A lot has been said over the past year about the rising valuations of software companies as revenue multiples have expanded roughly 50% from Pre-Covid levels.
While multiples have expanded across the board, hyper growth software companies (30%+ YoY growth for public companies) have exhibited outsized multiple expansion of approximately 100% while slower growth companies experienced a more “subtle” expansion.
In fact, the correlation of multiple-to-growth is at an all-time peak of R2=0.65, and the gap in correlation of multiple-to-growth versus multiple-to-efficiency is the widest it has ever been.
The question is whether we are experiencing a paradigm shift in pricing of a unit of growth, and if so, why?
A simple way to analyze this is to look at a ‘Growth adjusted EV/Forward revenue ratio’, which represents a company’s forward revenue multiple, divided by its forward growth expectations. For example, the implied Growth Adjusted Multiple of a company that trades at a 15x forward revenue and has expected YoY revenue growth of 30% would be 0.5x.
The goal is to index the ‘market price’ for a ‘unit of growth’ and evaluate how expensive or cheap a company is relatively to its growth expectations.
As with revenue multiples, Growth Adjusted Multiples have expanded, increasing from pre-Covid levels of 0.4x-0.5x to 0.7x- 0.8x in recent months.
However, when breaking down the data a clearer picture is revealed about how investors are pricing growth.
Historically the Growth Adjusted Multiple served as a pretty stable index and companies with different growth profiles received similar ‘value’ per unit of their growth – within the 0.4-0.5x range. Meaning, when neutralizing for growth, companies received fairly similar valuation multiples and a company that grew twice as fast earned double the multiple.
This paradigm has changed
Beginning Q3 2020, hyper growth software companies broke away and are awarded valuations that price their “unit of growth” at a premium. At the February 2021 peak a Unit of Growth for hypergrowth companies more than doubled to 1x (!), and materially widened the gap from slower growth companies.
This implies that “not all that grow is gold” and nowadays premium growth is very generously rewarded
Why is this important?
This shift, if sustained, implies that at every stage, premium growth rate to peers will be rewarded with material acceleration in value creation, as now three levers of valuation impact pricing versus historically just two. Historically higher growth implied higher year-end revenue base and a higher multiple, however on a growth adjusted base, the multiple was equally priced. Currently a unit of growth is not priced equally, adding another lever to create value for the best performing companies.
A quick example to illustrate the amplified effect of premium growth – holding other factors constant, company “A” expects 25% YoY growth while company “B” projects 35%. Assuming a $200M revenue base, the forward revenue would be $250M and $270M, respectively. In the “old days” both growth rates would receive a similar value for a Unit of Growth, say a 0.5x Growth Adjusted Multiple, and the two companies would earn a 12.5x and 17.5x multiple, respectively, resulting in a reasonable higher valuation for company B, explained by its higher expected growth.
Today, Company B would be awarded a premium Growth Adjusted Multiple, say, 0.75x which means it would trade at a 26x revenue multiple (vs. 17.5x). The premium Growth Adjusted Multiple results in an amplified effect on valuation – not only the expected revenue base is higher, but also each growth unit receives higher pricing, resulting in a significant gap in valuation – almost double! $3.8B vs. $7.1B , despite Company A and B being fairly similar expecting only a $20m gap in forward revenue.
Public market valuations often serve as a proxy to private markets and we believe this logic also applies to growth stage start-ups (albeit with different growth expectations). As investors we believe the implication for entrepreneurs is to truly test their revenue growth targets and understand how their expected performance compares to peers at their scale – if your company is expected to outperform peers on growth you should expect to earn an amplified premium on valuation! And if not, perhaps the variance in growth rate can explain the market “tag price”
Why is this happening?
As investors we try to understand why this might be happening now? Is it an aftermath of the global pandemic? It is probably too early to provide a definitive answer, however one can imagine that for many software companies the market opportunity has materially expanded and in some cases significant new opportunities have emerged. The greenfield is there to be conquered and most likely the companies that grow the fastest are best positioned to win those new pockets, establish market leadership, and be rewarded with long term moats and an attractive value creation opportunity.
* Company A: $250m (revenue) * 25 (growth rate) * 0.6x Growth Adjusted Multiple = $3.8bn
Company B: $270m (revenue) * 35 (growth rate) * 0.75x Growth Adjusted Multiple = $7.1bn