How to Value SaaS Companies
Software-as-a-service (SaaS) companies have had a great run over the course of the current business cycle. The sector has routinely traded at a multiple above five times revenue, even while having low or negative profit margins. From 2010 to 2013, market observers posited that valuation multiples in the sector were driven by growth alone – the faster the better – no matter how much cash burn it takes to achieve. Since the public market for software stocks hit a speed bump starting back in Q1 of 2014, however, there has been a general perception that profitability is becoming more of a factor in driving SaaS valuations. This awareness is driving capital allocation discussions at companies across the SaaS sector, both public and private. Should a company raise money to “keep its foot on the gas?” Or should it perhaps slow growth a bit but make the move to “EBITDA-positive?”
We decided to crunch the data to see what the public market (aka the “DCF in the sky”) is really telling us about SaaS valuations. The full research report, “SaaS Investors: Mind the Valuation GAP (Growth at Any Price),” can be viewed on SeekingAlpha or downloaded here. We analyzed a group of 63 public SaaS companies and analyzed their operational performance and stock prices since 2005 (with “n” increasing as we get closer to the present). The analysis reveals three big takeaways:
- Even with a decline in valuation multiples since 2014, the average total enterprise value (TEV) to last twelve month (LTM) revenue multiple remains above its long term average of 5x.
- Using two regression models to develop a SaaS valuation “rule of thumb,” we find that revenue growth remains more than twice as important for determining valuation multiple than EBITDA margin.
- Throughout the analysis, we detected clear patterns as to which types of companies achieve higher-than-predicted multiples (based on the formulas) and which trade below their predicted multiples.
Historical Trends in SaaS Valuation and Company Performance
Examining the SaaS universe reveals a long term median valuation multiple around 5x LTM revenue, revenue growth rate of 28%, and median EBITDA margin of 5%.
Source: Capital IQ, authors’ calculations
While revenue growth has remained fairly steady around 30% throughout the period (outside of a dip to 20% in the aftermath of the Great Recession), valuation multiples and EBITDA margin have shown more variability. Prior to the Great Recession, SaaS multiples tended to trade in the 4.5x to 5x revenue range. They then plunged to 2x in the pit of the market crash in late 2008 / early 2009, rebounded to 5.5x to 6.5x in the recovery between late 2010 and early 2014, and then settled in closer to 5.5x since that time. EBITDA margins, while less volatile than valuation multiples, went through three regimes. Pre-recession, margins averaged around 5%. In its aftermath, they rose to around 10% (concomitant with the brief dip in revenue growth), and then turned negative during the recovery where they have remained since. While EBITDA margins were as low as negative 13% in late 2014, they have since narrowed to negative 6%. It should be noted that this narrowing of EBITDA margin has been in conjunction with a slight slowing in revenue growth.
Revenue Growth Continues to Drive Valuations
Our research examines a number of ways to evaluate and predict the valuations of SaaS companies. These include Dave Kellogg’s growth-based formula, Brad Feld’s Rule of 40% (which adds together revenue growth and EBITDA margin) and our own five-factor regression. Our five-factor model proved to be highly statistically significant, but unfortunately it’s a bit unwieldly to use as a quick valuation rule of thumb. We decided to also run a two-factor model, incorporating just revenue growth and EBITDA margin. While less statistically significant than the five-factor model, it ultimately gets us to a similar place. The formula is as follows:
The takeaway here is that unlike with the Rule of 40%, where revenue margin and EBITDA margin are equally weighted, we see that revenue growth is more than twice as large a valuation determinant as EBITDA margin. The result is a new, statistically-driven approach to benchmarking and valuing SaaS companies.
Market Leaders and ERP Earn Premium Valuations
If we plot the actual valuation multiples of the SaaS universe against their predicted values using the two-factor model, we get the following chart:
Source: Capital IQ, authors’ calculations
There is a certain group of outliers on the high end that tend to be either clear market leaders in a large horizontal or vertical space and / or are “back office” or enterprise resource planning (ERP) platforms with lower-than-average customer churn. This group of “market darlings” includes Xero (XRO), ServiceNow (NOW), Workday (WKDY), Splunk (SPLK), Hubspot (HUBS), Netsuite (N), Ultimate Software (ULTI), AthenaHealth (ATHN), Salesforce.com (CRM), Adobe (ADBE), Veeva (VEEV), and 2U (TWOU).
There is also a group of “prove-its”, companies with strong enough metrics to be valued at more than 5x revenue, but are nevertheless trading at more than 20% below their predicted value. These include mostly vertical SaaS companies like ElliMae (ELLI) or TrackM8 (TRAK), unified communications software providers like Broadsoft (BSFT) and also developer platforms like HortonWorks (HDP) or AppFolio (APPF). Shopify (SHOP) also falls onto this list (probably because analysts forecasted a big drop in revenue growth next year), but regardless trades at a very high multiple.
There is a next group called the “underperformers”. These are companies that are both valued at less than 5x and are less than 80% of their predicted value. Most of these companies are more narrowly-focused “tools” (as opposed to platforms) that could potentially experience higher customer churn. This list includes “front office” solutions like Jive (JIVE), LivePerson (LPSN), and Bazaarvoice (BV), along with narrowly-focused vertical solutions like Intralinks (IL).
The analysis shows that the market valuation of SaaS companies exhibits a rational pattern over time. Outside of the Great Recession, market valuations have been relatively stable and the market has done a good job of distinguishing between the companies that should earn a premium and those that wind up receiving a discount. Given the predictable streams of recurring revenue that SaaS companies provide, the market has placed a premium on long term growth over profitability, yet has also sensed which companies are growing with more inherently attractive unit economics. So, while the market may say that SaaS companies are on average worth 5.5x revenue, not all SaaS companies are created equal. Revenue growth, EBITDA margin, and the type of software product are all key valuation drivers as well. The tools provided herein are intended to help SaaS investors make better valuation decisions and perhaps give CEOs a basis for their valuation expectations.