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Software Valuations and the Rule of 40

Kevin Cook

How is it that large investors are still piling into software stocks trading at over 20X sales?

There are at least 4 major catalysts...

1. Software is primarily immune to the current tariff battles

2. Software is part of a secular "technology super cycle" as it vaults productivity while taming costs in nearly every industry

3. Software is "the brains" of innovation, with nearly infinite capability to shrink, manipulate, and enhance time and space

4. Software lives in its own "valuation stratosphere" based on the Rule of 40

This year I began calling the industries that comprise SaaS, IaaS (Infrastructure-as-a-Service), and other Software applications and platforms that make use of cloud computing, The SOFTOSPHERE -- and not just to make a doubly cute "cloud" and "valuation" reference but to highlight what a dramatic agent of change the Software universe now represents in economics and society.

In the video that accompanies this article, I discuss these drivers and reference many Software-focused articles, data graphs, and winning stock picks I've delivered to my followers this year.

The fourth catalyst needs a little more explanation and here's how I introduced it to my TAZR Trader group in June...

The Rule of 40 = Software Valuations That Make (Some) Sense

June 21, 2019

TAZR Traders

As summer begins, and new highs bloom for the market above SPX 2960, I want to take a bigger picture view for you to consider this weekend.

Because while the market could take a 3-5% profit-taking swing any week this summer on some negative news catalyst, there is a bigger driver of stock accumulation and multiple expansion that will not be stopped: The SOFTOSPHERE.

To wit, I did some more digging in research about software growth and valuations and found more evidence and confirmation for the hunt I've been on.

If you are new to TAZR, you should review my two Zacks Confidential (ZC) pieces, from April and this week, on the most explosive space in technology -- or all of the economy, for that matter -- as those will be good background for this hunt.

In April I reviewed my thesis from 2017 about why productivity is so high and inflation so low in The Tech Super Cycle Continues.

And in my latest ZC, Big Data Gold Rush: Harness Chaos or Be Disrupted, I shared an incredible graph from Statista showing that worldwide revenues from big data and business analytics could swell to $275 billion in 2022.

(If you are not a Zacks Confidential subscriber, email Ultimate@Zacks.com to get access to these reports and their stock picks.)

The Rule of 40 for SaaS and Subscription Platforms

Famous VC tech investor Brad Feld wrote a blog post in 2015 titled The Rule of 40% for a Healthy SaaS Business.

The rule of 40% is nothing more than a heuristic to quickly analyze the health of a software/SaaS business. It takes into consideration two of the most important metrics for a subscription company: growth and profit.

The simple formula is revenue growth + profit margin = at least 40%. Here's exactly how Feld described it in his blog...

“The 40% rule is that your growth rate + your profit should add up to 40%. So, if you are growing at 20%, you should be generating a profit of 20%. If you are growing at 40%, you should be generating a 0% profit. If you are growing at 50%, you can lose 10%. If you are doing better than the 40% rule, that’s awesome.”

For most young SaaS companies, the most common way to measure growth is to do year-over-year on MRR (monthly recurring revenue) growth. You can always compare total revenue but it’s important to consider monthly revenue, especially if you have one time services in the mix.

Profit is harder to define. Again from Brad Feld's blog...

Are we talking about EBITDA, Operating Income, Net Income, Free Cash Flow, Cash Flow or something else. I prefer to use EBITDA here as the baseline and then back test with the other percentages. If you are running on AWS or the cloud, this should be pretty simple and consistent. However, if you are running your own infrastructure, your EBITDA, Operating Income and Free Cash Flow will diverge from your Net Income and Cash Flow because of equipment purchases, debt to finance them, or lease expense. So you have to be precise here with which number you are using and “it’ll depend” based on how your SaaS infrastructure works.

In the video that accompanies this article, I share some data and tables about Software valuations and explain why Zscaler ZS and Veeva Systems VEEV trade at over 20 times sales, and hot new IPO Zoom ZM, the video conferencing technology, trades over 40X sales.

Speaking of hot Software IPOs with stratospheric valuations, I also discus Slack WORK and which "wolves of Wall Street" are eager to short it. Its collaboration partner in workplace productivity is Atlassian TEAM which trades at only 10X sales.

I also highlight three more diverse Software players -- Alteryx AYX, Smartsheet SMAR, and Square SQ -- and why I was eager to buy them trading near 15X sales.

Finally, if you want daily commentary on the SOFTOSPHERE, email Ultimate@Zacks.com and ask about a trial to TAZR. Here's a sampling of the Software topics I tackled just in June...

What TEAM + WORK Tells Us About the Market

Stock Pickers Rule the World

Why AYX is the Lil' NVDA of Data

When Semis Go South, Stick with Software

Alteryx is the Answer to Big Data Chaos

Alteryx: A Data Engine Driving New Productivity & Collaboration

CRM Buys DATA: AYX and DOMO Share the Spotlight

AYX Gets a Booster and TTD is the Rocket

Smartsheet (SMAR) Guides Revs Higher to 48% Growth

And be sure to watch the video as I have some great graphs and tables that explain the size, growth, and power of The SOFTOSPHERE -- and why you should be a long-term investor here!

Disclosure: I own AYX, SMAR, and SQ for the Zacks TAZR Trader.

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Square, Inc. (SQ) : Free Stock Analysis Report
Veeva Systems Inc. (VEEV) : Free Stock Analysis Report
Atlassian Corporation PLC (TEAM) : Free Stock Analysis Report
Zscaler, Inc. (ZS) : Free Stock Analysis Report
Zoom Video Communications, Inc. (ZM) : Free Stock Analysis Report
Smartsheet Inc. (SMAR) : Free Stock Analysis Report
Alteryx, Inc. (AYX) : Free Stock Analysis Report
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