Modern Growth Investing SaaS Insights - Updated 08/21/2022

We look at the SaaS industry as a whole and find GARP businesses.

Modern Growth Investing SaaS Insights - Updated 08/21/2022
Disclaimer: The information provided is not financial, investment, tax, or other advice. Nothing contained constitutes a solicitation, recommendation, endorsement, or offer to buy or sell securities or other financial instruments. For more information, read the disclaimer.

Hey Everyone, I hope you have a great weekend. I wanted to share my coverage of insights for the SaaS industry, and I will be calling these articles "Modern Growth Investing SaaS Insights" and provide updates regularly.

Why do I look at the SaaS/Tech industry as a whole?

SaaS/Technology industry is my primary circle of competence. This is the industry that I have the most insights about. I build and use a lot of different software daily, so it’s easy for me to dive into SaaS/Tech companies and get a sense of what they are doing, relate it to my daily life and gain insights into whether some SaaS business is something I want to spend my time learning about and exploring for an investment opportunity.

In general, I want to know about all the SaaS companies; that way, at least I have seen all of them, and I have more chances of finding outstanding ones that are priced reasonably. Looking at the industry as a whole also informs me about the mean and median valuations in the industry so that I can avoid getting myself into really crazy valuations. It also gives me a guide to whether I am getting a business with a better growth profile for a significant discount than the industry.

This is also a form of idea generation as I will notice new businesses that enter the industry, and I get to identify new opportunities.

How often do I look at the industry?

I try to keep myself updated about the industry every month and sometimes every few months if I am busy with my life.

What insights do I look for in the industry?

In general, I try to get a feel for the SaaS metrics for the industry and identify patterns that give me quantitative and qualitative insights into a company through a metric.

I also use a valuation approach to sort companies in a way where I get the maximum value for my investment. I use a ratio of Rule of 40 LTM and EV/Revenues LTM  for a valuation approach that balances growth and value, and the results are sorted in order of GARP(Growth At Reasonable Price).

Following are the SaaS industry metrics for 08/21/2022

If you are having trouble accessing the image above, download and checkout the following pdf.

I like to observe the same data using another GARP metric known as FCF Yield.

Free cash flow yield is a financial solvency ratio that compares the free cash flow a company is expected to earn against its Enterprise Value. The ratio is calculated by taking the free cash flow divided by the current Enterprise Value.

Think of it in terms of bond/savings interest rates; according to the table above, Dropbox has a yield greater than 8%, compared to keeping your money in a bank with a laughable yield(currently).

Generally, older/stable companies will have higher FCF yields, and newer companies will exhibit lower yields.

That’s awesome, so how should I use the above table?

An excellent way to use the table to gain insights is to pick up a business you know something about, observe its metrics from the tables and compare them across different businesses in the table. This will give you a feel of how certain businesses are better than others on specific metrics. If you know what the metrics mean, you can use that insight to find a better business.

For example, if you like to look at the Rule of 40 metrics for businesses, you can find a better business based on that metric. You may want to analyze the business based on some other metrics from the above table before you get comfortable and understand the business a little deeper based on the metrics.

Yay, I found something, am I done? No. This is just the starting point. After this, you dive deep into the business and voraciously learn everything about them, find out if this is something you want to own for the long term.

But I don’t know what these metrics mean; what do they mean?

The Rule of 40 metric shows us the overall growth profile of the business. It is a sum of revenue growth + profit margins. People interpret this metric differently, and the components that make up that metric can be different/not standardized, but the overall insight you get here is that the business has a high growth profile. Generally higher, the better. Generally unsustainable over 60%, you see these numbers in very new businesses, usually coming down.

The implied ARR is an approximate ARR calculation. This metric tells us how much of the business is predictable(ARR is recurring and predictable), giving us more certainty in revenues.

LTM revenue is the Last twelve month's revenue; this includes the recurring revenues.

The % growth in implied and LTM revenues indicate the growth rates for those two metrics. Generally, the higher, the better.

GM is the gross margin that indicates how good the business is at keeping its costs down. Generally, the higher, the better.

S&M, R&D, and G&A % LTM Margins are the last 12 months’ margins as part of revenues for Sales and marketing, research and development, and general and administrative expenses. Generally, the lower, the better.

Opex is operational expenses. Generally, the lower, the better.

FCF is Free cash flows. Generally, the higher, the better.

The magic number is an indicator of sales efficiency, which shows how much Return on Investment you are getting from your S&M expenses. Generally, the higher, the better.

The payback period is similar to the magic number and indicates the number of months it takes for the business to recover its S&M spending. Generally, the lower, the better.

Net Dollar retention is the sum of the churn, retention, and expansion of revenues from current and new customers as a ratio of the same over a previous time period. Generally, the higher, the better.

Some of the things I look for are covered in my deep dives. For example, look at the Samsara deep dive.

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Chet @ Modern Growth Investing

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