A general rule of practice is that 3:1 for LTV/?$#@$ is a better ratio. [1]

• Monthly Recurent Income (MRR)

• MRR is a recurring income that SaaS companies earn within a month.

• Recurring Revenue is the portion of income that can be earned sustainably in the future.

• MRR is calculated as: MRR = number of monthly subscribed subscribers x average subscription amount per user.

• For example, a company takes a subscription fee of $20 a month, with a total of 500 subscribers, then the company's MRR is $10,000.

• Churn Rate

• Churn rate is an important indicator that refers to the percentage of customers who stop using the company's products or services over a certain period of time, either monthly or yearly.

• The formula for calculating churn is a simple way to divide the number of customers churn for the current period by the total number of customers at the beginning, then multiplying by 100%. For example, if a SaaS company had 2000 customers at the beginning of the year, 100 customers were lost during the year.

• Therefore, the churn rate is (100 ÷ 2000) x 100% = 5%.

• Retaining customers is important because the cost of acquiring new ones is high. If a SaaS company constantly has customer churn, the practice of constantly burning money to get new users will not work.

• Therefore, low churn rates indicate customer satisfaction and loyalty, potentially resulting in higher revenue growth and profitability.

[1] Source: CFI,”CAC LTV Ratios”

Valuation Indicators

P/E is a commonly used valuation indicator to determine whether a stock is overvalued or underestimated.

However, most SaaS companies tend to have a higher P/E ratio, and some may even be at loss for the following reasons:

1. Growth Prospects: SaaS companies drive high revenue growth through huge amounts of advertising to acquire new customers and expand market share, but this leads to low profits or even losses. But some investors believe that as companies gain more customers and scale their business, high growth rates can bring profits in the future.

2. Delayed Income: SaaS companies typically use a subscription-based model, which means revenue is recognized as customers use the service over time. This may delay revenue recognition, resulting in the look of a company's profit low or loss. Only when the user size reaches a certain level, the profitable state can be achieved.

In this case, other valuation indicators, such as P/S, may be better suited for evaluating SaaS equities.

P/S valuation methods are often applied to startups, high-growth industries, and volatile company valuations.

A 1x P/S ratio means that investors are willing to pay $1 for every $1 of sales brought by the company.

This shows the revenue growth rate and P/S valuation of some SaaS stocks.

Rule of 40

The Rule of 40 is a rule to determine whether a SaaS company's physique is healthy.

It is measured mainly in terms of company growth and profitability, namely revenue growth rate and profit margin. Its standards areRevenue Growth Margin+Profit Margin ≥ 40%.

Revenue growth rate is the rate at which the company's annual revenue grew year-over-year. The margin can be a free cash flow margin, operating margin, or EBITDA margin.

In general, some investors use the “40 Rule” as a criterion to determine whether a SaaS company is eligible.If the target company's score is higher than 40%, it means that the company's business is running well. In turn, the target company's score is below 40%, indicating that there is still room for improvement.

SaaS companies in early stages tend to exceed this standard because they are growing rapidly. However, mature companies with slower growth need to increase their margins to reach benchmarks.

Here are a few examples to help you understand:

1. Company A's revenue growth rate is 100%, operating margin is -40%, and the two add up to 60%, and the company score is up to standard. While the company is at a loss, its business is expanding rapidly. This may be an early stage company with growth potential.

2. Company B's revenue growth rate is 30%, but the operating profit margin is -10%, the final number after the two increase and decrease is 20%, the score is not up to the standard, indicating that the company is not operating well, in the constant burning but unable to promote growth.

3. Company C's revenue growth rate is 30%, operating profit margin is 15%, the two add up score is 45%, higher than 40%, indicating that the company is operating in good condition.

It is worth noting that the 40 Rule is just an indicator and should be used in combination with other factors when evaluating a company's performance and investment potential.

summed

The SaaS (Software as a Service) model changes the way software companies operate by providing software services in the cloud and continuously charging subscription fees.

Customer Acquisition Cost (CAC), Life Cycle Value (LTV), Monthly Recurrent Revenue (MRR) and Churn Rate are key metrics for evaluating SaaS company operational efficiency.

In addition, investors can use the Rule of 40 to measure the overall health of SaaS companies.

Finally, P/E ratio is not always suitable for SaaS equity valuation metrics, as most SaaS companies tend to have a high P/E ratio or lose money, so other indicators such as market rates may be more appropriate.