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.
- 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.
- 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.
- 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.