Before even investing in a company, it is vital to understand how a company generate its revenue and more importantly, how predictable it is. As an investor, one of the key priorities is to reduce risk and that comes hand in hand with predictability. Therefore, a company with a stable recurring revenue stream makes it easier to project and value as compared to a company that generates revenue from one-off sales.
There are mainly two types of revenue—recurring and non-recurring. Companies that earn a large portion of their revenue from recurring sources are easier to project and valuate. It is a much more stable source of revenue. Examples of recurring revenue are usually in the form of subscriptions, services, franchise and licensing. On the other hand, non-recurring revenues are not as stable. Examples of this include a one-time service or a single consumer product sale. Compare a monthly Netflix (NFLX) subscription vs purchasing a pair of sneakers. It is much easier to project future revenues for these types of businesses because the starting base of the business isn’t zero. Recurring revenue allows new sales to be added to the existing revenue base instead of simply replacing lost revenue.
Furthermore, having a much more predictable revenue stream will enable to management to have a better projection ahead on how much to budget for expenses and how much to invest for growth or expansion. In this way, recurring revenues enables downside protection of the business.
On the contrary, businesses that generate revenues from one-off transactions or those that depend on continually selling the same number of products to maintain their sales from the prior year. These types of businesses include consumer-products businesses. These types of businesses depend on orders that come in one at a time, with no guarantee or predictability in the revenue stream, and are therefore more difficult to value.
It’s all about predictability.
Recurring revenue has a certain level of predictability built right in, and paying attention to important statistics such as customer churn rate can help you make that revenue even more predictable in the future. Determine whether a business is retaining its customers or if it is constantly turning them over (churning them). The longer a customer is retained by a business, the more profitable that business becomes. Most of us acknowledge that it is more expensive to gain a new customer than to retain a valued one. Another reason: A loyal customer base generates more predictable sales, which can improve profits. In the long run, the businesses that spend time cultivating long-term relationships with their customers are more likely to succeed.
Examples of companies with recurring revenue streams:
– Apple (AAPL)
– Box Inc (BOX)
– InterDigital (IDCC)
– McDonalds (MCD)
– Microsoft (MSFT)
– Netflix (NFLX)
– Universal Display (OLED)