Annual Recurring Revenue: Is it only tech stocks that use this metric and how should investors look at it?
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Investors in software stocks would be familiar with the term Annual Recurring Revenue (ARR) or annualised recurring revenue.
But what does it mean and is it only for tech stocks?
Annual recurring revenue alludes to money a company expects to receive from its customers who have made a subscription and consequently received goods or services.
Stockhead spoke with Amir Ghandar, reporting & assurance leader at Chartered Accountants Australia, for a first-hand accounting perspective.
Ghandar began the chat by noting, “from the outset this [ARR] is really a performance measure, as distinct from something you’d find in your income statement or accounting standards.”
Nonetheless, he said it was worth knowing about.
“It’s a really important measure for subscription-based, primarily SaaS companies to be able to get a realistic projection and understanding of what their prospects are for generating revenue in the future and therefore all the decisions that come from that – whether that’s value of the company, the profitability of the company, ability to continue,” he said.
“Because Saas companies generally involve a pretty big investment up front so what you’re looking at is if you make that investment there’s a much higher margin later on than [if you’re] simply maintaining the system.”
So how do you calculate it?
“At simple terms how you calculate it [is] you’re taking your customer base and then the fee that you charge annually or the annualised cost and price of your SaaS and basically extrapolating that to show what sort of revenue that would give you in a particular year,” Ghandar said.
“Now of course it’s more complicated in practice with different level of subscriptions and you have to also allow for other types of fees that should not be included, that aren’t annual fees or recurring revenue.”
While tech stocks publicise this metric ahead of any other sector, they aren’t the only ones that use it.
“Any listed company that relies on membership or subscription fees to generate revenue must report their revenue including annualised recurring revenue in their financials,” Jane Rennie, general manager (External Affairs) at CPA Australia told Stockhead.
“Many companies in the technology sector are heavily reliant on recurring revenue, but it’s also very common in other sectors.
“For example, professional membership associations, membership based retail outlets, arts and entertainment providers and sporting clubs often use this model.”
However with few ASX stocks in any of these sectors, this explains why few stocks other than the software sector use it.
Ghandar warns it is difficult to answer this in a numerical sense but there was a different answer for every company.
“It’s important to a) understand how the company has come to their ARR and make sure that makes sense to you, that it is a realistic set of assumptions they’re looking at and is excluding non-ARR, it’s not overly ambitious in terms of any of the expectations.
“But b) the other important part is looking back at financial statements.
“Having a look at the financial statement will give you a harder edge reference point to assess if you believe the ARR being put out there is believable.”
The CPA’s Dr Rennie likewise says it depends on different companies and their business model – specifically how reliant it is on subscription revenue.
“It’s important to consider how frequently membership or subscription fees are paid and over what period the company has apportioned the payments,” she said.
“It’s also important to consider how much of the company’s revenue is derived from these fees.
“This is particularly relevant for some technology companies, where annualised recurring revenue may be the sole or primary source of revenue for the company.”