Maybe we were valuing software companies the wrong way all along

What’s a software company worth? It’s not an idle question, but one that underpins a huge amount of private-market investment and human effort.

In 2021, the presumed value of software revenues grew, adding to a longer upcycle that pushed tech companies’ valuations into the stratosphere. Since late 2021, however, a decline in tech valuations in private and public markets has entirely shaken up the game. And then, after quarters of declines, tech stocks took another gut punch Friday, with a key index tracking the value of cloud and SaaS stocks reaching a fresh 52-week low.

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To paraphrase SaaS investor Jason Lemkin in the wake of the selloff, we didn’t think that it could get worse.

So much for that misplaced optimism. The recent selloff is news in and of itself, but past examining the latest contractions, it’s worth asking the question lurking at the back of the entire software revaluation saga: Were we using the right valuation metrics all along?

Maybe not. And if not, we’re not only seeing a reevaluation of software companies, but perhaps a new era of tech valuations more generally. It won’t be one that is attractive to startups. Public tech companies are also running afoul of the shift.

Call it the return of the P/E ratio, or the revenge of profits, but the days of the revenue multiple might be behind us. At least for now.

Tell me the growth rate and I’ll tell you the value

It was easy to value tech companies last year. Simply take a peek at their growth rate, adjust for the size of their revenue bases, and then multiply the latter figure by a huge number. Simple!

That wound up being bullshit. First, the value of growth was exaggerated by optimism that cloud companies would hold onto prior growth rates longer than previously anticipated. This meant that tech companies would get bigger, faster than expected. So, they were worth more. Investors have since decided that the revised growth estimates were either wrong or simply worth less than they might have thought.

The latter is probably close to the truth, I reckon, due to the second reason why the 2021 tech company valuation method was tosh — namely, profitability matters. Simply growing quickly from a small revenue base was enough to become a unicorn in 2021. But as it turned out, many of those companies were simply transmogrifiers for external cash, ingesting dollars and spitting out losses at a simply staggering rate.

When growth was valued vertically, no one cared that cash incineration was reaching epic proportions; cash had no value in a zero interest rate environment, and growth had infinite value. It was akin to playing a slot machine that always paid out. Put in $1, get $100 out!

That didn’t last. Now growth is worth a lot less than it was, and investors are talking about cash burn and profitability levers, like investors of old.

Revenue multiples are not the only way to value a tech company. You could also use the old-school price/earnings ratio, in which you don’t extrapolate a company’s worth by a multiple of its top line, but its bottom.

Price/earnings ratios — P/E ratios for short — are far stricter mechanisms than mere revenue-based calculations. Of course, what you count as profit, the E in our equation, matters greatly, but no matter what you determine it to be (from adjusted EBITDA all the way to GAAP net income), it’s still a more serious metric than a revenue multiple adjusted for growth rate.

With investors now caring so much about profit that we’ve seen tech companies large and small flip from stockpiling human capital to proactive staff cuts, it’s clear that profitability is back in vogue. This yields an interesting question: Was the revenue multiples era simply an aberration? Should we have been paying attention to profits all along?

Yes and no. Yes, we should have paid more attention to profitability for late-stage private companies: anything Series C and later. But no, revenue multiples are actually a good way to vet startup value. The problem came when unicorns were told by their backers that going public was always something that could be delayed, and the startup moniker was stretched to unsound levels, with multibillion-dollar companies clinging to the title like eighth-year high school seniors. Those companies were not startups. They were public tech companies aping as startups by staying private due to abnormal market conditions.

This is why we’re seeing software valuations compress in revenue-multiple terms again and again and again, and finding ourselves surprised that there is more fat to cut. We’re probably looking at the wrong metric for most companies. Should we really not care about enterprise value divided by NTM revenue as much as trailing P/E ratios? If so, a lot of companies are going to evolve from investor darling status to market pariah. (Twilio was worth $317 per share at max in the last year. It’s worth around $45 per share today. Its revenue grew 33% in its most recent quarter. As its net losses have scaled along with top line, however, it has lost value as its revenue base has expanded. A lesson, perhaps.)

The siren song of growth led to lots of poor choices last year, trades that we have yet to see unwind. That will come later. Soon.