Looks Like a Bubble, Smells Like a Bubble — What Large Software Company Valuations are Saying
Last week we looked at publicly traded online retail marketplaces and analyzed valuation multiples over the past few years. To no one’s surprise, multiples are approaching all-time highs, but we uncovered that revenue multiples for these marketplaces are actually not that crazy (at least compared to EV/EBITDA) when we look back to 2016. Several winners were disproportionately propping up the losers.
To keep the momentum going, I decided to shift the focus to publicly traded software companies, particularly the largest of them all. While the term software is quite broad, I used the following criteria to compile the list of 50 companies:
- Headquartered in the US
- Publicly traded
- Listed under the “Software” sub-vertical of the Information Technology sector by Capital IQ (implying that software as a product/service accounts for the majority of their business)
- Greater than $750 million in LTM revenue*
What did we find?
Similar to marketplaces, the largest publicly traded software companies have approached record-high valuations. EV/LTM Revenue has reached a median of 9.86x revenue, versus only 4.90 x in Q4 2016. What’s even more interesting is that average EV / Revenue has jumped to 13.47x, from only 5.08x in Q4 2016. The gap between the average and median increased from less than 0.2x to nearly 4x.
This phenomenon is similar to what we saw play out with online marketplaces — where the few winners are being given exceptionally favorable premiums, while the valuations of the laggards have only slightly budged. Consider that when we break it out into 25th percentile and the 75th percentile. The 25th percentile traded at 3.58x revenue in Q4 2016, and has only modestly increased since then to 5.12x. Compare that to the 75th percentile, and we see that revenue multiples exploded from 6.79x to 17.62x over the same time period.
We observe the same on an EV/LTM EBITDA basis, where the 25th percentile increased from 15x to 18.07x, and the 75th percentile increased from 30.37x to 73.17x.
To no one’s surprise, valuations are higher than ever, and the winners at the top are holding up the rest of the pack. But let’s dig a little deeper.
Who’s winning here?
Looking at the companies being valued most favorably by investors, we begin to see a few common themes. CrowdStrike, Zoom, Palantir, DocuSign, and RingCentral round out the top 5 at 59.69x, 50.51x, 39.02x, 32.02x, and 31.32x, respectively. While Zoom, DocuSign, and RingCentral all provide SaaS solutions enabling some form of remote work communication & collaboration, a trend brought on by the pandemic.
However, CrowdStrike and Palantir both center intelligence and security systems. While not directly related to pandemic-induced adoption, these companies highlight the increased focus on the fragility of our digital infrastructure, especially as a significantly greater part of our daily lives has moved online. The recent cyber attacks exposing weakness in our government’s online security have only further strengthened this focus.
It’s interesting to point out that 4 out of these top 5 companies have negative EBITDA, with Zoom the only one coming out positive at $519 million (a healthy 26.5% margin).
It appears that investors are weighing heavily on the most recent year’s growth. Of our top 5 by revenue multiples, 4 of them are also the fastest-growing by revenue year-over-year. Zoom, CrowdStrike, DocuSign, and RingCentral have grown at 262.3%, 85.9%, 44.3%, and 31.4% y/y, respectively.
Why does it matter?
The key question to be answered is whether or not this phenomenal year of growth these companies are experiencing is an outlier due to COVID, or if these new customers acquired will continue using the services long after the pandemic. Regardless of whether or not remote work is here to stay, I find it hard to wrap my head around the extremely high valuations we see. Even if the “new normal” looks a lot like the present, how can the growth rates we saw during the pandemic be sustained afterwards. Just because the car can go 0 to 100 doesn’t mean it will just as easily go from 100 to 200.
To illustrate this hesitation, look at Microsoft. They have the highest EBITDA margins (46.6%) of all the companies we measured, and still grew at 13.5% y/y, despite their massive size (nearly $150B in LTM revenue and market cap approaching $2T). Even their revenue multiple has doubled over the last 2 years to just over 11x. If Microsoft, the best in the business, is getting only 11x revenue (and remember, this is high for them), maybe it’s a sign we should take another look at some of the others on the high end.
With the democratization of retail investing, record-low interest rates, and what seems like a time of more speculation than ever before, the story makes sense. Sure, software is eating the world, but it’s only doing so one bite at a time. Will the music ever stop? Who knows — I was only an infant during the dot-com bubble; but everything I’m hearing from more ~seasoned~ investors would indicate that it looks strikingly similar. And if they’re right, you’d better be ready for when the tide goes out.
*Note: We use LTM data as of 12/31/2020 for Q4 multiples.
