Building technology companies

The Valuation Pendulum – Growth or Profitability ?

Anik Bose and Yash Hemaraj BGV colleagues share their perspective on the valuation pendulum.  During Bull market cycles, private companies tend to be valued at far higher multiples than public companies. While we do not believe that private valuations should match public valuations (hyper-growth companies in new and exciting markets should deserve a premium) we do believe that as companies mature and scale, profitable growth has to enter the valuation equation. While early stage companies may attract higher valuation multiples based solely on top-line growth in up equity market cycles, the picture changes in down equity market cycles – empirical data from the recent past provides good validation. Up Market Cycle To better understand the valuation sentiments of the market and how valuations were driven by growth and profitability during the up equity market cycle, we looked at data from 180 publicly traded technology companies in April 2015. The companies ranged from sectors such as Application software, Security, Data Processing & Warehousing, Research and Data Services, IT Services as well as Computer hardware and Peripherals. The sample set was large enough for statistical significance and included public companies founded in the early 1900s as well as public companies founded as recently as 2010. In April 2015 at the peak of the Bull market, the technology industry performance was characterized as follows:

  • 1 Year Revenue Growth: 16.8%
  • Gross Margins – 65%, Profitable Industry: EBITDA Margin = 12.8%
  • Total Enterprise Value (TEV)/LTM Revenues – 3.9X
  • Total Enterprise Value (TEV)/FTM Revenues – 3.67X (~90% of LTM Multiple)
  • Total Enterprise Value (TEV)/LTM EBITDA – 17X
  • Industry Beta: 5 year Beta = 1.06 (markets have a beta of 1)
  • Analysts expecting target price to appreciate by 11.2%
We regressed the Enterprise Value (EV) to Last Twelve Months (LTM) revenue multiples using the 1 year growth rates as well as gross margins. (Of course, this does not explain all the different variations within the dependent variables, but these two variations form a large part of valuations.) There was a very clear impact of Growth Rates and Gross Margins on LTM Revenue Multiple. We classified the companied into 4 Gross Margin and 4 Revenue Growth categories as listed below. These categories were chosen along general industry classifications. As expected, Revenue Growth Rates commanded high premiums over Gross Margin Categories. The premiums increases from one Revenue Category to the next were close to a 3X factor. The increases were not as prevalent from one Profit Category to the next, but still showed a 1.5X factor. One could argue that when the market values companies with such “growth premiums”, it encourages companies – startups to established ones – to sacrifice profits in exchange for growth. You get what you incentivize.   Slide1 Down Market Cycle The current market situation, (with the public equity markets being down at least 20% from the beginning of the year) has sparked numerous debates on how market sentiment has shifted from valuing companies for growth to valuing companies for profitability.  We believe that today the pendulum has now swung to the other extreme, as is often the case in economic cycle transitions. We have observed startups raising flat rounds despite achieving close to 3-4X year over year revenue growth in attractive emerging markets. We collected and analyzed the new data for the same set of companies this January (before the Q4 2015 results were announced.) Much has changed over the subsequent couple of quarters:
  • 1 Year Revenue Growth Rate has fallen to 8.3% YoY.
  • Gross Margins remain close 64%, It is still a Profitable Industry: EBITDA Margin = 12%
  • Total Enterprise Value (TEV)/LTM Revenues has shrunk to 3.1X
  • Total Enterprise Value (TEV)/FTM Revenues – 2.86X (~92% of LTM Multiple)
  • Total Enterprise Value (TEV)/LTM EBITDA – 15.8X
  • Industry Beta: 5 year Beta = 1.2 (up from 1.06) (markets have a beta of 1).
The increase in multiples as you move from one margin category to the next still persists. However, the stark difference between then and now is that, across the Revenue and Profitability categories, we do not observe the same jump in the multiples we observed as revenue growth categories jumped from one to the other. Slide2 The pendulum has definitely swung. We believe a startup must find the right balance between the objectives of growth and profitability based on the stage of the company. Clearly, this balance must also reflect where we are along the economic cycle as well. As the company matures and scales, the need for profitable growth must influence the startup mindset and culture, a difficult shift to operate if the startup team has been 100% focused on growth. When the market is valuing businesses favorably for growth, capital is easy to find. Companies showing rapid topline growth are able to raise more money at favorable valuations. Businesses can afford to spend in order to acquire customers, even when the unit economics are not favorable. However, when the market sentiments change, the same companies are no longer able to fund their expansion. They find it hard to attract investors; it is hard to pivot a business from a growth oriented mindset to a profitability focused mindset overnight. There are several implications for entrepreneurs:
  • Demonstrating revenue growth potential continues to be important, although no longer the only dimension to optimize
  • Cultivating a longer-term profitable growth mindset and culture by engaging the full team in the profitability discussion
    • Operations teams should think about cycle times, software release frequencies, inventory costs etc. and tie these discussions to the bottom line.
    • Product managers should think about every feature they incorporate for development in terms of incremental value it delivers.
    • Sales team should think about sales/channel productivity, sales cycles and cost of customer acquisition. This will ensure that the longer term business plan shows a path to profitable growth
At BGV we believe that private companies must be built for long-term sustainable value creation. This requires a focus on the fundamental economic drivers (instead of a short term focus on achieving a valuation “blip” on fashionable “valuation metrics” that may disappear in a different stage of the cycle). We strive to invest at or below “median” valuations, informed by our experience across many stages and full cycles. We refrain from momentum investing and following the hot trend of the moment. Remember the “eyeballs” valuation metric from the Dotcom era in early 2000? When internet startups raised financing at exorbitant valuations with no business models or revenues and later came crashing down to earth. “If we do not learn from the mistakes of the past we are destined to repeat them…”