Demystifying the revenue multiple
Fast growth information technology businesses are today valued on multiples of revenue, not the traditional multiple of earnings investors have come to expect.
Is this appropriate?
We believe that multiple of revenue valuations are appropriate for valuing fast growth information technology businesses, but arriving at an appropriate valuation, which in practise means an appropriate multiple, requires a lot of detailed work.
The long-term value of any company remains the current value of future cashflows. Because fast growth information technology companies are often consuming cash not producing cash in their early years it is not possible to extrapolate current cash generation performance to understand future cash generation potential.
The solution is to separate the cash generated by already acquired customers from the cost to acquire new customers. In the industry jargon, this is called understanding the ‘unit economics’ of customers. The logic is simple and compelling. If an individual customer generates positive cash over their lifetime, then a lot of customers will generate a lot of cash. This is particularly true when customers are paying a recurring subscription. Recurring subscription revenue compounds over time.
To understand the lifetime profitability of acquired customers we simply start with the revenue generated by the customer, it might be $2,000 a year for a typical software-as-a-service customer and subtract from that the direct cost to provide the service to the customer to get the gross margin (gross margins are typically very high). We then subtract a pro-rata share of long run steady state company product development and other overhead costs to understand the unit profitability of the customer. We must then also subtract the one-off costs to acquire the customer in the first year.
After a period of operation, the business will have a good idea of the average time a customer stays with the company and by multiplying the lifetime cash profitability of a customer by the average lifetime of a customer we can calculate the lifetime value of the customer, which is to say the lifetime cash generated by the customer, discounted to today. Sound familiar?
The Year 1 contribution of a new customer is almost always negative because of the one-off cost of acquisition, but so long as soon thereafter the customer generates positive cash for the business and on average customers stay for a long enough period, we can be sure that as we accumulate more customers the business as a whole will generate positive cashflow.
The unusual feature of fast growth information technology companies with recurring revenue models is that the faster they grow, that is the more Year 1 customers they acquire, the more cash is consumed until the accumulation of Year 2 customers and beyond delivers enough cash to offset the cost of acquiring new customers.
Multiples of revenue, then, are a convenient proxy for the complicated trade-off occurring in a fast growth company between the lifetime value of acquired customers and how quickly those customers are being added.
A shortened version of this article was first published in the Bailador Technology Investments (ASX:BTI) April 2018 NTA Statement.
