The term software-as-a-service, or SaaS, was first coined in 2005 by John Koenig. The SaaS business model gained prominence in the past decade, driving shares of companies within this sector significantly higher.

However, due to a challenging macro-environment and concerns over the steep valuations surrounding tech companies, several SaaS stocks have significantly trailed the broader market in 2022.

For example, shares of Salesforce, which is the largest SaaS company in the world, are down 42% from all-time highs. Similarly, shares of companies part of the SaaS vertical such as Twilio, Shopify, and Zoom Video have declined by 78%, 79%, and 73%, respectively.

Comparatively, the S&P 500 has declined by 18% from all-time highs, while the tech-heavy Nasdaq Composite index has slumped by 29% since November 2021.

Let's see what are SaaS stocks are and how these companies generate revenue.

What are SaaS stocks?

A software-as-a-service company hosts its software on the cloud, allowing customers to access its services for a subscription fee. The clients can cancel or upgrade these subscriptions as per their requirements and the ever-changing market environment.

A SaaS company's primary aim is to improve customers' operational efficiency by offering solutions across business functions such as analytics, finance, human resources, cyber-security, customer relationship management, and collaboration.

SaaS platforms are easily scalable as they are hosted on the cloud, providing users flexibility to handle increasing workloads. Further, enterprises don't have to shell out vast sums of capital for purchasing a one-time license, but can instead spread out expenses over a period of time. 

Basically, SaaS models can be compared to renting out an apartment instead of purchasing one. 

A SaaS customer "rents" the software periodically (monthly or annually) while the vendor generates recurring income with an opportunity to increase subscription fees each year and upsell other services to its customer base.

Important metrics associated with SaaS companies

Some of the most important metrics used to analyze SaaS companies include:

Net dollar-based retention rate

SaaS companies spend substantial resources to acquire customers. But once acquired, it's imperative for them to remain engaged on the platform and increase spending over time. The net dollar-based retention rate is crucial to measuring customer retention and spending.

For example, Snowflake ended its most recent quarter with a net revenue retention rate of 174%. It suggests existing customers increased spending by 74% on the Snowflake platform in the last 12 months.

Annual recurring revenue

Annual recurring revenue or ARR is among the most common metrics which provide insights into a SaaS company's revenue growth. The ARR is high if a company's retention rate remains robust. A company's ARR is measured by combining sales generated from contracts, subscriptions, and other forms of recurring revenue.

While Cloudflare's sales rose by 54% year-over-year in Q1, its annual recurring revenue increased by 27%. The ARR is also used to calculate the net dollar-based retention rate.

Revenue churn

In addition to higher sales, SaaS companies would ideally want revenue churn to trend lower. The revenue churn rate calculates the percentage of customers who have downgraded or canceled subscriptions in a particular period.