6 Signs You've Found a Quality Software Company

If you're interested in investing in software-as-a-service (SaaS) companies, you'll want to know the right way to measure their merits. At The Motley Fool, we're big fans of using investment checklists to help us make smarter decisions about stocks. Here's a checklist covering six key areas that can help you find better stocks in the SaaS industry. 

1. Total addressable market
Determining a SaaS company's total addressable market will help you understand where the company could go in the future. Often these companies are growing quickly, with stock prices that aren't cheap. Finding companies with growing addressable markets increases the likelihood of success when investing in them. Keep in mind there are typically a variety of ways these companies can be successful. Optionality may be key to the future of the business, as it is for Workday . The company provides human capital management software via the cloud; however, the team is working on several follow-on products that they can hopefully sell to new and existing customers. Some bulls may even believe Workday will offer a full-scale enterprise platform in the future.

2. Customers
Three questions come to mind when trying to understand a SaaS company's customer base: Can they keep customers? How much does it cost to acquire new customers? Are the customers satisfied?

Retention rates are the best way to see whether customers are staying. The best companies will have retention rates well above 90%. ServiceNow , a cloud-based provider of software solutions, reports retention rates above 95%.. Customer acquisition costs are important because they are a driver of the value of each new customer. Often, these are broken out in the company's filings. Look at the trend over time to see if the company is becoming more or less efficient at acquiring new customers.

Customer satisfaction levels are a great thing to look at, and they're pretty self-evident in terms of the value they add. Workday reports 97% customer satisfaction, though they are based on internal surveying. Though it's unlikely companies will flat-out lie about customer satisfaction, we should always look at internal metrics with a skeptical eye. When possible, look for third-party surveys to substantiate what the company reports. What you'll likely find from third parties like Gartner will be independent reviews of the products, which aren't necessarily straight from customers, but will work as a proxy.

3. Financials
The attraction to SaaS companies is their ability to scale, which allows them to sell products at incrementally higher margins as fixed costs become spread among larger volumes. That said, this should be reflected in their margins. The trend should be consistent over time in the gross margin; operating margins should ramp up, especially with younger companies as they leverage their infrastructure. The Ultimate Software Group has expanded its operating margin from negative percentage to almost 11% in the most recent year. This shows the ability of the company's SaaS business model to scale and produce operating leverage.

Also, most SaaS companies will report a backlog, which is revenue the company already has under contract but has yet to recognize in the financial statements. Backlog gives analysts insight into future sales and can shape how you expect the company will grow in the future.

4. Competitive strategy
Competitive analysis, as with every company, is an important thing to analyze as it has a direct effect on profits. For SaaS companies, competition can be intense, so it's important to understand how competition might react to actions taken by the company you're investigating. You should always look for evidence of the company winning business over competitors. This is always a good sign, but it's not necessarily sustainable. Look for reasons that might suggest particular advantages will allow the company to win business over the long term. Some companies will publish the rate at which they win new business. It's up to you to determine what exactly allows them to win business over competitors, if they are actually winning.

5. Valuation
The best way to check a SaaS company's valuation is by using the lifetime value (LTV) model. The LTV model puts a present-day dollar amount on what each customer might be worth in the years ahead. From here, you can compare your estimates on customer acquisitions to get a rough valuation. Alternatively, a relative valuation using free-cash-flow yield and the price-to-sales multiple are quick-and-dirty ways to understand how a company is priced relative to competitors.

Many of the SaaS companies you're likely to look at will seem expensive. For instance, salesforce had an average price-to-sales ratio of 8 times in 2013. The tendency for these companies to trade at high multiples reinforces the importance for analysts to fully understand what a company's addressable market is in order to estimate where sales can reasonably go.

6. Management
High inside ownership is something to look for in software companies. Managers that have a significant amount of their own wealth tied up in the company will have very similar interests to what you would have if you were a shareholder. More often than not, this will produce a shareholder-friendly culture. Workday is a great example since the company's chairman and its CEO own a significant portion of the common shares outstanding and a supermajority of the voting rights. Compensation structure is also important to consider as many software companies use equity compensation as a significant portion of total compensation. Sometimes this equity compensation has a dilutive effect on existing shareholders (meaning your percentage ownership of the business is reduced), and we don't like that.  

The Foolish bottom line
Software companies can be difficult to invest in; however, by focusing on the things I mentioned here -- total addressable market, customers, financials, competitive strategy, valuation, and management -- you will get a much better idea of the basic qualities of each company you look at.

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The article 6 Signs You've Found a Quality Software Company originally appeared on Fool.com.

Micah Robinson has no position in any stocks mentioned. The Motley Fool recommends Salesforce.com and Ultimate Software Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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