Salesforce.com (NYSE:CRM) kicked off the transition to the software-as-a-service business model in the early 2000s, and many companies that have made the switch have seen their stock prices soar.

In this episode of The Motley Fool's Industry Focus: Technology, host Dylan Lewis is joined by Motley Fool contributor Brian Feroldi to talk about the benefits and drawbacks of investing in the sector.

A full transcript follows the video.

This video was recorded on July 6, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, July 6th, and we're getting SaaSy. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com's Brian Feroldi. Brian, what's up? How was your July 4th?

Brian Feroldi: It was fantastic! Very hot up here in Rhode Island, so we did our best to avoid the beaches. They were crowded. How was your 4th, Dylan?

Lewis: It was also hot here in D.C., it was also a particularly bad time for my AC to decide to stop working in my house, because I had a bunch of people over to barbecue. But we made the best of it and hung out on the deck. 

Brian, we're tackling a listener question today; not one that was submitted to us, necessarily, but one that was passed along from someone that I think a lot of IF listeners probably know. Here's the clip.

David Gardner: Rule Breaker Investing mailbag item No. 1. This one comes from Lewis Miller. "David, I'm a longtime Fool from back in the 90s, and regular RBI podcast listener." Thank you, Lewis. "In the last few years or so, as well as Tom and some of the other Fool services, you have recommended several software-as-a-service," or SaaS, I think a lot of people may know that acronym, even buzzword, if you will, these days, "companies. In my memory, Salesforce," CRM is the ticker symbol, and that's a Rule Breaker recommedation for the last ten years or so, "was the first such business model when it went public in the early 2000s. But recently, there's been an explosion of SaaS companies."

Lewis goes on. "There's been platform-as-a-service, data-as-a-service, transportation-as-a-service, AI-as-a-service." I heard somebody the other day, by the way, talking about games-as-a-service. If you think about something like World of Warcraft, or what Grand Theft Auto has done in recent years, which is just keep sending you more content from your initial buy, you're still playing the game four years later with constantly new stuff. Games-as-a-service. So, x-as-a-service, "a business model," says Lewis Miller, "that's maybe here to stay. What they all seem to have in common: two things. The cloud and a subscription revenue source.

I wonder if you could devote some time on a future RBI podcast to discussing, from an investing perspective, both the pros and the cons of the SaaS model, and how you differentiate among them in selecting which ones to recommend. Do you see SaaS as a market sector with many sub-sector winners, or a few giant winners taking all? Perhaps you could do a five-company sampler, etc. Thanks, David, for all you and Tom and The Motley Fool team do to educate, amuse, and enrich. Lewis Miller."

Well, I thought about this for about a minute, and then I thought, you know, I think there's a better podcast at The Motley Fool to really nail that.

Lewis: So, Brian, I feel like Lewis knows a bit more about SaaS than he let on, because he hits on a lot of core tenants of SaaS in his question. To answer this, why don't we start with what software used to look like, and make our way to the present?

Feroldi: Sure. Rewind the clock 15 or 20 years. The way that software was distributed to users was primarily at retail stores. If you wanted a certain program, you would walk into, say, a Best Buy or Radio Shack and you would pick it out off the shelf, you would buy a physical CD ROM, and you would purchase it. That kind of model was, the user paid a one-time, large, upfront fee to essentially own that software, and they would install it on their computer and they would use it, essentially, as much as they wanted, forever. 

The downside to doing this is, one, it was pretty expensive upfront; and two, whenever updates came out to the software, they had to be manually made. And whenever there was a major release of a software, the customer would have to go back to the store and purchase a new version of it in order to keep up with the most recent date. 

While this worked pretty well if you were just an individual home with just one PC, the real big problem with this model was when it came to implementing it at a large company. You can imagine having to maintain 50 or 100 or even 1,000 computers like this. Just the physical process of installing the software on each of them would be a huge burden.

Lewis: Yeah, that sounds like a headache for any tech department. Thankfully for folks that work in tech, in the late 90s, Salesforce.comcomes around, and they change the way that enterprises interact with software.

Feroldi: They were the first to push the idea of what we now call cloud computing to consumers. Salesforce.com's resolution was, they would take the software, and instead of distributing it on CDs, they would actually host it in servers. Their idea was that users would connect to this software through the internet. They would go on their browser, log into a website with a username and password, and they would have access to this software through the internet. They called that through the cloud. Instead of selling the software up front, you're almost renting time to use this software. That model is called software-as-a-service, or SaaS.

Lewis: This delivery mechanism really removes a lot of the issues that we see with the old CD ROM system. You are able to access software from anywhere. You're always working on an up-to-date version with this delivery mechanism. It seems to eliminate a lot of the friction that we'd see normally.

Feroldi: There are a lot of benefits to the SaaS model. You touched on a couple of them. If you, again, go back to the enterprise model, it's extremely easy to deploy this across 50, 100, 1,000 users, because all you're doing is giving them a website, buying a username for them and time on it, and then everybody can access this software instantaneously. It's also a lot lower cost upfront for the user. Instead of paying a large bolus of money upfront, you're just paying a low monthly or annual fee.

A couple of other benefits are that, depending on the software, some of these programs can be very intensive on your processing power. But when you host it in the cloud, all of that processing, that heavy lifting, is done by servers that are stored elsewhere. So, you don't necessarily need to have the most up-to-date, latest version of a computer to run some of these programs.

Lewis: You mentioned the low upfront cost. Something that you'll see a lot with SaaS providers is this idea of a virtuous cycle. You start out small, and it's something that an individual entrepreneur can use. As they grow their business, their use case grows with it, they add more licensed users, maybe they build out the functionality. This is a benefit for consumers. It's also a great benefit for these businesses because they grow, and they share in the successes of the people that are using their software.

Feroldi: That's absolutely correct. There are a lot of benefits for consumers to switch to this model. Having said that, there are some downsides, too. Adopting a SaaS model can be a lot costly in the long-term. While you're paying smaller monthly fees, those fees do add up over time to typically be a bigger number than the initial bolus that you would pay upfront for the old model when you were purchasing the software. 

You also need to always have an internet connection to access it. And, the data that you're actually using at your company is also stored on a server that resides at another company. That can create some problems if you're working with really sensitive information. But, overall, the switch makes a lot of sense for consumers.

Lewis: Let's look at SaaS from an investing perspective here. Lewis asked this question, and I think it's probably prompted by looking at a decade-plus of returns from SaaS companies and realizing that this has been a great place for investors to park cash. I think one of the biggest benefits to these types of models is the fact that, instead of having a one-time sale, you now have predictable, recurring subscription revenue.

Feroldi: Yeah. The markets love certainty, the markets love predictability. Going from a single software sale that occurred, say, every two or three years, turning that into a monthly, predictable, recurring revenue is highly attractive. 

There's other benefits for the companies, too. Back in the early 2000s, there were a lot of issues with piracy. People were taking software and trading it over the internet for free. When you convert to a SaaS model, it basically eliminates the piracy issue. 

Software companies, when they were distributing them at retail stores, would also have to split the revenue with their retail partners. But, if you're distributing it over the cloud, the company gets to keep all that money for itself. 

One of the things that you touched upon was what's known as the "land and expand" model. That's when the SaaS company essentially gets their foot in the door with a customer and then upsells them with more licenses, more products, more ways to create revenue over time. That's a very low-risk way to have growth from your existing customer base.

Lewis: You'll see different SaaS models approach this differently. Some of them low price their baseline product very cheaply so that entrepreneurs and very early stage start-ups can afford to use them. Some of them will go with the freemium model and say, "We're going to make ourselves available for free to individual users." The hope there is that they then become evangelists at their company when it comes to making software decisions.

Feroldi: Yeah. Both models definitely work.

Lewis: One other thing that I think is really important for investors looking at this space, and why it's so appealing, is that these businesses tend to have very high margins. Just as a case in point, we've talked about Salesforce a couple of times, they post gross margins of over 70%. That speaks to how profitable these types of businesses can be once you hit a critical mass of users.

Feroldi: Gross margins tend to be very high for these SaaS companies. Having said that, some of these SaaS businesses employ a couple of different models. Some of them have a service component to it, where they're selling a subscription, but they're also providing actual, physical human services to it, which can be a lower-margin business. Some of them sell subscriptions, but users can also pay one-time fees for access to higher-value services. Those can have different gross margins in them. 

When you're comparing SaaS companies, you can't just look at the gross margin, you have to understand how it's made. But, to your point, the subscription portion of the SaaS business model does tend to be very high margin.

Lewis: Another strength that we see with this model, too, is the idea that switching costs become high once you become installed. This is the case whether you're delivering it in the old school method of software or SaaS. The switching costs are high because you trained people to use a certain type of software and you build out service functionality as they become more and more comfortable with it. To retrain an entire group of employees to use something else, it's going to be disruptive for a business, so these tend to be very sticky businesses.

Feroldi: Absolutely. From my own personal experience, the company that I worked for prior to coming to The Fool was a salesforce.com customer. We used that software for customer support, marketing, selling, for financials. If, by chance, salesforce.com was offline for a day, our business would grind to a halt. We were 100% dependent on salesforce.com for day-to-day operations. That just shows you how much power some of these SaaS companies can have over the customers.

Lewis: There are some drawbacks, though, for investors in this space, and some things that I think people need to be aware of when they're looking at SaaS companies. We talked about how we're building out these nice, stable, consistent cash flows with the subscription model. What that does mean is that there's going to be less cash on hand when the first purchase is made.

Feroldi: Yeah, that's absolutely the case. You can imagine, say, a company was selling a CD ROM for $100. Under the SaaS model, they're selling it for, say, $8 a month. From a revenue perspective, when they sold one user under the old model, they got that $100 upfront. Under the new model, they can only go up $8 in revenue per month. It does make their financial statements a little bit harder to decipher, because the way that the accounting works is, it masks a lot of the true profitability that these companies have just because of the timing of the revenue. 

Another major risk for investors to watch is churn. You can imagine, if somebody bought a product ten or 20 years ago, they used it once and then they abandoned it, well, the software company still kept all that money upfront. Under the SaaS model, if somebody abandons the product after a month or two, then that company spent a lot of money acquiring the customer and they didn't even come close to recouping their cost back.

Lewis: Yeah. Much of the SaaS model is built into the expectation that once you acquire a customer, you keep this customer; and not only do you keep them at the current level that they're at for their subscription, you actually grow whatever their account value is. That might be through added users, or through new services being added to the suite of products that they're using. But it's not something that stays flat in the eyes of most of these management companies.

Feroldi: Yeah. For SaaS investors, one of the most critical metrics to look at is churn. You want, obviously, churn to be as low as possible.

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?"

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 MicrosoftAdobe (NASDAQ:ADBE), 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 (NASDAQ:BL). 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 (NYSE:SHOP), Paylocity, AppFolio (NASDAQ:APPF) -- 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 (NYSE:HUBS) 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.

Lewis: Well, thank you for hopping on, Brian. Anything else before I let you go today?

Feroldi: No, I think we covered it pretty good.

Lewis: Alright. Thank you to David Gardner for reading the question so that I did not have to. He had me on his Rule Breaker podcast last week to run through this a little bit and tee it up. Listeners, if you don't listen to his show, you absolutely should be.

Otherwise, that does it for this episode of Industry Focus. If you have any questions, or if you want to reach out and say hey, you can shoot us an email at industryfocus@fool.com, or you can tweet us at @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass. For Brian Feroldi, I'm Dylan Lewis. Thanks for listening and Fool on!

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. David Gardner owns shares of Facebook. Dylan Lewis owns shares of Facebook and Shopify. The Motley Fool owns shares of and recommends Adobe Systems, Facebook, HubSpot, Paycom Software, Salesforce.com, 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.