All software-as-a-service businesses benefit from recurring revenue and most have the ability to scale quickly, but how can investors know which ones are the best bet?

In this episode of The Motley Fool's Industry Focus: Technology, host Dylan Lewis is joined by Motley Fool contributor Brian Feroldi to discuss customer acquisition cost, lifetime value, and a few other must-know metrics. They also chat about why Adobe Systems (NASDAQ:ADBE), BlackLine (NASDAQ:BL), AppFolio (NASDAQ:APPF), HubSpot (NYSE:HUBS), and Shopify (NYSE:SHOP) might deserve a spot on your radar.

A full transcript follows the video.

This video was recorded on July 6, 2018.

Dylan Lewis: Why don't we talk about some of the other things that are worth looking at as an investor in this space? I think that, for me, one of the struggles with SaaS businesses is that, very often, it's a space that I don't know super well. I think that this is a space where you can definitely enjoy some of those Peter Lynch-style advantages in investing in what you know -- if you're in a space where highly technical software is very valuable and helps eliminate a lot of business friction, then you might have an advantage here. When I read these press releases or these company write-ups from SaaS companies, they're often sounding like high-flying, amazing businesses that are going to change the world. It can be a little difficult to parse through, "What is this company's actual standing in the market? How much better is it than the existing competitors that are out there?"

Brian Feroldi: That is something that can be tough for investors to wrap their head around, especially if you're not actually using the software itself. That can be a difficulty with investing in this space. If you're not exposed to the software like you would be as a user of, say, Facebook or Twitter or some mass-consumer brand, it can be difficult to figure out where the company stands in the market.

Lewis: That's why I think looking at some of these metrics is important. Why don't we talk about customer acquisition cost and some of the other things that play into what builds a sustainable and successful long-term SaaS company?

Feroldi: There are a couple of metrics that are unique to the SaaS business model that are really important for investors to know. The first one there is customer acquisition cost. This is basically, how much money does a company have to spend on sales and marketing to acquire one new customer? The way you calculate this is, you take the amount of money spent on sales and marketing in one period -- say, a year -- and you divide it by the number of new customers that are obtained in that same time period. Really quickly, let's pretend that a company spent $1 million on sales and marketing, and they picked up a thousand new customers. Their customer acquisition cost would be $1,000 per customer.

As a rough guide, a good customer acquisition cost number to aim for is, you want about a 12-month payback period. If it costs you $1,000 to acquire a new customer, you want them to pull in $1,000 in revenue from that customer in about a year.

Lewis: You can look at customer value that way. You can also look at things from a lifetime value perspective with these SaaS businesses.

Feroldi: The lifetime value is another absolutely critical number. It's basically, how much revenue are you going to pull in from a customer over their lifetime with your product? The way that you calculate this is, you figure out how much revenue the average customer or average user is pulling in per year, and then you divide that by their churn rate. Again, let's say a customer is $1,000 per year in revenue, and every year, you lose about 10% of your customer base. Well, $1,000 divided by 10% is $10,000. So, the average lifetime value of any given customer would be about $10,000.

Lewis: To put together the two metrics we just talked about, you want your lifetime value to be higher than your acquisition cost. That's the way that, eventually, this software that you're offering is going to be profitable.

Feroldi: Yeah, absolutely. As long as the lifetime value of a customer exceeds its customer acquisition cost, that's a good thing. As a general guideline, you want to see the lifetime value of a customer exceed about 3X the customer acquisition cost. That's a good metric for telling you that you have a good SaaS business.

Lewis: Something else you'll see in looking at some prospectuses and filings from these SaaS businesses is the idea of a dollar revenue retention rate. It's a mouthful as a metric, but really, it's a simple calculation. It's something that anyone that follows restaurant stocks might be somewhat familiar with, because it's very similar to a comps number that you'll see there.

Feroldi: Exactly, it's very similar to same-store sales. The idea is, how much revenue are you pulling in from your existing customer base one year compared to the next. Calculating it is, revenue at the start of the year, and then you add in upselling, you subtract churn and downgrades. This number is expressed as a percentage. Any number over 100% means that you're growing revenue within your existing customer base; then, if you add in new customers on top of that, that can lead to explosive revenue growth.

Lewis: I think that you have to focus on some of these metrics, because by traditional valuation metrics and a lot of traditional financial analysis, a lot of early stage SaaS companies can look kind of ugly on their financial statements. A lot of them wind up losing a lot of money. You need to see that, down the road -- maybe it's five years out, maybe it's ten years out -- there's a path to profitability, and there's a stickiness with the existing user base that will continue to grow.

Feroldi: If you look at a lot of the SaaS companies that are on the market today, many of them, especially the smaller ones, are still posting losses. That's because of the revenue dynamic we talked about before, where they're not pulling in as much upfront. A lot of them are also tech companies, so they're giving out a generous amount of stock option grants, which also subtracts from revenue. Looking at the traditional numbers, like earnings per share, isn't necessarily the best way to look at these businesses.

Lewis: But the reason Wall Street is willing to afford them the ability to lose money for such a long period of time is, with this model, at a certain customer count, you are basically making pure money. There's some additional usage fees and costs that come with adding those customers on, but really, you've laid out all these costs with infrastructure and building out your services, and it's just a matter of spreading that over enough customers and enough account usage to make the numbers work.

Feroldi: Yeah, absolutely. After a certain point, after a certain size, every new customer that you add, it's not pure profit, but it's pretty darn close. These businesses scale beautifully, where they go from very, very low profit margins to very, very high profit margins very quickly.

Lewis: One of the things that Lewis asked in his question that I want to get back to is, "Do you see SaaS as a market sector with many sub-sector winners, or a few giant winners taking all?" I think that's a very natural question when you look at the players in this space. You have the big companies like Microsoft, Adobe, Salesforce, IBM, Oracle. They're all playing there. Any time you look at a space where you have those big tech giants, it's easy to say, "Well, they could just hop in and take everything. They could eat everyone's lunch if they wanted to."

When you look at this, Brian, how do you approach that? How do you look at what segments of the market might be clear from being scooped up by big tech?

Feroldi: That's something that I do think about, but my response to that would be, in general, the switch from the traditional model to SaaS is ongoing. The whole SaaS pie is expanding very quickly from year to year. It's not necessarily a winner-take-all market yet.

There's also a ton of room for niche applications for these businesses. One of the companies that we've touched on a few weeks ago when I was on the show was BlackLine. They have targeted this niche of real-time accounting software, which is something that not many other companies are going after. So, there is plenty of room, I think, for smaller players that take a more niche focus to succeed.

Lewis: The way that I look at this space is, you can go with some of the big folks and have exposure to both the cloud tailwinds and software-as-a-service tailwinds; or, you can go and look at mid and small-cap companies. A lot of the names that we've discussed on this show together before -- whether it's Shopify, Paylocity, AppFolio -- a lot of those companies operate in spaces that are, or were when they started, a little too small for these tech companies to get into. For them to lay out the resources, they weren't going to move the needle enough for it to make sense for them as a business.

Feroldi: Yeah. That's exactly the way that I look at it, too. I think there's room for the big guys, the middle guys, and the small guys in anybody's portfolio that's interested in this. I personally invest in companies that are small, mid and large-cap.

Lewis: Why don't we talk about a few companies that are on your radar right now, or ones that you currently own that you like?

Feroldi: I've talked about a couple of them on the show before. A big company, I think most people know who Adobe is. They make their Creative Suite of products like Acrobat. They're the premiere name in photo and video editing.

A couple of years ago, they decided to transition their entire business from a license software model to a SaaS model. While that transition period was a little bit rocky, just because of what happens to your revenue when you do that, they are now, the majority of their sales are subscription-based, and their business has just been on fire for the last couple of years. Revenue and profits are growing by over 20%. That's a business that I own and like a lot.

Lewis: It's nice to see a big legacy player make the pivot to this space and make it, what seems to be, very well. What are some smaller names or companies that have come into the world as pure-play SaaS companies that you like?

Feroldi: Here's a couple of the ones that I've talked about previously. There's BlackLine -- their niche is disrupting the way that accounting is done. They're going for real-time accounting vs. the batch model. What I really like about them is, there's very little competition in their space, and they're a leader.

Another one I've talked about before on this show was AppFolio. They focus on real estate and legal, small legal businesses and small real estate businesses. Those are super niche markets that they can establish dominance in. They add more niche markets over time, so they can grow.

HubSpot is a company that is transitioning to inbound marketing, which is when you have a blog, or you create content that consumers want to reach that helps you grow your brand. That's a company that I like a lot.

And then, one that listeners are probably very familiar with is Shopify. They help businesses sell products, basically, online, and they create tools that make payment processing very easy.

Lewis: Thank you very much for giving me that rundown, Brian. That was a bit of a mouthful there. I think, to wrap all of this conversation, why don't we hit a couple of risks and things that people should keep in mind? We gave that metrics rundown before. I think, to get a little bit less technical, we talked about how a lot of these companies are high-growth and very often not profitable because they are so early on in building out their customer base. That can put people in a spot where they're buying stocks that are already pretty bought up and are at pretty rich valuations.

Feroldi: Yeah. SaaS businesses in general have been on fire over the last couple of years. I've seen price to sales ratios for almost every business that I follow just keep expanding and expanding and expanding over time. There is the risk that, at some point, investors are paying way too high of a price for these businesses. That's a risk for investors right now.

There's other ones, too. So many companies are getting into the SaaS space that competition in a lot of these is really starting to increase. A couple of companies that I like a lot in this space are Paylocity and Paycom Software. They focus on payroll processing. Well, that market is big and growing, but it's also becoming intensely competitive. That's another risk for investors to watch.

Finally, the thing that I'm going to focus my time and attention on is really looking at churn. The SaaS business model only works if you get a customer and keep them for as long as possible. If competition comes in, or the company doesn't innovate fast enough, and churn starts to increase, that could lead to revenue not growing as quickly, and investors can really get burned.

Lewis: You can almost think of SaaS companies as gym memberships. You want to be able to sell gym memberships and have people just continue to pay you to use them.

Feroldi: That's exactly right. That's a great analogy.

Lewis: I guess where it falls short is that there's unlimited number of memberships at this gym. Space doesn't matter.

Feroldi: That's right, there's a lot more potential for profit expansion at SaaS.

Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Brian Feroldi owns shares of Adobe Systems, AppFolio, BlackLine, Inc., Facebook, HubSpot, Paycom Software, Paylocity Holding, and Shopify and has the following options: short January 2019 $185 puts on IBM, short January 2019 $180 puts on IBM, long January 2020 $170 calls on IBM, short January 2020 $170 puts on IBM, long January 2020 $38 calls on Oracle, and short January 2020 $38 puts on Oracle. Dylan Lewis owns shares of Facebook and Shopify. The Motley Fool owns shares of and recommends Adobe Systems, Facebook, HubSpot, Paycom Software, Shopify, and Twitter. The Motley Fool owns shares of AppFolio and Oracle and has the following options: long January 2020 $30 calls on Oracle. The Motley Fool has a disclosure policy.