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​Are Software Companies Good Businesses? ​

In “Do software companies actually have good margins?”, Benn Stancil makes a case for a counterintuitive point : Software companies are much less profitable than they might seem.

Why?

Because the research & development costs associated with software should be part of their cost of goods sold. Software companies don’t invest once in R&D & then sell copies of the software as we did in the 90s on CDs.

It’s software-as-a-service. So the costs of developing & maintaining the software are ongoing.

If that argument is correct, then the average gross margin of a software company in the public domain would fall from 72% to 47%. Quite a stark difference.

Profitability for software companies isn’t straightforward. Different accounting rules govern revenue & cost recognition. In 2017, the industry migrated from ASC 605 to ASC 606, which are financial arcana as esoteric as it reads. Overnight, some companies were more profitable & others were not.

So let’s set profitability aside for a minute, & look at free-cash flow yield.

Free cash flow yield offers investors or stockholders a better measure of a company’s fundamental performance than the widely used P/E ratio. Investors who wish to employ the best fundamental indicator should add free cash flow yield to their repertoire of financial measures.¹

FCFY is a metric that measures this : how much of a company’s revenue, after funneling through every cost imaginable, is left over in its bank account at the end of the year. That’s my mental model for it, anyway.

Software companies top the charts at 3% over the last 20 years, according to data from New Constructs, a financial research firm. For a period from December 9, 2009, to approximately March of 2016, technology companies produced nearly 5% free cash flow yields on average.

There are times when other sectors yield more. For example, energy tops the list at the moment, primarily driven by the fluctuations in those markets. But over two decades technology tops the list.

And if AI fulfills anywhere close to its promise, we should expect that trend to continue.

¹ Despite the enthusiasm from Investopedia, I think it’s important to say that no financial metric is perfect & all of them are proxies for the ultimate performance of a business. Free cash flow yield has its imperfections & nuances like any other metric.

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