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  1. Home
  2. / Investing

Here's Why I Believe Most of SaaS Should Be Viewed Through a Different Metric

I don't have a cute acronym, but I guess we could say this is the GPS to find relative value.
By TIMOTHY COLLINS
May 08, 2020 | 03:12 PM EDT
Stocks quotes in this article: FSLY, SHOP, TEAM, NOW, BILL, DDOG, WORK, EVBG

One of the biggest challenges I've found in the cloud space is valuation. Traditional fundamentals are not applicable as we've come to know them. For quite some time, the focus for investors was Price to Earnings (P/E). We came to realize that not all earnings were equal as growth needed to be considered. We evolved P/E to PEG - Price to earnings divided by growth. Unfortunately, many of the cloud names are early in their financial lives. Building a product along with a subscription model means pushing some revenue recognition downstream. Gone are the days of selling software (or hardware) outright, recognizing all the revenue immediately, then chasing down the next sale.

That is why I believe most of SaaS should be viewed through a different metric: Growth divided by Price-to-Sales. I don't have a cute acronym, but I guess we could say this is the GPS to find relative value. It's one of the main draws I had to Fastly (FSLY) .

I included a chart of 20 names all grouped together in the same sector. There are a ton of different cloud names we could include, your mileage may vary, but this is Software Applications. For simplicity, I included only the quarter-over-quarter sales numbers and this is one quarter back. When we finish earnings season, I'll include current quarter-over-quarter numbers along with year-over-year and even projections moving forward.

My preference is to identity names with a GPS number of 2 or greater. That's where I start. It won't be the only consideration, but it provides a solid starting point. Profitability is a plus, but it's easy to see the group lacks much in the way of P/E numbers because you need earnings to make that happen. Have a low GPS doesn't mean failure. Shopify (SHOP) is a great example. They do have a niche that excelled during Covid-19, but as earnings rolls along we're seeing many of these companies do. The other thing to consider with names like Shopify, Atlassian (TEAM) , and ServiceNow (NOW) is their size. Their market cap drawfs most of the other names in this group.

One that caught my eye today was Bill.com Holdings (BILL) . Another name that produced stronger than expected top and bottom line results this week. The stock initially dipped after hours on Thursday, then rocketed higher. What caught my eye was the change in its GPS. Going into today, that number already sat low, but after the market cap skyrocketed to $7.26 billion at the high, the GPS hovering around 1. That's before knowing growth this quarter only came in at 46%. If we factor that, BILL ties SHOP with the smallest GPS number yet it's one-twelfth the size.

The smaller the company, the higher its GPS number should be. If you sorted these by market cap, you'd fine four of the five lowest GPS scores in slots 15 through 20. You'd only find one in the top 5. That would be Bill.com. Four of the other top seven land in the yellow, flagging my attention to check these out first. Datadog (DDOG) is the only one of the largest 10 market caps here with a with yellow alert. Slack (WORK) is close as well while Everbridge (EVBG) is teetering on becoming another of the smallest five to fall into the red.

This is my approach with all the cloud names, not just software application, but if you want to make some attempt with traditional fundamentals, I believe this is a tweak worth exploring as a starting point.

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At the time of publication, Timothy Collins was Long WORK, FSLY, FSLY puts, Short FSLY calls.

TAGS: Investing | Stocks | Technical Analysis | Trading | Value Investing | Software & Services

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