Industry Discussion

106 To conclude our discussion regarding Zoom, we deem their internal capabilities to be a god fit with the external environment the company operates in and therefore presents solid growth opportunities. More specifically, we think the company’s strategic choices facilitates growth similar to the 19,90% implied by its stock price. In other words, we believe Zoom’s share was fairly priced as of January 1^st, 2021 and would label ZM with a hold recommendation.

107 reflected in the share price of IBM compared to the other companies in the analysis. As a result, when there are differences in how the free cash flow is allocated, the implied growth rate in FCFF alone does not necessarily provide a good metric of how the share price is valued. This is also why we categorize in order to avoid making senseless comparisons. Furthermore, one could argue that the reverse engineered DCF model used in this thesis is better suited for companies that reinvest all earnings because growth the FCFF is a better representation for the share price for such companies.

When it comes to fast-growing companies, we chose to investigate Zoom in detail, for which we retrieved an implied annual growth rate of 19,90%. As a result, given their valuations, the model predicts that three of the other growth companies will have to grow faster than Zoom. This means that they must outperform Zoom every year for the next ten years in terms of growth in FCFF. Our research revealed that Zoom is a standout company that has outperformed the competition in terms of revenue growth. Furthermore, internal analysis indicates that Zoom is well positioned for the future and possesses capabilities that allow the company to capture market share at a rate aligned with market expectations.

DocuSign, for example, is a growth company that our model claims will need to increase its FCFF by 36% per year for the next ten years. These are unquestionably high expectations. However, when the CAGR of revenues over the last five years of 42,1% is considered, the implied growth rate does not appear irrationally high. As previously discussed, given the advantages of the SaaS business model, revenue growth may serve as a good proxy for FCFF growth. As a result, the financial market anticipates that DocuSign’s performance and growth will continue current pace.

This also applies to the other companies, which have shown exceptional revenue growth in the past. However, with the market expected to grow at a rate much lower than this per year, there simply is not enough cake for everyone. The industry has grown at an incredible rate of 26,59% in the last five years, but the pace will slow significantly, according to industry forecasts on which our analysis is based. Of course, there is a high degree of uncertainty in all forecasting, which is the main reason as to why we chose the reverse-engineering model. However, in order to extract value and insights from the model, we need to put the results in context. Therefore, industry growth is a good benchmark, reflecting the possibilities in the environment in which the companies compete.

108 Despite the predicted decline in growth, reports from McKinsey, Deloitte, and Gartner all agree that COVID-19 has forced a rapid digital transition across all industries, resulting in a massive increase in demand for SaaS products. The question is whether this shift is short-term or long-term for which we argue in favor of the latter. In most cases, a digital transformation is often motivated by operational cost efficiency. This transition was clearly forced and exacerbated by the pandemic, and certain demands, such as remote work, will probably be reduced after the pandemic has passed.

However, we doubt that businesses that have invested in this transition will fully reverse their investment once employees are allowed back into their physical workplaces. When businesses measure the cost savings and efficiencies produced by the SaaS products they used during the pandemic, they are more likely to want to maintain those levels of cost efficiencies, we think.

Nonetheless, as previously said, after the pandemic, demand for certain items, such as video conferencing products, may decline. This emphasizes the value of SaaS providers offering a diverse product ecosystem rather than being dependent on a single product.

Another angle to consider is whether this transition would occur in the next ten years regardless of the pandemic. The pandemic has undeniably accelerated companies' transition to SaaS, but businesses were already shifting toward such products before the pandemic broke loose, which is illustrated by the historical growth rate in end-user spending in the market. Therefore, we do not think that businesses will reduce their SaaS product usage significantly after the pandemic. In other words, the potential to maintain the high industry growth that SaaS has experienced over the last five years appears promising, which improves the industry outlook. This boosts the industry valuation and strengthens the arguments that justify the companies' high implied growth rates.

Based on this reasoning, we believe that demand for SaaS products will continue to grow during the forecast period, and that the rate will be slightly higher than the estimates provided by Gartner (2020) and MarketLine (2020). Therefore, we suggest that the annual industry growth rate will stabilize around 15%-20% for the next 10 years. However, as revealed by the Porter's Five Forces analysis, the industry shows, among other threats, characteristics of relatively low entry barriers.

This implies that a large number of new providers may enter the market, increasing competition and reducing profit margins. This simply means that more players compete for the same customers, and that each player's market share shrinks. As a result, the maximum amount that each company can grow is limited.

109 Considering each company’s different growth rates, low entry barriers and high competition, the industry will most likely experience market saturation during the next ten years. This in turn, implies that not all companies will be able to grow as fast as the valuations requires. In this regard, it is also important to consider the value stocks that are expected to experience a decrease in FCFF each year during the forecast period, according to the model. This simply allows other players to take their market share and makes sense of the equation in favor of the growth companies with high growth predictions. Nonetheless, some of the implied growth rates for some of the companies are so high that they are difficult to justify. Twilio and Slack, for example, have implied growth rates of 276% and 62%, respectively. According to our findings, Zoom is well-positioned in the market and has the capabilities to maintain a competitive advantage in the coming years – yet Zoom's implied growth rate is within the industry's expected annual growth rate (15% -20%). This means that Twilio and Slack will need to significantly increase their revenue growth, gain market share, and outperform companies like Zoom over the next ten years in order to justify their current valuations. Zoom, on the other hand, may maintain its current position and follow industry growth to justify its valuation.

Given the above discussion around current market size, attractiveness of the industry, expectation for further industry growth, and the identified positioning of Zoom, which is revealed to be one of the most attractive companies in the market, there are numerous signs that indicate an exaggerated expectation of how much certain growth companies can grow during the forecast period.

So, what accounts for these underlying expectations and valuations of specific growth companies in the SaaS industry? Have the fundamental effects of the pandemic's consequences been overstated, or are there other factors that contribute to such high valuations?

The provided literature review suggests that several factors have an impact on stock valuations.

So far, this thesis has only looked into fundamental factors like macroeconomics, finance, and strategy. We used theories, models, and frameworks from these topics to assess current valuations, and the results strongly suggest that the two case companies are priced reasonably. According to the provided literature review, a variety of factors influence stock valuations. So far, this thesis has concentrated on macroeconomics, finance, and strategy. We assessed current valuations using theories, models, and frameworks from these fields, and the results strongly suggest that the two

110 case companies are priced reasonably. Given Zoom's strong market position and implied growth consistent with the rest of the market, one could argue that the implied growth of the other companies, which exceeds the market's expected rate, is unattainable. On the basis of this reasoning and previous discussion, one could argue that Twilio, Slack, and DocuSign are overpriced. Although we have not conducted extensive internal analysis on these companies, we believe there are clear indications of exaggerated expectations among investors based on the extreme deviations in implied growth rates and using Zoom and the broader industry as benchmarks.

In addition, fundamental valuation metrics on an aggregated level, such as Shiller P/E and market-cap-to-GDP, shows all time high valuations in the overall stock market. This indicates that investors appear to be overly optimistic, with unrealistically high growth expectations. As a result, one can argue that fundamental focus cannot fully explain valuations, and that we must consider behavioral finance as a possible explanation.

The literature review provides several examples of how investors are frequently biased and irrational in their decision-making. Specifically, price fluctuations in growth companies may be more sensitive to effects from behavioral finance theory than price fluctuations in value stocks; a large portion of the valuation of a growth stock is, by definition, in its future investments. As a result, there is more uncertainty surrounding the valuation of such companies. Momentum from herd instinct trading, in which investors follow what they perceive other investors to be doing, may thus have a greater impact on price fluctuations for growth stocks than for value stocks.

Furthermore, Tokic (2020) emphasizes positive feedback trading, i.e., trading solely on technical analyses, as a key factor in the formation of stock bubbles. He claims that the valuations of tech stocks in 2020 are a textbook example of a high divergence between market prices and fundamentals, and that the market currently resembles the anatomy of a positive feedback-driven bubble. Investing in stocks has also become more accessible to young people, thanks to phone apps and social platforms where people can share their experiences and encourage one another.

These investors have a higher risk tolerance and a shorter investment horizon than institutional and professional investors, and the accumulation of this type of young investors may magnify the impact of herd instinct and positive feedback trading (Wijayanti, Suganda, & Thewelis, 2019).

111 Moreover, TINA, equities' popularity as an investment asset because all other assets yield less is a momentum strategy that may have influenced growth stocks. Although one could argue that this strategy is due to fundamental factors such as low interest rates, it is primarily a momentum strategy in which stock prices are inflated by the belief that they can only rise. In addition, we had completed one of the stock market's longest bull runs in history before the first wave of the COVID-19 pandemic swept the markets into bear territory. According to many, the bull market already began in 2009, following the financial crisis, and the stock market has risen continuously with the help of the Federal Reserve's quantitative easing and low interest rates ever since, with equities being the winning asset class. In terms of behavioral finance, this long-term bull may facilitate investor anchoring bias: Investors may become anchored to the value of a given index at its current level rather than considering historical figures. When the S&P 500 approached a value of 4000, for example, investors were more likely to predict values closer to that figure rather than considering standard deviation of values, which has a fairly wide range for that index, according to theory.

For this particular analysis, there may also be an anchoring bias in overemphasizing the case companies. Allowing Zoom's and Microsoft's success and recent performance to represent the attractiveness of the entire industry is unfair and may provide incorrect assumptions for the discussion. We attempted to address this by conducting objective analyses on both an industry and a company-specific level. Another potential pitfall is generalizing and assuming that a company's characteristics and abilities are valid across an entire market. Revenue growth has already been identified as one of the most important drivers in the SaaS industry. Based on our analysis of Zoom, we also assume that the business model is scalable for all companies in the industry. The problem is that we run the risk of overestimating the entire market and exaggerating the benefits and features of the business model. Overall, there are numerous indications that there are various biases among investors in today's market. However, we lack sufficient evidence to claim that the industry as a whole is overvalued and that a new tech-bubble is forming in the absence of a thorough strategic analysis of all companies.

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