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Investing in SaaS Stocks

Updated: Dec. 21, 2020, 11:32 a.m.

The old way of buying software -- pricey one-off purchases of perpetual licenses -- has some big downsides. Software companies must continually convince customers to upgrade to new versions, and customers are forced to shell out a bunch of money all at once. If you wanted to use productivity software a decade ago, you had no choice but to spend hundreds of dollars for software that would be out of date in just a few years.

Today, many software companies have shifted to a software-as-a-service (SaaS) business model. Instead of a one-and-done transaction, customers now subscribe to a software product that’s continually updated. The software company gets a reliable stream of recurring revenue, and the customer gains flexibility and always-up-to-date software.

Did You Know?

Fast-growing SaaS companies often post large losses as they scale up their revenue.

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What are the best SaaS stocks?

SaaS stocks are popular among investors, and that popularity has shifted into overdrive thanks to the COVID-19 pandemic. Valuations are very high, making many SaaS stocks incredibly risky.

The best SaaS stocks and the best SaaS companies are not the same, because valuation matters in the long run. If you want to invest in SaaS stocks without taking on excessive risk, consider these stocks:

1. Microsoft (NASDAQ:MSFT): Microsoft has been around for 45 years, dominating the era of traditional software. Microsoft Windows became the standard operating system for PCs, and Microsoft Office was the productivity suite of choice.

Microsoft’s dominance was tested by the proliferation of mobile devices not running Windows, and by competition from Alphabet’s(NASDAQ:GOOG) (NASDAQ:GOOGL) Google in the form of Google Docs. Microsoft eventually abandoned its Windows-centric strategy by bringing first-rate versions of its Office applications to mobile devices, and it launched Office 365, a subscription version of Office.

Office 365 has been a success, garnering around 40 million consumer subscribers and cementing Microsoft’s lead in the productivity software market. Other SaaS products from Microsoft include Teams, the company’s collaboration software, which is quickly gaining subscribers during the pandemic.

Microsoft isn’t a pure-play SaaS company, and the stock is historically expensive. But the company has been able to successfully transition to the SaaS era while maintaining its market dominance.

2. Adobe (NASDAQ:ADBE): Adobe is best known for creativity software like Photoshop. Adobe’s software products are the industry standard, and while there are cheaper and even free alternatives available, that hasn’t been enough to derail the software giant.

Adobe has gone all in on subscriptions, having announced back in 2013 that it would stop developing new versions of its stand-alone creative software in favor of its subscription products. This initially hurt the company’s financial performance, since revenue that had once been recognized right away was now being spread out over time. But the move has paid off in a big way.

Adobe’s revenue topped $11 billion in fiscal 2019, up from just $4 billion in 2013. Moving from selling one-off licenses for hundreds of dollars to selling subscriptions costing as little as $10 per month has opened up the company’s software to a wider audience.Like Microsoft’s, Adobe’s stock is historically expensive. The company’s subscription business model hasn’t been tested in a recession, so it’s unclear how much Adobe will be affected by the pandemic-driven economic downturn. But the company’s software is as dominant as it’s ever been, and that’s unlikely to change.

3. Salesforce (NYSE:CRM): Salesforce, a 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 sales and marketing to drive growth. But that hasn’t stopped the stock from soaring. Shares of Salesforce have surged around 700% over the past decade as the SaaS model became an industry standard.

Like any enterprise software company, Salesforce’s revenue will be affected by business failures during the pandemic-driven recession. But Salesforce is a good option if you’re looking for a profitable, pure-play SaaS investment.

What to look for in SaaS stocks

While Microsoft, Adobe, and Salesforce all turn healthy profits, many SaaS companies are unprofitable, so the standard price-to-earnings ratio doesn’t apply. A lack of profits isn’t concerning on its own. A SaaS company must spend on sales and marketing to gain customers, but those customers pay for the product over time. This timing mismatch means that fast-growing SaaS companies will often post large losses as they scale up their revenue.

One thing to look at is how much a SaaS company must spend to acquire each new customer. The lower the ratio of sales and marketing spending to revenue, the better. And that ratio should be declining over time. If it’s not, it could be an indication that the company is spending too much to bring on new customers.

The price-to-sales ratio is often used as a valuation metric for SaaS companies. The higher the ratio, the more optimistic investors are that high rates of revenue growth will continue, and that that revenue will eventually lead to profits. For reference, Adobe trades for around 18 times sales, while Microsoft trades for around 11 times sales.

An exceedingly high price-to-sales ratio is something to be wary of, regardless of the quality or growth prospects of the underlying company. SaaS high-fliers like Shopify (NYSE:SHOP), Zoom (NASDAQ:ZM), and Datadog (NASDAQ:DDOG) trade for between 50 and 100 times sales, levels that are difficult to justify even under the rosiest of scenarios.

Microsoft and Adobe aren’t the most exciting SaaS stocks, but they’re both profitable, and they both 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 poor results.

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