Software-as-a-Service (SaaS) stocks were once the darlings of Wall Street, where incredible revenue growth was the primary focus. Companies could lose vast sums of money as long as their sales continued to climb. That has changed dramatically. In a world of higher interest rates, investors are no longer willing to fund growth at any cost. Today, the path to profitability is as important as, if not more important than, top-line growth.
The ‘Rule of 40’ Becomes King
A key metric that has gained prominence for evaluating SaaS companies is the “Rule of 40.” This is a simple guideline: a healthy SaaS company’s revenue growth rate, combined with its profit margin, should exceed 40%. For example, a company growing at 30% with a 10% profit margin meets the rule. A company growing at 20% with a 25% profit margin also meets the rule. This metric provides a balanced view of both growth and profitability.
The Problem with Stock-Based Compensation
Many SaaS companies looked profitable on a “non-GAAP” basis, but this often excluded a huge expense: stock-based compensation (SBC). They were paying their employees with a large amount of stock, which dilutes existing shareholders’ holdings. The market is now scrutinizing this practice much more closely. Investors are seeking companies that generate real cash profits, not merely accounting profits that ignore SBC.
Efficiency is the Name of the Game
The new focus is on efficient growth. How much is a company spending on sales and marketing to acquire a new dollar of revenue? Can the company grow its revenue without increasing its headcount and expenses proportionally? This concept, known as operating leverage, is critical. The best SaaS companies are those whose profit margins expand as they get bigger.
Not All Growth is Created Equal
Investors are now scrutinizing the quality of a company’s revenue more closely. Is growth coming from signing up new customers or from upselling existing customers (net revenue retention)? High net revenue retention is a great sign, as it shows the product is sticky and valuable. It’s also much cheaper to sell more to an existing customer than to acquire a new one.
Finding Value in the Rubble
Many high-quality SaaS stocks were sold off indiscriminately when the market sentiment shifted. This has created opportunities for patient investors. Look for companies that have a dominant position in their niche, high net revenue retention, and are already profitable or have a clear and credible plan to get there soon. Avoid the “cash-burners” that still have no focus on the bottom line.
Conclusion
The SaaS investment landscape has matured. The simple story of “growth at any cost” is over. Profitability, efficiency, and cash flow are now the key metrics. This represents a healthy evolution for the industry, as it compels companies to establish sustainable, long-term businesses. For investors, this new reality provides a much clearer framework for identifying the true high-quality operators in the space.
