DocuSign (DOCU 0.12%) is pumping out free cash flow and has a huge growth runway ahead of it, but are there any red flags that investors need to be aware of?

In this episode of The Motley Fool's Industry Focus: Technology, host Dylan Lewis and contributor Brian Feroldi discuss DocuSign's leadership team, internal culture, and check the company for thesis-busting red flags.

A full transcript follows the video.

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This video was recorded on Nov. 16, 2018.

Dylan Lewis: This is a look at a company's customers.

Brian Feroldi: Customers are the lifeblood of any business. I like to think about how a company interacts with its customers from a multitude of angles. The first thing I look at is how expensive they are to onboard. As we mentioned at the top of the show, DocuSign is spending lavishly on sales and marketing right now to grab as much of the pie as they possibly can. Last year, they spent $278 million dollars on sales and marketing, and they added about 85,000 new customers onto their platform. That's a huge amount of money to spend on sales and marketing in any given year. But since their customer base is growing so quickly, and there are high switching costs, that's a trade-off that I think investors should be happy about, especially since it is leading to top line growth.

Next, I like to think about how dependent a customer is once they sign on. I think that DocuSign's dollar-based net revenue retention rate of 115% is a really good indicator that once a customer becomes a customer, they not only stick with it, but they spend more over time. That's something that I like to see.

The next thing I check is, is the revenue recurring? About 93% of DocuSign's revenue is recurring in nature, and it was earned from subscriptions last year. DocuSign also has a small services business where they onboard companies. But that's basically a break-even business form and it's almost immaterial. You can say that the vast majority of their revenue is recurring.

Lastly, I like to look at pricing power. Does this company have the ability to raise prices or at least expand its gross margin over time? If you look at their recent history, DocuSign's gross margin was 71% in fiscal 2016, which is a very good number on its own, but that number expanded to 77% in the most recent fiscal year. That's a clear sign that they are leveraging their fixed costs and growing over time, which is great.

Lewis: I'm with you on the customer acquisition costs being a little concerning. What I think that ultimately boils down to is, they're spending a lot for these customers. Are these customers going to behave the same way that past cohorts of customers have? If they are able to maintain this mid-teens dollar-based net retention number, then I think we're in OK shape. Because that other metric is so strong, I'm not as worried about it, but you want to keep an eye on, they're spending so much to bring these folks in, are they behaving the way that all these other customers that they've brought in in the past have behaved?

Feroldi: Totally agree. Like any software-as-a-service business, that net revenue retention rate number is a key metric for investors to watch.

Lewis: Brian, #5 on this checklist is management and company culture. This is something that we really focus on here at The Fool writ large. I think that it's so much easier to get on board with an investment when you know that the company is being run well, that employees like working there, that they like management. Those are the kinds of things that lead to employee retention, and generally tend to lead to pretty strong business results.

Feroldi: Yes, exactly. This is a tech company. Hiring and maintaining the best and the brightest is an absolutely critical business function for them. As I've said before, we like to check in on a company's culture to make sure it's a good place to work, and that it has good leaders. Ideally, you'd see that the founder of the business is still running the show, or at least involved. In DocuSign's case, Tom Gonser is on the company's board of directors. He doesn't hold a management position within the company, but he does have some influence since he is on the board. He also still owns about 2.1 million shares of DocuSign's stock. That's worth about $85 million at current prices. So, you can say that he absolutely has an incentive to see this business continue to succeed.

Moving on to their CEO, they hired a new CEO about 18 months ago named Dan Springer. He joined right before the IPO process. He owns about $20 million worth of stock. He's relatively new, and I would like to see his ownership rates be higher. But if you look at the company's Glassdoor ratings, it's very clear that Springer is beloved by his employees. His approval rating among his employees is 98%. That's so good that he literally placed third on Glassdoor's annual rating of CEOs. He was ahead of leaders like Jeff Weiner of LinkedIn, Marc Benioff of Salesforce, and Mark Zuckerberg of Facebook. Employees really like working for Springer. If you look at their overall rating, they get 4.6 stars out of 5. That's a very good indicator that this is a great place to work.

Lewis: What you mentioned was a lot of the softer stuff that we look at with management -- the Glassdoor ratings, and obviously, skin in the game is important. Something that really stands out to me looking at management's role in this business is looking at the executive officers and directors. They control more than 25% of shares outstanding for this company. That is a lot of skin in the game by people that are going to be making big-picture decisions. I love to see that.

Feroldi: Same here. You want to know that the people that are in control of the company will be financially hurt if their stock goes down, just like you would as a shareholder.

Lewis: Last item on the checklist. This is one of my fun ones. This is the "what can go wrong?" element. This is the risks in the stock, painting a fuller picture of what's going on with this company. Why don't we start out with red flags? Then we'll wrap it all up talking about the company, a little bit on the valuation, and what we think of the stock.

Feroldi: The first thing I check for is to make sure it's not a penny stock. I've been burned very bad when I first started investing on those. DocuSign is absolutely not. Shares are trading for about $40 each. The market cap is over $6 billion.

Next, I check up on the customers. I don't like to invest in businesses where there's excessive customer concentration, where if any one customer left, it would cause the business harm. In DocuSign's case, they have hundreds of thousands of paying customers. The largest one accounted for only about 3% of revenue. That's not an issue here.

Then, I think about the industry in general. Is it facing long-term headwinds or long-term tailwinds? I think it's a very clear argument that the market for electronic signatures is growing rapidly, and DocuSign is a big reason why.

The next thing I think about is, is this business reliant on any outside forces for success? Does it need a strong economy or low interest rates or anything like that? I don't see any reason that DocuSign won't be able to grow, even if the global economy does slow down. I don't think that's an issue.

Finally, I think about stock-based compensation. You don't want to see so much of the value that's being created going just to employees through stock-based compensation. When I looked, last year's total stock-based compensation for this company was only about $30 million. That's actually a very reasonable number compared to their $520 million in revenue and their $6 billion in market cap.

This company does not trip any of my thesis-busting of red flags.

Lewis: We talked a little bit about the path that this company has gone on in its life on the public markets. It was very quickly a stock market darling, and really shot up after its IPO. Returns looked pretty good in the first couple months. Then, it came crashing back down to earth. It's now trading roughly around where shares first hit the market. You look at the valuation, and it really makes sense why that happened. This is a company that will do just under $700 million this fiscal year. And there was a period where they were hitting about a $10 billion valuation. Trading at 14X sales, give or take, is pretty rich. We're seeing them come back down to earth. That puts them at a $6 billion market cap. Like I said, somewhere in the neighborhood of $650 million, maybe $700 million, in revenue for the year. 10X sales is a little bit more reasonable. It's still a little rich.

Feroldi: Yeah. This company is priced for growth. There's no doubt about that. Even with its high valuation, though, my personal view is that DocuSign checks so many of the boxes that I like to see in a business that I think this is a great company to buy and hold today. I can tell you that I am personally not a shareholder, but as soon as The Fool's trading rules allow, I do plan on purchasing shares myself.

Lewis: When you look at that valuation, you might balk at it, especially when you consider top line growth is about 30%, and we've seen it come down a little bit over recent quarters. I think the thing that you have to remind yourself of when you look at a company like this is, yes, there might be some decelerating growth, and that growth might not be 40% or 60% year over year. But, with the structure of a subscription business, that's probably going to taper off over a much slower period. The growth that it's enjoying it will probably sustain for a decent amount of time, and the deceleration will be fairly slow, because the expansion rate's great, because they're bringing more customers on board. They've also made some acquisitions where it's pretty clear that they're going to be building out their suite of products, which gives them more upsell opportunities.

So, yes, 30% growth might not be gangbusters. But also realize that the runway's long for this business, and I don't think the drop in growth rate is going to be that severe over the next coming quarters or years, even.

Feroldi: I agree with you there. The other thing to note is that this company is, in its most recent quarter, producing adjusted earnings per share. Not GAAP earnings per share, but they're basically right on the cusp of doing so. It's very reasonable to assume that next year and thereafter, this company will actually be producing profits. Because their profit margin will be so small initially, you can expect, I believe, triple-digit profit growth for many years, or at least the first couple of years, as the business continues to scale.

Lewis: Brian, I'm with you on this being a stock that I'm very interested in. It's on my watchlist now. We've given the necessary caveats in the past that when you're talking about a company that has been traded for less than 12 months, you really need to take small bites. I think that's an important approach. We want to dollar-cost average no matter what we're buying into, but I think it's particularly important for companies that haven't even gone through their first four quarters on the public markets. That's just because, to the history that we've seen so far with DocuSign, there are probably going to be some pretty wild price movements. If you are interested, make sure that you are buying in installments with this company, you are not buying all at once and banking on one cost basis.

Feroldi: I think that's exactly the way to go. Also, as we said in the last show about Upwork, you never know how a company is going to react to being on the public side and dealing with Wall Street's expectations for producing a good earnings report every 90 days. This company did exceed expectations in both of its first two earnings reports, which is a good sign. But I typically to give a company at least a year of being on the public markets before I would take a full position. As I said, I do plan on purchasing this stock, but it would just be nibbling as we go along.

Lewis: I think that's a great approach. That's actually something that we talked about in the 13 steps to investing. When we're trying to teach people how to invest, one of the things we mention is, it's good to buy a share of a stock, even if it's just one share, because it gets you following that business. It might be that you're just getting introduced to the stock market, you're just getting introduced to the idea of buying individual stocks. You open up a Robinhood account, where you don't have to pay to trade, and you buy one share. Maybe your entire brokerage account has $100 in it, but you're buying one share. You're going to find yourself following that business a lot more, because you have skin in the game, and because you're following the earnings reports that come out, the news that impacts it on a day-to-day or week-to-week basis. So, yes, there's a lot of value in getting a little bit there so that you can then follow the story and be a little bit more invested, so to speak.

Feroldi: I think that's the right way to think about it.