There are a lot of factors to consider when looking at potential tech investments, including the size of the potential market and the people leading the company. But at the end of the day, financials matter too, and with young, early-stage companies often focused on growth over profits, financial statements tend not to always provide black and white answers about the health of a business.
Appearing on Motley Fool Live to record the Industry Focus podcast, Motley Fool analyst Tim Beyers explains to Industry Focus host Dylan Lewis why he tends to look at things other than financials first, and talks about what numbers he does focus on when evaluating a tech investment.
Dylan Lewis: when you're looking at the numbers, does it start with Total Addressable Market, are you looking at the financials first? You know, where are you tending to focus your early research?
Tim Beyers: The financials are the last thing that I look at, they quite literally are the last thing I look at. I look at customer and product, like, those two are the first two things that I look for, customer and product. Then I look at leadership and I look to see whether or not this is a customer zero company, if it's a customer zero company, I'm really interested. And one of the other patterns that I have found in tech that really resonates is a technical founder paired with a business founder. So, that's like HubSpot (NYSE:HUBS), you know, Brian Halligan, Dharmesh Shah, one is the CEO, one is the CTO. Shared vision, but division of responsibilities, that can be a really great combo.
That was also true, for example, at MongoDB (NASDAQ:MDB). Now, those founders, more than 13 years later after starting the business, they've since moved on. I'm not really concerned about that, because 13 freaking years, [laughs] that's a long time to do a heavy-lift, right, but similar idea. So, I like that a lot. And then when I finally get to the financials, Dylan, I start looking at some metrics that are a little off-standard, I start looking for what I call the compounding metrics, because very often what you're seeing are things like, it's not profitable yet or, you know, revenue growth is off the charts, but they're burning cash. You know, how much money are they going to need to raise, when are they going to get profitable? Like, things like that.
So, instead, I started looking for high rates of revenue growth, but I started looking for things that give me some sense of unit economics. And unit economics meaning, for every product that they sell, say, every license, every time somebody uses the product, the more people that use it, the more profitable it becomes. Like, I want to be able to see evidence that that is going on. So, I look for things like gross profit growing faster than revenue, that's really useful. I also like to see, over a long period of time, when revenue growth is leading, let's say, R&D growth. Revenue growth leading R&D growth, that can be really useful as well, because I don't just want to see, like, good products, what I really want to see is good products that are saleable. So, if a company is spending a boatload on R&D, but revenue growth is slowing, you know, they may be throwing a lot of money at products that don't work, so I like to see that too.
And then there's this unusual statistic called the rule of 40, it's not a perfect statistic, but I like to see some improvement in this area. I don't need it to be over 40, but here's how the math works. You're taking the revenue growth rate, so as a percentage, so let's say, a company is growing 50% annually, and then I add to that the operating margins. So, revenue growth rate plus the operating margin percentage, so let's say a company is growing 50%, and its operating margin is -10%, still losing money, well, that's still 40%. So, the rule of 40 says there's enough growth there that over time we can expect this to be a cash generating company. I like to just see that, even if it's not 40, I like to just see it improving; if it's improving, I'm good. Like, I want to see signs that this company is gaining steam as it grows, if it's not, then I have to ask why.
Lewis: I love all of that. [laughs] And I think Brian and I have joked on the show before, you know, doing the prospectus breakdowns, like, it's a high growth company that's losing a ton of money because they're just shoveling money into sales and marketing. Tell me if you've heard this before, right --
Beyers: Yeah, right ...
Lewis: And just like, we see this over and over and over again. And so, I think, to be clear, we're talking about relatively early stage businesses with a lot of the criteria that you're using. This kind of goes out the window for something that has been profitable for maybe five or 10 years and is a lot firmer in its position in the market that it's going to be growing into.
Beyers: Yeah, totally. I mean, a mature business, you really wouldn't want to use the same level of diligence. You would want to be looking at profit, you want to be looking at margins and you'd really want to be looking at, like, if this was a dominant tech business, one metric, it's not a bulletproof metric, but one you could really look at, is free cash flow margin. You know, the best of these tech businesses have ridiculous free cash flow margins.
Let me give you an example; Amazon (NASDAQ:AMZN) Web Services, 30% free cash flow margin. That is bananas. Meaning, $0.30 of every $1 of revenue flowing down for Amazon Web Services shows up as cash. Period. Just cash. Like, that is extraordinary.