Most people are familiar with the names Adobe and Intuit TurboTax. Both well-known companies started out by offering customers a physical disc containing their software. To get the latest version, consumers had to buy and install a new program – sometimes as often as every year.

In the last decade, both Adobe Inc (NQ:ADBE) and Intuit Inc. (NQ:INTU) have evolved into successful SaaS companies by taking advantage of the recurring revenue streams available through subscriptions, and by providing updated services without requiring customers to make a new purchase.

There are many advantages to the SaaS revolution, both to providers and consumers, alike. While SaaS tools were previously used mostly by finance, cybersecurity and information services industries, they are now being utilized across a host of other sectors, including construction, agriculture and retail.

Savvy investors have taken note. In 2021, more than two dozen SaaS companies went public, requiring more than $200 billion in capital. In fact, SaaS funding has outpaced total venture capital funding by nearly 6 times in the last decade.

The use cases for software continue to grow, making it one of the most intriguing investment opportunities today. But as with any type of investing, you need to do your homework. Here are three quick ways to analyze a SaaS company before you invest.

1. The Rule of 40 Makes Things Easy

There are quite a few different formulas and factors that can be involved in thorough SaaS valuation, but there's one simple rule you can follow when taking a first glance at any particular stock you want to buy. That is the rule of 40.

If you're familiar with growth capital and venture capitalism, then you might already be familiar with this popular metric. If you want a SaaS company stock to be a good investment, then the combination of that company's percentage profit margin and growth rate should be more than 40%.

Assume you're looking at a SaaS company with a 20% profit margin and 25% in revenue growth. The number for the rule of 40 would be 20% + 25% = 45%. Given that 45% is more than 40%, that SaaS company's stock should be an alluring prospect for your investment.

2. Three Primary SaaS Benefits

Companies that choose to utilize the advantages of technology involved with SaaS open themselves up to three specific benefits that help them. These are also reasons why SaaS companies might become attractive to you as an investor.

First, when a company utilizes the SaaS model, it can simply focus on its software creation. Manufacturing and shipping CDs is no longer necessary, nor is extensive hardware testing or licensing servers that they have to support. This seriously reduces operating costs for more revenue retention investors like to see.

Second, their revenue is far more steady. Rather than getting one-time lump sum payments on an irregular basis, they now have a subscription model. The fees are smaller, but they happen a lot more often.

Many SaaS models replaced annual or even longer intervals of payments with monthly or even weekly subscription fees. Reliable and routine income makes it easier for investors to analyze the financial health of a company they might want to invest in.

Third, updates can happen nearly instantaneously. Going back to the previous TurboTax example, new features consumers might want wouldn't possibly show up until the following year or even the one after.

Now, any company using the SaaS model can roll out updates, changes, and patches to their cloud presence nearly immediately. As these software services become ingrained in the daily lives and operations of many consumers and businesses, brand loyalty is much easier to attain.

If you're like most investors, you love seeing companies have a robust base of regular consumers unlikely to take their business anywhere else.

3. Customers Coming and Staying

Before making a specific decision on which SaaS stocks you invest in, there is a third way to analyze such companies. Take a look at how they're getting customers into their system as well as how they might be locking them in.

How do you know if a company is bringing enough customers in? There are three metrics for that. First, their growth in total users will likely be evident and even bragged about in press releases and conference calls. Second, make sure their customer acquisition costs are growing slower than any jumps in their APR. Third, their annual recurring revenue is what shows that sales money is being spent well.

Getting customers into a company's SaaS ecosystem is important, but they also need to stick around and keep using existing products or even adopting new ones. Looking at a company's churn rate is a useful metric, although that data isn't always readily available.

You can also look at the dollar-based net expansion rate, known as DBNE. Another option is the revenue retention rate or RRR. Both of these measure money current customers spent in the first year to what those same customers spent the following year. A rate of 100% usually indicates a SaaS company is retaining its clients. Higher rates are even better.

Risks Do Remain

While you might feel ready to start investing in SaaS stocks, you should know that risks exist for any kind of investment. Returns are never guaranteed, no matter how much you manage your risk. Marketplace and technology trends point to a strong future of growth for many SaaS companies, but high valuations can happen with the risk of some stocks plummeting.

This is a high-growth sector, so your risk tolerance needs to be just as high. Also, keep in mind that many technology companies aren't actually profitable yet and might not generate long-term market shares that convert into reliable streams of revenue.

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