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QuestionsCategory: Valuation QuadrantValuing SaaS companies
Thomas Chua asked 2 years ago

Hi Victor and Rusmin!
How would you value a company like Shopify when their net profits/ FCF are negative due to very heavy investments but the company shows incredible moat with very sticky recurring revenue? Would P/OCF make sense for Shopify?
And on comparison of valuation against its competitors do you think it make more sense to compare against Square or Amazon? Given that there are overlaps in activities for these companies and different stages of business life cycle.
Lastly, appreciate if you have any inputs/ metrics you look at when assessing SaaS companies.
Thanks!

4 Answers
Victor Chng answered 2 years ago

Hi Thomas,
 
1.Yes, you can use P/OCF to value them but have to make sure that their cash flow are increasing or consistent. 
 
2. I think their closet competitors should be WIX and square. Amazon will not be a good comparison.
 
3. As for analysing Saas companies, I think the most important things is their retention rate follow by whether are they consistently spending on R&D. R&D is crucial for them to maintain their competitiveness.
 
 

April Lo answered 2 years ago

Hello Victor and Rusmin,
I want to ask you on the use of Price/Sales ratio to value SaaS companies. I did not want to start a new thread so I thought I would ride on this thread since it is related.
What do you think of using P/S ratio to value SaaS companies? According to Valuation Quadration taught in IQ, P/S ratio is suitable to value cyclical companies whose net income become distorted due to depreciation & amortization etc. The similarity of this with SaaS companies is that SaaS companies’ net income are also distorted due to the cost to build up their businesses etc. Reasons why I am looking at these companies is they have >30% of Gross-Profit-to-Assets ratio which means that they have the potential to grow in the future.
As mentioned above, P/OCF is a good metric to start but I am also looking for more metrics to cover the downside of the businesses due to the risks of SaaS companies. Thanks :)

Victor Chng answered 2 years ago

Hi April,
 
I think P/OCF will be good to value SAAS companies but if the company is making loss on net profit and cash flow then P/S ratio will be the substitute. 

April Lo replied 2 years ago

Hi Victor,

But if the compay is making losses, you’ll avoid companies like this right? Since one of the criterias of Financial Quadrant is to choose companies that are making consistently increasing net profit and free cash flow for the past 5 years. Some SaaS companies look very attractive but then the risks are there.

Would love to hear your opinion. Thanks :)

Tan Hong Fu replied 2 years ago

Lol, I’m also asking the same question as i’m having trouble switching from a brick and mortar business valuation to a SaaS valuation.

Admin, can delete my question if you feel is it’s a duplicate.

Victor Chng replied 2 years ago

Hi April,

To be honest, SAAS have very good business model and most of them perform well. So I will not avoid the company but rather keep tracking them until they generate positive free cash flow.

April Lo replied 2 years ago

Thank you, Victor, for sharing your views with us. Will do portfolio sizing it is, to mitigate the risk :)

Victor Chng replied 2 years ago

Welcome :)

April Lo replied 1 year ago

Hi Victor,

I would like to ask again, can we take into account the net cash or debt of a company when it comes to calculating P/OCF or P/S? Eg: Adding net cash per share to operating cash flow per share and divide the share price by the sum.

Sorry for asking so many questions, am just wondering.

Victor Chng replied 1 year ago

Hi April,

You don;t have to include net cash or debt when using P/OCF and P/S. Also do note that you may be investing in some unprofitable SAAS so it is better to be conservative by excluding net cash or debt. Personally, for US market when calculating intrinsic value I will not include net cash and debt because they are unlike Asian companies where they tend to hoard a lot of cash.

On the side note, feel free to ask many questions as possible. Fifth Person exist to help investors like you so if you don;t ask any questions then I will be out of job :). I am more than happy to answer all your questions. Keep it up the good work.

Tan Hong Fu answered 2 years ago

Hi Victor and team, 

My understanding is for traditional brick and mortar businesses, it’s important to see a consistent track record of positive net profits. 

However, when it comes to valuing SaaS companies, “growth” metrics seems to be more important than profitability. 

I understand SaaS companies spend a lot of money to pursue growth (e.g acquiring new customers, market share, RnD) and therefore tend to reflect net losses in their income statements. 

The general idea that when their companies become “stable”, they will start to turn a net profit instead. 

But isnt there a risk whereby a company can burn money and not generate positive net profit at all? 

I’m confused if i should follow the above metrics ‘P/OCF’ , P/S ratios and place less importance on net profit OR  wait until the company turns a net profit before deciding to invest.

But this method might probably make me too late to the game. 

Victor Chng replied 2 years ago

Hi Hong Fu,

you can still allocate your money into unprofitable company but you have to make sure that it is a small percentage of your portfolio like 2% or less. By doing so, you will mitigate risk in the event that the company did not turn out well and it will not hurt your portfolio that much.

As mentioned above, I will still track the company even if it is not profitable as long as it have huge potential. I had seen many cases that even if I wait until company generate FCF or profitability then purchase the stock, I still don;t lose out on the gain because the market potential is high.