SaaS stocks as a group have outperformed for some time, and this trend has only accelerated over the past couple of years. Companies have come to prefer the SaaS model—where software is delivered via the cloud instead of being installed on expensive and hard-to-maintain corporate servers. Cloud-based software is both cheaper to operate and offers significantly greater flexibility, since it is updated several times per year with new features, instead of every few years, as under the old model.
For their part, investors appreciate the SaaS business model because its recurring revenue offers good visibility into prospective growth. Additionally, during the 2010–2020 period, investors gained a greater appreciation that SaaS companies are expanding their categories and even creating new ones. When software is easier and less expensive to consume, more companies and users tend to be drawn to it. And if that software is better and drives savings in other areas of a customer‘s business, such as creating a more efficient supply chain, improving employee productivity and collaboration, or democratizing a previously complex science like data analysis, the total addressable market is often multiples of what was previously envisioned.
Finally, the COVID-19 pandemic has generally both accelerated the expected pace of digitalization throughout the US economy and resulted in higher valuations due to low interest rates and the scarcity of companies delivering above-average revenue and earnings growth.
While the overall SaaS category has produced many years of outperformance, the chart below shows that these returns have been largely driven by the top half of the group—that is, the companies with the highest expected valuations over the next 12 months, expressed as a ratio of enterprise value to sales. Many of these companies are growing extremely fast and have very strong competitive moats around their businesses, but their valuations are extreme in a historical context and may argue for caution.
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