4 questions to ask yourself before buying tech shares

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Investing in ASX-listed technology stocks is difficult, as much of the conventional wisdom about how to assess and value stocks does not apply to the tech sector.

But that does not mean that it is impossible to assess the investment merits of a stock. The questions below are simple yes / no questions. The more “yes” answers, the better chance the company you are considering has of eventual success.

Does it solve a real problem?

Just because technology has enabled us to do many novel things, that does not mean that all of those things are worth doing or profitable to do.

Aconex Ltd (ASX: ACX) is one standout example of a stock that solves a real problem for its clients. Aconex researches, develops and refines software that allows construction companies working on multi-billion dollar, complex and long-term construction projects to consolidate and manage their project management. With thousands of invoices, hundreds of sub-contractors and dozens of companies simultaneously working on these large projects, having a single “dashboard” is invaluable.

Does it actually earn money?

As I said before, a technology company does not have to be profitable to be an attractive investment candidate. But it does need evidence that its target market is willing to pay for its services.

Looking at quarterly cash flow reports under the operating cash flow section for receipts from customers is one way to quickly and easily check for this.

Technology companies generally talk a great game, but far fewer can back up that talk with substantial revenues. A good example of this phenomenon is the case of 1-Page Ltd (ASX: 1PG) which saw stellar share price rises with close to zero revenues booked. At the other end of the scale, XERO FPO NZ (ASX: XRO) has over 600,000 customers willing to pay monthly subscription fees for continued access to its cloud-based accounting services.

Is it hard to replicate?

Unlike traditional industries, most internet or software-based business models, have low barriers to entry. This means a well funded competitor can usually enter the market without too much trouble.

However, the strength of a technology stock often comes from the fact that it is easy to copy, but difficult to replicate. Ltd (ASX: CAR) is a stellar example of this.

The company has always had numerous challengers such as Carsguide and, as it is not particularly expensive to create an online list of cars for sale. However, it has built its network effect through user experience improvements that increase the speed and efficiency of selling a car while reducing the cost. That means that both buyers and sellers gravitate to the site, which in turn means that more buyers and sellers end up using the site.

Is the market big enough?

To build a profitable business over the long term, a company has to target a market big enough to drive those profits.

Cloud-based human resources platform Reffind Ltd (ASX: RFN) is one such example. The company has developed software that runs for smartphones that helps companies train new staff, reward employees, take surveys and refer others for jobs.

The appeal of the software is that it is not confined to any particular industry, geography or size of company, with law firms, construction companies, fast food franchisors, and retailers from Australia, New Zealand and the United States all signing on to date.

Foolish takeaway

Investing in technology stocks is a little different to investing in more “traditional” industries, but with a consistent approach, you can uncover those companies likely to prosper, and avoid those that are little more than an interesting story.

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Motley Fool contributor Ry Padarath owns shares of Xero. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia owns shares of Xero. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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