Stuck Inside a Cloud: Do SaaS business models require a rethink of the traditional approach to public market valuation?

Abstract

This paper explores the rapid growth in the public valuations of SaaS companies and examines whether this growth can be explained by investment theory. SaaS companies have experienced a remarkable rise in stock market valuations in recent years. Through the construction of a SaaS Index, constituted of 20 publicly traded SaaS companies, the empirical study tests the efficacy of two traditional models of investment theory, The Capital Asset Pricing Model and Fama-French's 3 Factor Model. The Index is used as the basis for these models and additionally is supported by Linear Regression models. Ultimately, the assumptions which underlie these models are shown to be unsuitable for the SaaS Industry due its relative youth and unique characteristics. It then seeks to expand upon existing theory and practice by building a positive argument and highlighting additional possible factors including Growth, Profitability and Enterprise Value/Revenue which exhibit a greater explanatory role in share price movement. This enables the construction of a new model, of a company's revenue growth and Enterprise Value relative to revenue supported by a qualitative narrative which better accounts for the relative growth in the SaaS Index over the observed period. Ultimately, while this new model holds greater explanatory power, the underlying characteristics of SaaS companies such as the subscription model, capital efficiency and ability to scale are important and are more likely to be effective drivers of value into the future.