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Software priced for forever
Take Guidewire: a model with 12% growth for 20 years is good to go. In the SaaS apocalypse, people began putting its growth in years eight, nine, ten, and eleven at 4%, 2%, 0%, and minus 2%. Thoma Bravo's own modeling puts the effect on valuations at about 30%.
Other habits drew scrutiny once the tailwinds were gone. Software companies had handed out stock compensation like candy, and the industry had run near-zero margins for 20 years.
On a price-to-earnings basis, software now trades at a discount to the S&P median despite twice the growth rate and 80% gross margins.
Why do distant years move a valuation?
A discounted cash flow model values a company as the sum of its future cash flows, each reduced to today's value, plus a terminal value for the years beyond the forecast. For fast-growing companies, terminal value often makes up well over half of the estimate, according to the valuation textbooks of NYU professor Aswath Damodaran. Small changes to long-run growth rates therefore move the final number a lot. Analysts who extend the forecast period with lower growth cut the valuation without touching near-term sales.
Why does stock compensation flatter software margins?
Many software companies report both GAAP earnings and adjusted earnings, and the adjusted figures commonly leave out stock-based compensation. Under US accounting rules, that compensation counts as an expense measured at the value of the shares on the grant date. Excluding it makes operating margins look higher than the GAAP figure. Stock-based compensation also dilutes existing shareholders when new shares are issued.
Why can software earn 80 percent gross margins?
Copying a finished program costs almost nothing, so the cost of delivering one more customer is small. Cost of goods sold for a subscription software company is mostly cloud hosting and customer support. Gross margins of 70 to 80 percent are common for software as a service. Physical manufacturers carry materials and labor in every unit sold, which keeps their gross margins far lower.
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