Reverse DCF for Software Stocks

Start from the Price; Solve for the Path

A conventional DCF asks what a business is worth given a set of forecasts. A reverse DCF flips the question: given a price, what growth and profitability path does that price already contain? Michael Mauboussin and Alfred Rappaport formalised the idea in Expectations Investing: read the cash-flow expectations embedded in the price, then judge whether those expectations look plausible.

In software the natural outputs are ten-year revenue growth and net retention, because those are the drivers that compound recurring revenue. The method does not produce a buy or sell label; it produces a description of what must happen for the price to be earned.

A Fictional Seat-Subscription Company

The worked example uses a fictional subscription company. Opening recurring revenue is $2.0B, with $0.1B of services held at 5% of recurring. Gross retention starts at 92% and net retention at 115%, fading in a straight line to 102% net retention over ten years. New-customer revenue starts at 12% of opening recurring revenue and fades to 1%. Gross margin rises from 78% to 80%. Sales and marketing moves from 40% of revenue toward 24%. Research and development moves from 20% toward 15%, and G&A (excluding stock pay) from 10% toward 9%. Operating margin before stock pay therefore rises from 8% to 32%. Stock compensation fades from 18% of revenue to 8%. Deferred-revenue inflow is 25% of the revenue increase; capex and D&A are each 3% of revenue. The built discount rate on this path is 10.0%. Terminal growth equals terminal net retention minus 100% plus terminal new-customer revenue, or 3.0%, with reinvestment equal to that growth divided by a 25% return on new capital.

Those inputs define the forward model. The reverse step types any price and values the company across a range of paths that scale expansion and new-customer revenue from zero to twice the base path. It then interpolates the ten-year revenue growth and the net retention that price requires.

At an illustrative $40.50 a share, the price asks for 14.6% a year of revenue growth for ten years and year-1 net retention of 115.0%. At $60.75 it asks for 19.6% and 120.7%.

What Moves the Implied Path

Hold the price fixed and change one terminal assumption at a time. Terminal net retention moves both the explicit fade endpoint and the terminal growth rate built from retention plus new business. A one-point change in the keep-and-expand rate revises the whole back half of the model. Terminal margin after stock pay moves free cash flow in every late year and in the Gordon terminal. It often shifts the implied growth required by more than a same-sized change in year-one sales and marketing.

Near-term net retention still matters: it sets the base that later years compound. But once the fade has run, two prices that looked similar on a Rule of 40 screen can embed very different terminal retention and margin pairs. Running those reverse paths shows which terminal pair each price depends on.

Retention definitions still apply before you interpret the implied net retention. The model’s net retention is a single defined input; a filer’s labelled percentage may measure something else.

How to Read the Result Without Turning It into a Verdict

Write down the implied ten-year growth and the implied net retention. Compare them with the company history you would underwrite and with how wide the retention definition is. Ask whether the terminal margin after stock pay in the model matches a cost structure you believe. If the price requires net retention that never fades, or a terminal margin the cost lines cannot support, the expectation is already clear.

The reverse DCF translates a price into a path. Judging that path is a separate step, and on this page it stops at the fictional company.