Why Microsoft Stock Just Jumped 4%
Earnings trump estimates, and Microsoft's guidance is golden.
The software-as-a-service (SaaS) business model has become the norm for many software companies. Customers who subscribe to a software product that’s continually updated benefit from the latest technology and increased pricing flexibility, while software businesses receive attractive streams of recurring revenue. The SaaS trend has been a significant driver of growth in the tech industry.
With SaaS stocks being popular among investors, and that popularity only accelerated by the COVID-19 pandemic, valuations of SaaS stocks are high. But buying high can lead to lackluster returns for investors, even if the company performs well.
If you want to invest in SaaS companies that are reasonably valued, then consider these three alternatives:
For 45 years, Microsoft (NASDAQ:MSFT) has been dominating the market for traditional software. Microsoft Windows is the standard operating system for PCs, and Microsoft Office is still frequently the productivity suite of choice.
Microsoft’s dominance was tested by the proliferation of mobile devices, which do not use Windows, and by competition from Alphabet’s (NASDAQ:GOOG) (NASDAQ:GOOGL) Google in the form of Google Docs, Sheets, and Slides. Microsoft eventually abandoned its PC-centric strategy by bringing first-rate versions of its Office applications to mobile devices, and it launched Office 365, a subscription-based version of Office.
With Office 365 garnering around 40 million consumer subscribers, Microsoft has preserved its lead in the productivity software market. Other SaaS products from Microsoft include Teams, the company’s collaboration software, which quickly gained subscribers during the pandemic. Teams aims to be a one-stop shop for collaboration by offering group chats, video meetings, and plenty of other features.
Microsoft isn’t a pure-play SaaS company, and the stock is historically expensive relative to earnings. But the company has been able to successfully transition to selling subscription-based software while maintaining its market dominance. Both revenue and earnings have been growing swiftly, even as the subsiding pandemic is altering the demand for SaaS offerings.
Best known for creativity software such as Photoshop, Adobe (NASDAQ:ADBE) creates industry standards. Cheaper and even free Adobe alternatives are available, but that hasn’t been enough to derail the software giant's market leadership.
Adobe has gone all-in on subscriptions, announcing back in 2013 that it would stop developing new versions of its stand-alone creative software in favor of selling subscription products. The move has paid off in a big way, with Adobe’s revenue at nearly $13 billion in its fiscal year 2020, up from just $4 billion in 2013. Transitioning from selling one-off licenses for hundreds of dollars to selling subscriptions costing as little as $10 per month has made the company’s software available to a much wider audience.
Like Microsoft’s, Adobe’s stock is historically expensive. But the company performed well during the pandemic, posting record revenue and profit, and that solid growth has continued into 2021. The company’s software is as dominant as it’s ever been, and that’s unlikely to change.
Fast-growing SaaS companies often post large losses as they scale up their revenue.
Salesforce (NYSE:CRM), the provider of cloud-based customer relationship management software, is a SaaS pioneer. The company went public in 2004 and has since grown its annual revenue to around $17 billion.
Salesforce isn’t nearly as profitable as Microsoft or Adobe, partly because it spends close to half of its revenue on customer acquisition in order to keep growing. Shares of Salesforce have still surged in price by around 550% during the past decade as the SaaS business model has become the industry standard.
The pandemic wasn’t much of a problem for Salesforce, with the company posting double-digit revenue growth throughout 2020. The resiliency of Salesforce during the crisis makes it a good option for investors looking for a pure-play SaaS stock, and its soon-to-close acquisition of Slack (NYSE:WORK) could further boost Salesforce's performance.
Many investors use the price-to-earnings (P/E) ratio to evaluate a company, but with many SaaS companies not yet profitable, this type of analysis is not always possible. Instead, you can consider these two important metrics:
How much is a SaaS company spending to acquire each new customer? You can calculate the ratio of sales and marketing spending to revenue and evaluate whether that ratio is declining over time. If it’s not, then the company may be growing but still spending too much to bring in new customers.
The price-to-sales (P/S) ratio, which equals a company's market capitalization divided by its annual revenue, is often used as a valuation metric for SaaS companies in place of the P/E ratio. A higher P/S ratio denotes optimism among investors that attractive revenue growth will continue and that the revenue will eventually generate profits.
However, an exceedingly high P/S ratio is something to regard cautiously regardless of the quality of the company or its growth prospects. SaaS highfliers such as Shopify (NYSE:SHOP), Zoom (NASDAQ:ZM), and Datadog (NASDAQ:DDOG) trade for between 35 and 55 times sales, ratios that require plenty of optimism to justify. Adobe, for reference, trades for around 20 times sales, while Microsoft's P/S ratio is about 13.
Microsoft, Adobe, and Salesforce aren’t the most exciting SaaS stocks, but they’re all profitable, and they all sport valuations that don’t require mental gymnastics to justify. Growth in subscription-based software, supercharged by the pandemic, will create plenty of winners in the SaaS industry -- but ignoring valuation is a recipe for disappointing returns.
Earnings trump estimates, and Microsoft's guidance is golden.
MSFT earnings call for the period ending September 30, 2021.
GOOGL earnings call for the period ending September 30, 2021.
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