Software companies are firms that provide programs that help run hardware like computers and smartphones. In the past few years, the role of software has become important in all industries like management, word processing, and architecture.
In this article, we will look at how software companies make money and some of the top strategies of investing in them.
How software companies make money
In the past, software companies used to make money by selling software on DVDs. They also made money by offering other services like installation and providing technical support.
These days, however, most software companies are making money by offering software by subscription. This process is commonly known as software-as-a-service (SAAS). These firms typically sell the service for as little as $10 per month.
There are several well-known examples of companies that have successfully transitioned from the traditional approach to the software-as-a-service model. For example, in the past, Microsoft used to make most of its money selling Windows and Office software disks. Today, the firm makes most of its money by offering these products as a subscription service.
Adobe used to make its money selling its software products like Photoshop and DreamWeaver as individual software. Today, these solutions all come as a subscription service that starts at around $10 per month. Similarly, AutoDesk makes its money in a subscription model.
There are several benefits of the SAAS model. First, the model ensures that customers can remain loyal to a company. For example, companies find it difficult to move from one service provider to another. Second, software companies are able to provide free software updates to customers at no extra cost. Further, the SAAS model helps companies with their forecasts since subscriptions are easy to predict.
Types of software companies
To invest in software companies, it is important that you learn their types. This is a good thing to realize because these firms are valued in different methods. Broadly, these firms are classified into three:
- Enterprise-facing firms – These are companies that provide their software solutions to companies. Examples of these firms are Salesforce, CrowdStrike, and Okta.
- Consumer-facing firms – These are SAAS companies that provide solutions primarily to individuals. They generate a small portion of their income from corporations. Examples are DropBox and Spotify.
- Hybrid software companies – These companies provide their services to both consumers and enterprises. Examples are Microsoft and Adobe.
Software companies can also be classified in terms of what they do. Some of these types are:
- Cybersecurity companies – These firms provide solutions that help companies and individuals stay safe and protect their operations. Some of these firms are Okta, DarkTrace, and CrowdStrike.
- Productivity companies – These companies provide software services that help companies boost their productivity. Examples are Microsoft, Adobe, and Autodesk.
- Marketing – These firms provide solutions to help companies improve their marketing solutions. They include firms like Adobe, Hubspot, and Salesforce.
- Accounting software – These companies help other firms that provide tools to simplify accounting and tax processes. The best-known of these firms are Intuit and H&R Block.
- Database companies – These are firms that provide database solutions like Oracle and Microsoft.
- Hybrid software companies – These are firms that provide multiple software solutions. Examples are Microsoft, Oracle, and Salesforce.
- Talent management – These companies help other firms manage their talent lifecycles like hiring, tracking, and payroll.
Key metrics for software companies
Software companies are different from other types of firms like retailers, banks, and oil and gas. Therefore, investors look at different metrics when valuing these companies. The most popular metrics are:
- Growth – In this, they look at how a company is growing its revenue and profitability from one quarter to another. They also look at the current quarter and that of the same quarter in the previous year.
- Churn – This refers to the percentage of customers who cancel their subscriptions in a certain period. Since this is a non-GAAP figure, many companies don’t publish the figure.
- ARPU – This is a term that measures the average revenue per user. Investors watch it to see how the company is monetizing its current customer base.
- Margin – This is an important number that measures the profitability of a company. Examples of margins are gross, profit, EBITDA, and operating.
Therefore, to invest in software companies, you need to look at whether the firm is growing, losing, or adding customers and growing its market share. You should also look at whether the firm is growing its average revenue per user or not.
How to invest in software companies
There are two main ways to invest in software companies. First, you can invest in companies individually. For example, you can create a portfolio with companies like ServiceNow, Okta, Microsoft, and Salesforce. The benefit of creating such a portfolio is that its returns should be relatively higher in the long term.
The second option is that you can invest in software exchange-traded funds (ETFs). These are funds that are made up of several companies. The best-known fund with most software companies is the Invesco QQQ, which tracks the Nasdaq 100 index. Other software ETFs are the FirstTrust Cybersecurity ETF, First Trust Cloud Computing Fund, and SPDR Software and Services ETF.
There are several benefits of investing in software ETFs. First, they are a cost-effective way of investing. For example, if you invest in the CyberSecurity ETF, you will pay one tax when you exit the investment. Second, investing in ETFs helps you to invest in many companies at a go. Further, ETFs give you an opportunity to reinvest dividends.
Software is changing the world. Today, platforms like Slack and Microsoft Teams help people to collaborate, while companies like Adobe help companies to design and track their promotions. The companies are also experiencing substantial growth, which has helped them have bigger valuations than other traditional firms. In this article, we have looked at how the companies make money and some of the top strategies to invest in them.