The Art and Science of Software Company Valuation

While most public company investors would agree on the importance of revenue growth as a key metric to monitor year-over-year, quarter-over-quarter, or even month-over-month, not all take the information at face value. In the software sector for example, three key revenue lines typically make up the large majority of total revenue and each tells a different story. Recently, publicly traded Sage Group saw a little bit of art and science play out on its company stock price as it announced a decline in license revenue.

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SaaS revenue, which stands for Software as a Service, is generally viewed as the most valuable revenue type given it is recurring in nature and an investor can assign a certain degree of confidence that SaaS customer contracts will continue to cash flow year-over-year for the next two years, three years, five years, or more, depending on the specific contract terms.

Traditional software, however, is typically sold under a license and maintenance framework, where the license involves the customer paying a relatively large up-front payment for the right to download the software and use it on their premises. Meanwhile, the maintenance portion is an annual fee typically ranging from 15% to 20% of the up-front license cost and covers ongoing customer service while the software is being used as well as any software updates the company rolls out. License and software is viewed differently by investors since the license portion is a one-time event and the maintenance piece is a small fraction of what SaaS revenue would be for the same software deployed in the cloud.

When Sage Group, a well-known software company in the U.K. whose solutions are used by over half of British businesses to pay their employees, announced that their decline of license revenue was due to a gradual transition to offering their software in the cloud, or in other words, as SaaS, the market overreacted viewing the decline as a net negative to the business. However, a closer look would reveal that the transition in revenue towards SaaS will play out favorably in the long run. As more revenue shifts to SaaS, public investors will assign a higher multiple per SaaS dollar generated.

Such a transition to the cloud takes time and can be painful for the company undergoing the transition. Public investors are not always the most forgiving for short term underperformance but neither are they always the most informed or concerned about long term strategy.

Sage Group overall continues to increase revenue year-over-year. Its latest reported was $1.9 billion for the year ending September 30, 2019. Its most recent market capitalization is approximately $8 billion.