Are SAAS valuations too high?

technicalrise2 · Post by **technicalrise2** » Fri May 07, 2021 11:29 am

This is a perennial question and of course almost unanswerable in the abstract. The unique features of an SAAS company certainly justify higher multiples than the average company.

Here are the considerations:

No marginal cost to add new customers (extremely elevated margins)
Old customers experience lock-in as they build systems around the SAAS offering
The software is not pirate-able because it is offered as a service
High customer satisfaction because software patches, upgrades, and fixes can be rolled out anytime
Modular with the ability to sell collateral offerings based on the core service offering
Some degree of pricing power because of the value of the offering to customer

So these companies have a high degree of optionality far beyond your typical company.

But how do we put some kind of back-of-the-envelope number on the value of a company like Snowflake (SNOW)?

Here's one way, using the traditional metric of the P/E ratio, which is used to value traditional companies.

Snowflake currently generates $500 million in revenue, the growth predictions, (very roughly) are as follows

2020: $500 million
2021: $1 billion
2022: $2 billion
2023: $4 billion
2024: $8 billion
2025: $16 billion

This assumes what one might think is a pie-in-the-sky growth rate of around 100% per year for the next 5 years, but suppose it was accomplished (and it's not impossible!).

Suppose now that in 2025, Snowflake stopped growing, or started growing substantially more slowly, but instead started to take profits and managed to take a 50% profit on its revenues, of $8 billion/year. A P/E ratio of 20 would give Snowflake a market-capitalization of $160 billion, a gain of 2.3x its current market capitalization or 166% in only 5 years. That's a compound annual growth rate (CAGR) of 33.3% over 5 years!

And this is a conservative valuation based on the idea that Snowflake, rather than continuing to invest in GROWTH decides to just start taking profits.

Thus, holding onto a company even when its valuation fluctuates wildly in the short term is very worthwhile as long as the growth story stays stable. These are GREAT companies.