Understanding these 2 metrics will make you a better growth investor

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

A man rests his chin in his hands, pondering what is the answer?

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

Market pundits are comparing the recent throttling of technology stocks to the Dot.com bubble of the early 2000s. With the tech-heavy Nasdaq Composite down nearly 30% year to date, its easy to see why. But there’s a key difference between the two crashes. At the turn of the millennium, many internet companies saw their stock prices skyrocket purely on speculation.

The majority of these companies lacked any meaningful revenue to show their business models could be substantiated. In other words, they didn’t really have business models — just plans (see Pets.com). The CEO of UBS, Ralph Hamers, said this at the recent World Economic Forum:

It is not like 20 years ago. We had some models that were just models on paper and not real. In the last 20 years, we have been able to show that there are real changes happening in retail businesses, in financial businesses etc., and that trend is not going to stop because of what we see currently.

In the Dot.com meltdown, most internet companies were wiped out with the exception of a few mega winners like Amazon (NASDAQ: AMZN) and Booking Holdings (NASDAQ: BKNG).

Because many of today’s technology companies have proven business models, dozens of huge winners — instead of a handful — will come out of this valuation compression. And being able to distinguish the cream of the crop will be key for investors. 

To that end, let’s unpack two really important metrics for analyzing technology-driven businesses: recurring revenue and dollar-based retention rate.

Recurring revenue creates predictability and optionality

Recurring revenue is the backbone of every subscription company. Unlike one-off sales, recurring revenue is stable and can provide a high degree of predictability that you don’t get with lumpy revenue models.

The superiority of a recurring revenue business model is perfectly showcased in Adobe (NASDAQ: ADBE)‘s switch nearly 10 years ago from selling its software through priority licenses to cloud-based subscription access.

At first, the company struggled as customers tried to navigate the change. But within 3 years, the company was producing more annual revenue than ever, and 20% of its customer base was made up of first-time Adobe users.

So why is recurring revenue a strong indicator of a superior business?

Well, first of all it’s sticky. Just think of all the subscriptions you’re paying for right now that you rarely think about (and maybe even rarely use!). Second, it allows management teams to spend less time forecasting their yearly revenue and more on enhancing their services and expanding customer spending.

Getting customers to upgrade a one-time purchase is extremely difficult, but convincing them to upgrade a subscription to instantly unlock new features is much more compelling.

Today, 93% of Adobe’s total revenue is recurring, and in turn, the company has seen its operating margins balloon from 10% to over 30% since making the switch.

The ability of technology companies to focus on innovating and expanding their product offerings by using a recurring revenue model is one of the primary reasons beaten-down growth stocks look much more resilient today than those of the early 2000s. 

High retention indicates strong demand

Dollar-retention rate is a key indicator of quality because it showcases software demand and loyalty from existing customers. The metric not only reflects churn (cancelled subscriptions) but shows when customers are increasing their spending on the platform.

This is immensely important because getting your existing customers to spend more is much cheaper than trying to land new customers. In other words, high dollar retention equates to improving margins. So, what would be considered high retention?

First of all, anything under 100% should be a red flag that indicates the company is losing revenue from its existing customers (either due to subscription downgrades or churn). Anything over 100% indicates the business is retaining its customers and deriving more revenue from them.

Robotic process automation leader, UiPath (NYSE: PATH), reported a dollar-based net retention rate of 138% in its most recent investor presentation. This means that over the last quarter, the company increased revenue from existing customers by an impressive 38%.

You can compare a software company’s retention rate to that of its competitors to see how their product stacks up. Appian (NASDAQ: APPN), which offers low-code automation solutions, posted a much lower subscription retention rate of 117%, further substantiating the quality and demand of UiPath’s. 

It’s also worthwhile to compare the current retention to past reports. Consistently declining retention is likely a red flag. In the case of UiPath, there was a quarter-over-quarter decline from 145% to 137%. The company’s management team attributed this to macroeconomic headwinds, such as the war in Europe, and reduced enterprise budgets.

While a single-quarter decline is probably not a reason to write off the company, this trend should be monitored closely moving forward.

All in all, a high retention rate indicates that existing customers are sticking around and increasing their spending, which will ultimately improve the company’s bottom line.

Technology companies are stronger today than in the early 2000s

There are countless similarities between the tech-fueled crash of 20 years ago and the one currently unfolding. But I think this has created opportunity for investors. Technology businesses today are very clearly stronger than those of twenty years ago, and while there may be more near-term pain for growth investors, there will likely be a high number of big winners once we emerge from this bear market.     

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

The post Understanding these 2 metrics will make you a better growth investor appeared first on The Motley Fool Australia.

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Mark Blank has no position in any of the stocks mentioned. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has positions in and has recommended Adobe Inc., Amazon, and Booking Holdings. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has recommended the following options: long January 2024 $420 calls on Adobe Inc. and short January 2024 $430 calls on Adobe Inc. The Motley Fool Australia has recommended Adobe Inc., Amazon, and Booking Holdings. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

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