It’s easy to dismiss Xero as grossly overvalued compared with better-known, profitable rivals. Or to resist buying its shares because they have already soared. But Xero, potentially a magnificent company, deserves close inspection, such is its potential to disrupt the multi-billion-dollar global market via cloud computing. If it does, its current valuation will seem puny in hindsight.

Xero has a strong headstart in the move to price accounting software as service instead of a product. Rather than paying hundreds of dollars upfront for desktop software, small businesses are starting to pay a small monthly fee to use Xero’s cloud-based software.

Xero has four big attractions: The first is the ability for companies to collaborate online with the accountant or adviser in real time, via the internet. Xero could help reconfigure the relationship between small enterprises and their advisers over time.

Convincing the SME gatekeepers – accountants and financial advisers – that small enterprises should change how records are kept is critical. For advisers, cloud-based computing promises new revenue streams, as more time is spent helping companies grow their business, rather than on data input.

The second attraction is the coming tipping point in cloud-based software. Xero-commissioned research shows 28% of UK accounting practices use cloud-based software, with 27% intending to move. Xero is superbly positioned for the rapid adoption of cloud computing.

The third attraction is potential scale. Xero says cloud computing creates a single global market for accounting software that is accessible by more than half a billion small businesses. Like all great software innovations, Xero will have recurring, visible, high-margin revenue from global clients.

The final attraction is competitive dynamics. Insurgent companies such as Xero often disrupt incumbents like Reckon and MYOB by moving much faster with a capital-lite business model. Their speed and ability to operate on a much lower cost base becomes a serious competitive threat.

That is the good news. The bad news is Xero’s valuation has factored in this potential – arguably by too much for now. The company lost $17.1 million in the half to September 2013 and customer growth, while impressive, is off a tiny base. About 4% of all small businesses in Australia, and less than 1% of those in the UK and US, use its software.

Optimists will argue that low market share implies Xero has huge room for growth, and it does. But it also overlooks the potential competitive response from Reckon, which is rapidly building its capabilities in this area and has a new cloud-based product, Reckon One, in beta mode.

MYOB has released a web-based version of its software, and global giant Intuit, which is severing it relationship with Reckon from 2014, is going into direct competition in this market.

Xero’s long-term potential and management execution so far impresses. But its valuation, relative to other software providers, has run too far, too fast. Reckon, too, is well positioned to compete in the cloud software space, although the market will need to see rapid uptake of Reckon One. So far, it has rebranded Quickenbooks and Quicken (after the change with Inuit) with no adverse revenue effect, and looks slightly underpriced for long-term value investors at $2.16 a share.

The consensus of analyst forecasts for Reckon is a 12-month price target of $2.50. Morningstar’s fair value is $2.60 and StocksInValue believes Reckon is worth $2.61 in 2014. Reckon’s forecast Price Earnings of 11.7 times FY14 earnings is arguably a touch low for a company of its quality.

Prospective investors in Xero might wait until some steam comes out of the share price, and current investors could recoup their initial investment, and reinvest into Reckon. Xero looks like the one to be reckoned with in the long run, but for now, better value is found in Reckon.

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