In a previous article I discussed the declining importance of revenue growth in setting valuations, the question that now needs to be asked is what factors are now driving valuations and what the remainder of 2016 holds for tech valuations.
A conundrum in understanding the recent selloff in stocks (and the associated compression in tech valuations) is how indiscriminate the mark down valuations was. Aside from the reduced premium for high growth companies little attention appears to have been paid to companies’ internal fundamentals (such as profit margins or cash flow). As such, regardless of what measure of profitability is used there remains no correlation between valuation and profitability for Saas companies (or for Social Media/Digital Media companies).
I prefer to view the recent market repricing as the first stage in a two stage process. In the first stage (which appears to have been completed) all valuations are written down in a sharp market adjustment with little regard being paid to the individual companies’ fundamentals.
The second stage of the repricing is a more gradual reassessment of the merits of each company. So the key question is what metrics will the market focus on in future for valuing tech (and more specifically Saas) companies.
The end goal of any business is (or should be!) to generate profit. There are two primary measures of profitability to focus on — gross profit (revenue less costs directly tied to producing the good/service) and net profit (gross profit less other costs such as marketing or R&D).
Gross profit margin is sometimes fashionably referred to a ‘unit economics’ as is the first measure of profitability to assess — after all if a firm cannot even sell a product for more than its cost its prospects are bleak. Recently, there has been extensive discussion on incorporating ‘unit economics’ into private market valuations and expect for this to be mirrored in the public markets. Thus in the short to medium term look for an increased correlation between valuations and gross profit.
Net profits tend to be a long time coming for tech companies and especially so for Saas companies (as they cannot recognize the full value of new customer in their revenue figures). Seeing a correlation between valuation and net profit for tech companies is still a long way off.
Cash is the fuel that all companies run on and so a negative cash flow can only be sustained for so long. Companies that run persistent free cash flow deficits are likely to be heavily punished by the markets. There is some evidence that this is already happening, Box has seen its value cut in half since its IPO despite healthy gross profit margins of 70% and growing revenue 10% per quarter. Box’s free cash flow to revenue ratio is -0.47, meaning that for every dollar of revenue it looses 50 cents in cash. To compound this, Box can only sustain this level of negative free cash flow for less than 18 months before it will need a cash infusion.
The major impediment in converting revenue into profit is operational efficiency — ie what levels of costs relative to revenue does it take to maintain the business in its current state. Two useful benchmarks of operational efficiency are revenue per employee and Sales/Marketing/Admin expenses to revenue.
If cash flow and profits are to be a factor in valuation it therefore follows that measures of operational efficiency will affect valuation.
‘Legacy Tech’ Benchmarks
A notable feature in the early 2016 tech stock selloff was the resilience of legacy tech companies (ie mature tech companies whose growth has plateaued and are generating profits such as Oracle, Microsoft, IBM). Since 2014 the Enterprise Value/Revenue ratio of legacy tech companies has steadily increased whilst that of Saas companies more than halved.
The above graph shows that Saas valuations are now, on average, very similar to those of legacy tech companies. However, whilst the overall EV/Revenue multiples are now similar, legacy tech valuations are much more nuanced and profitability, cash flow, and operational efficiency are all correlated with valuation ratios. We can therefore reasonably expect that as Saas companies mature and the market turmoil settles that valuations of Saas company metrics should start to converge with those of legacy tech shown below:
Median Legacy Tech Company Valuation Benchmarks
- Gross Profit Margin : 63%
- Net Profit Margin : 13%
- Free Cash Flow/Revenue : 24%
- Revenue Per Employee : $340,000