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The Risk Premium Factor: A New Model for Understanding the Volatile Forces that Drive Stock Prices by Stephen D. Hassett

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Appendix F

Making a Case for Salesforce.com Valuation1

Numerous articles have criticized Salesforce.com (CRM), claiming that it is overvalued and represents clear evidence of a tech bubble. Most recently, an article entitled “Shades of the Dot-com Bubble” appeared in Barron’s on January 22. With a stratospheric price-to-earnings (P/E) ratio of 234, how can it not be overvalued? Customer lifetime value (LTV), not P/E, is the key to understanding Salesforce.

Let's look at what it would take to justify a $200 share price today and then ask if it's reasonable. The bottom line is that if sales growth averages 26.1 percent; sales, general and administrative (SG&A) growth averages about 9 percent; and the terminal value P/E is 20, the company is worth $128.50 per share today.

One key factor that many analysts miss is that the software-as-a-service (SaaS) business model creates an annuity revenue stream, since customers pay an annual subscription to access the service. Implementing the software takes time, and switching to another provider is expensive. The switching costs increase over time, as each client accumulates historical data and processes become entrenched in the organization.

Salesforce, however, incurs high up-front customer acquisition costs but low ongoing expenses. A solid product combined with high switching costs yields excellent customer retention. Since each new customer is expected to remain for many years—and even grow as they add new seat licenses and expand services—customer ...

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