In the pre-internet, pre-globalisation days, it's tempting to believe that investing was simpler. In part, this belief is based on the fact that business models were simpler. The Coca Cola company sold carbonated beverages – the more it sold, the more money it made.
Likewise, supermarkets, utility stocks and retailers were simple to understand as businesses, meaning much more work was devoted to understanding competitive dynamics and the market.
However, in 2016, tech companies do not operate easy to recognise revenue generation models. In fact, in some instances, they are creating brand new markets. But when buying stocks, one of the most fundamental things an investor must do is understand exactly how a company gets cash into its bank account.
So how do these two emerging tech stars do it?
Freelancer Ltd (ASX: FLN) is one of the few truly global stocks listed on the ASX. At its simplest, Freelancer is a jobs marketplace that uses the internet to connect those who are looking to outsource jobs to those who are willing to do them. It is the largest website of its kind both in terms of total jobs posted and total users.
Say for example, that the Motley Fool wanted a new logo designed. It could then post its requirements on the Freelancer website, state its desired budget and even the expertise it required from the freelancer. Freelancers would then bid for the job, providing a brief pitch, budget and how long it would take them to complete the job.
If the job was awarded with a budget of $100, Freelancer would then take a 10% cut of the freelancer's fee. The company also takes 3% of the cost of the project from the employer. Paid membership plans are also available for regular freelancers, which gives those users the ability to lower the percentage of their fee that Freelancer charges them in exchange for a fixed monthly cost.
The strategy saw the company report revenue of $38.6 million, a jump of 48% on the previous year, at gross margins of over 85%. The company is still in a net loss position as it prioritises growth over profits for now.
Xero FPO NZ (ASX: XRO) is a company with a somewhat complex business, and a very simple revenue generation strategy. Xero provides accounting services to over 600,000 small and medium-sized enterprises in Australia, New Zealand, the United Kingdom and the United States.
Legacy providers of accounting software did this via annual CD-based updates. Xero, by comparison, does this 100% over the internet. That makes it one of the new breed of "software as a service" or SaaS companies.
Xero charges users of its online accounting software a simple monthly fee. In exchange, users get full use of the software, user support as well as rolling, continuous upgrades. Xero has two of the features that I look for when assessing tech companies: it solves a real problem, and it has customers willing to pay for its services. Like Freelancer, Xero is still posting bottom line losses as it seeks to grow further.
Foolish takeaway
It's easy to get caught up in the interesting "stories" surrounding emerging tech companies. But before buying shares, it is crucial that investors understand exactly how the company plans to earn its cash, and whether it is doing so. While this may sound simplistic, there are no shortage of tech companies that do neither.
Freelancer and Xero are two exceptions to this rule. However, investing in cash generating, but unprofitable, technology companies should only be considered by those with a high risk tolerance and sound understanding of the industry.
