The Declining Importance of Revenue Growth

To recap the first post on the Great Compression in Tech Valuations there are two related trends in EV/Revenue for Saas companies over the past three years – the overall decline in valuations (ie EV/Revenue ratios) and the clustering of valuations around the average (so it is increasingly unusual to be able to achieve a valuation far higher than the average).

These two trends are actually closely related with the driving force being the premium the market has placed on high revenue growth companies.

The market used to put a very high premium on Saas companies which were able to achieve high levels of revenue growth (ie greater than ~10% per quarter). This is best examined by looking at regressions of Revenue Growth vs EV/Revenue since March 2013 (a regression will show the strength of the relationship between Revenue Growth and EV/Revenue , with the ‘slope’ of the regression being the change in EV/Revenue per unit of change in Revenue Growth).

The below graph is the monthly slope of the regression for EV/Revenue vs Revenue Growth.

Note in the graph the slope units are in 1/100th of a percentage point so a slope of 100 would mean each 1% increase in Revenue Growth results in an increase of 1 unit the EV/Revenue ratio.

At its peak in September 2013 each percentage point increase in quarterly revenue growth would be rewarded with an increase of 1.4 in the EV/Revenue ratio – thus in Sept 2013 LogMeIn with revenue growth of 5% had a EV/Revenue ratio of 4, whereas Tableau Soft with growth of 15% had a EV/Revenue of 20.

By March 2016 the slope was down to 0.36 so each percentage point of growth is worth a mere 0.36 in the EV/Revenue ratio (for example MobileIron which is growing revenues at 4% has a EV/Rev ratio of 1.7 whereas the faster growing New Relic which is growing at 13% and has a EV/Rev ratio of 6.1).

The decline in the premium for high-growth companies has primarily affected the top quartile of fast growing companies. The below graph shows Saas EV/Revenue ratios divided into revenue growth quartiles with the highest growth companies attracting the highest EV/Revenue ratios.

Note the greater decline in the valuations of the fastest growing quartile of companies which converged with the slower growth companies, reducing the valuation differential and dragging down the overall average.

Why Did the Market Fall Out of Love with High-Growth Companies?

As explained in detail by Joseph Floyd, Saas valuation compression is simply a reversion to the mean after valuations diverged from other tech companies in 2012. But was the cause of the divergence and subsequent reversion? As I see it there are three possible explanations for this – although it is difficult to assess the validity of any of these.

  1. The number of Saas public companies for investors to invest in has grown from approximately 10 in 2012 to 40 in 2016 (depending on your definition of Saas of course..). Investors looking for exposure to Saas have more options for companies to invest in.
  2. General market risk appetite has declined. Since mid-2015 the S&P High-Beta index has under performed the broader index as investors rotate into less risky companies. Saas companies which typically are young and have minimal profits would certainly be considered as high-beta or risky assets.
  3. Failed promises of public Saas companies. Public Saas companies have in general failed to deliver on profits and in several cases such as LinkedIn the growth trajectory has leveled off earlier than expected.

It is important to note that this is a big reason that private companies can have higher multiples than their public counterparts as they are very often growing faster and so should have a higher multiple.

The Great Compression in Tech Valuations

In this series of posts I will examine the compression in tech valuations (as measured by the Enterprise Value/Revenue ratio).In this first post I will take a look at what exactly happened and look a little beneath the surface at some of the underlying trends.

In the second post I will focus on the causes of the upheaval in valuations and finally in the third post I will look to the future and highlight some of the possible and probable valuation trends for the remainder of 2016.

Measuring Valuations for Tech Companies

The received wisdom for tech company valuations, especially young fast-growing companies, is that they should be valued on a multiple of revenue. There are two primary reasons for this, firstly fast growing tech firms rarely have any significant profits (and so ratios such as Price/Earnings or multiples of Net Income will not be useful). Secondly, revenue is a relatively ‘clean’ metric as it is less prone to manipulation and earnings management than figures lower down the Income statement such as Net Income or calculated metrics such as EBITDA.

I will examine other valuations methods and metrics in a future article but for now the primary metric will be the Enterprise Value to Revenue ratio. Enterprise Value (EV) takes market capitalization as its starting point and then adjusts this for the firm’s debt and cash balances to get a more comprehensive valuation (for a more detailed explanation, please refer to Damodaran’s overview of valuation methods).

How Have Valuations Changed?

The compression in the Enterprise Value/Revenue multiple has been extensively documented but just for completeness note the below graph with shows the median EV/Revenue ratio for Saas companies declining since 2013 from a high of 11 in early 2014 to a low of 4 in February 2016.


EV/Revenue Mulitple For Saas Companies

Despite the recent proliferation of blog posts about the ‘Great Compression’, the trend is the trend is not new – the peak in valuations was in early 2014. Most of the commentary on this compression in valuation ratios has focused on Saas companies, so it is worth looking at other tech sectors. The below graph shows the ratios for Digital Media (Google, WebMD, Yahoo, Pandora), eCommerce, Marketplaces and Legacy Tech (comprising mature tech companies such as Microsoft, Oracle and Computer Associates).

EV/Revenue Multiples for Tech Sectors

There are a few interesting things to note here. Firstly, Legacy Tech has been immune to the trend of valuation compression with its valuation ratio actually increasing from 2.2 in early 2013 to 3.4 in March 2016. Digital Media, eCommerce and Marketplaces ratios have all peaked from Dec 2013 to Dec 2014 and suffered declines since. eCommerce companies have the lowest valuations with the median EV/Revenue ratio at just 1.4.

Before examining the reasons for this compression we can take a closer look at the individual valuations within the averages, in particular the range of the valuations. In March 2013 there was a wide spread of EV/Revenue valuation ratios for Saas companies ranging from 2.75 (for LifeLock) to 31 (for Workday). By March 2016 the range was from 1 (Bazaarvoice) to 11 (Workday).

This can be better illustrated by using fitted normal distributions for different time periods (these distribution curves show frequency for different values of EV/Revenue). The graph below shows the distributions on March each year starting 2013. The graphs graphically illustrate the decline in the average value for Saas EV/Revenue multiples (note that the average is the peak of each graph which has consistently shifted lower – it to the left) more notably the distributions are more compact with March 2016 showing most companies clustered around the mean EV/Revenue of 4 versus the very spread out March 2013 distribution.

 

TL:DR;

  • EV/Revenue ratios for Saas, Digital Media and eCommerce companies hit their peaks in 2014 and have been declined since. Legacy Tech companies (such as Oracles) have seen the valuations ratios steadily increase (albeit from a low base).
  • eCommerce companies continue to attract the lowest valuation ratios.
  • Individual company valuations are now more tightly clustered around the averages with far fewer outliers.

In the next post I will examine the causes of the compression in valuations.