Subscription businesses, from software firms to streaming services, often talk about a number that traditional companies rarely mention: annual recurring revenue. Investors love it because it promises predictability. But like any headline figure, it is worth understanding what it includes and what it leaves out.
What annual recurring revenue means
Annual recurring revenue, usually shortened to ARR, is the value of the revenue a company expects to receive from its existing subscriptions over the next year, if nothing changes. It is typically calculated by taking the value of current subscription contracts and expressing it as a yearly figure. A business with monthly subscriptions worth £10 million in total would have ARR of about £120 million.
ARR usually excludes one-off fees, such as set-up charges or consulting work, because those may not repeat. The point is to measure the reliable, repeating part of the business.
Why investors prize it
Recurring revenue is easier to forecast than one-off sales. If most customers renew each year, a company starts every year with a large chunk of its revenue already secured. That predictability lets it plan investment with more confidence and makes its earnings less volatile.
As a result, investors are often willing to pay higher valuations for businesses with a high share of recurring revenue. Software companies are frequently valued as a multiple of their ARR rather than their profits, especially when they are growing quickly.
The numbers that go with it
ARR on its own tells only part of the story. Investors also look at churn, the share of customers or revenue lost each year when subscriptions are cancelled. They look at net revenue retention, which compares this year’s revenue from existing customers with last year’s, including upgrades and downgrades. A figure above 100 per cent means existing customers are spending more over time.
A simple example
Suppose a software company has ARR of £200 million and loses 5 per cent of it each year through cancellations, but existing customers upgrade by 15 per cent. Even without new customers, ARR would rise to about £220 million. A rival with the same ARR but 20 per cent churn and few upgrades would see its recurring revenue shrink unless it kept winning new business.
Limits of the measure
ARR is not a standard accounting figure, so companies can define it differently. Some include contracts that have been signed but have not yet started. Others may include usage-based revenue that can fall if customers use the product less. It also says nothing about profitability. A company can grow ARR quickly while losing money on every customer.
Common mistakes
A common mistake is comparing ARR between companies without checking how each defines it. Another is focusing on ARR growth while ignoring churn and the cost of winning customers. A third is assuming recurring means guaranteed. In a downturn, customers cut subscriptions too.
The bottom line
Annual recurring revenue measures the repeating subscription income a company expects over the next year. It is valued because it is predictable, but it needs to be read alongside churn, retention and profitability, and its definition varies by company. For a related measure of business health, read our guide to gross margin. To test how you assess growth companies, try the free Samuel & Co Trading Trader Assessment.
