Before we get into our in-depth piece on a unique valuation method used for SaaS (Software as a Service) companies, we’d like to thank everybody for the feedback received in our last e-mail.
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Over the last week or so, Mathieu and I made some changes to our portfolios, ones that involve the purchase of Bull List stocks late in the week.
Portfolio changes for Mat and I
Both Mat and I have purchase Dialogue Health (TSE:CARE) after what we feel is a widening valuation gap with the digital healthcare company. This is a long term purchase for both Mat and I, and this is likely one of the higher risk/higher reward plays on our Bull List right now.
Another stock that just keeps getting cheaper is Parkland Fuels. And as a result, Mathieu took a position late in the week, and I added to my position as well. Parkland is a stock that I (Dan) have owned for over 5 years now, and the company’s dip in price is leading to valuations becoming very attractive.
You can read our in-depth report on Dialogue here and Parkland here.
An introduction to the rule of 40
Investors sometimes have a hard time with high-flying growth stocks, especially in the tech sector – the Software as a Service (SaaS) industry in particular.
Often, many of these companies are not yet profitable and are trading at high valuations. This makes it difficult for traditional and defensive investors to ‘take the leap’ and invest in these types of stocks.
Unfortunately for those with risk-averse investing profiles, they’ve missed out on some of the best performing stocks of the past decade. In fact, growth investing has trounced value and income investing and it doesn’t appear to be slowing down. One of the key drivers of this is the record low interest rate environment we are in, and have been in since the financial crisis.
There are so many examples of growth stocks that have looked expensive yet continue to trek towards new highs on an annual basis. In the U.S., Amazon (NYSE:AMZN) was the first example of a non-profitable company that was trading at high valuations. It took the company years before they finally became profitable.
In Canada, Shopify (TSX:SHOP) is perhaps the most notable example. Investors have been calling Shopify expensive for years. It was deemed expensive at $50, $100, $500, $1500, and again today at ~$1,800.
It is important to note that these stocks aren’t without periods of volatility, but their long-term results speak for themselves.
So how can one identify good SaaS stocks to invest in? Enter the Rule of 40 (RO40)
The RO40 was introduced in the mid-2010s to help address this issue – mainly to help venture capitalists identify potential early-to-mid stage companies worth backing. It is a simply formula, one that attempts to bridge the gap between profitability and growth.
The basic premise is that a company’s revenue growth rate combined with its profitability margin should be equal to or greater than 40%. Here is the simple formula:
Revenue growth rate (%) + EBITDA Margin (%) => 40%
This is the original formula, but over time many have modified the formula to suit their own needs.
Some use operating income or various cash flow margins in place of EBITDA, while others use Annual Recurring Revenue (ARR) or Monthly Recurring Revenue (MRR) growth rates instead of revenue. Some also strip out stock-based compensation from profitability numbers.
While there are pros and cons to many of these nuances, at its core the original formula still has plenty of value. The main reason is because revenue and EBITDA are GAAP (Generally Accepted Accounting Principles) numbers, whereas cash flows, ARR and MRR, are not and can be reported differently from company to company. This makes direct comparisons difficult.
It is also the simplest approach for retail investors and won’t require hours of additional calculations and reports to sift through.
For those wanting a little more risk, there is also growing momentum towards using the Weighted RO40 which gives more weight to revenue growth rate vs profitability. Here is the modified ratio:
Weighted Rule of 40 = (1.33 * Revenue Growth rate) + (0.67 * EBITDA Margin)
Typically, trailing twelve month figures are used, but one can use any timeframe. An argument can also be made that forward-looking metrics based on analysts’ estimates or company guidance, while less reliable, can also make for good proxies.
As with any metric, it should only be the start of one’s due diligence
However, it makes for an excellent starting point for those who are uncomfortable with the lack of profitability of these high growth SaaS companies.
Research has shown that tech companies that beat the RO40 ratio have valuations that are twice as high as those that didn’t. In general, younger companies often beat that mark with their rapid revenue growth while older companies, whose growth has tapered off, need to improve performance and profit margins to hit that metric.
There is also a general rule of thumb that the RO40 should only be applied to those companies have achieved at least $50M in revenue. This allows for a certain level of maturity and on average, companies usually hit this mark in year 5 or 6 of the company’s growth cycle.
We like this caveat, as it strips out micro-cap companies who may have been able to scale rapidly in the beginning, but then hit a wall where growth stalls.
With all this said – which companies on the TSX Index meet or exceed the RO40 today?
There are only 38 companies in the Tech – Software industry that meet the $50M threshold for inclusion. Of those, the following meet the RO40 (make sure your e-mail client has images enabled to see).
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You’ll notice quite a few familiar names. OTEX, LSPD, REAL, SHOP, LSPD, DND, ENGH, are all (or were) picks that made our lists at one point in time. We’ve also talked a lot about NVEI in recent months.
Interestingly, Voyager Digital is one we are keeping an eye on but at the time, we decided to add Galaxy Digital to our watchlist instead of VYGR simply because of valuations at that point in time. VYGR however, makes for another excellent crypto stock.
In terms of valuation, Real Matters stands out like a sore thumb
There is no reason for the company to be bid down as much as it has, and its inclusion among these top tech stocks and relative valuation is one of the main reasons why myself and Dan are holding tight.
You might also notice some names that are notably absent. Names such as Constellation Software, and Docebo. Don’t fret, both of these were next on the RO40 list with numbers of 37% and 36% respectively. They just missed the cut and are still excellent options.
You also might notice that some of these are not exactly SaaS plays – think TIXT, CTS, or CMG – however, their inclusion is certainly relevant and there is increasing evidence that the RO40 can be applied to non-SaaS pure plays.
All this said – you are likely to see one of these make an appearance as our next Bull List selection.
