Dreams of Premium Revenue Multiples
Dreams of Premium Revenue Multiples
Lessons from current public cloud valuations, why revenue multiples can be deceiving, and how to receive a premium valuation
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Understanding Revenue Multiples
When people talk about revenue multiples they are referring to a company’s valuation relative to its revenue. Defined as:
Revenue Multiple = Enterprise Value / Revenue
There are some terms and definitions you should understand when it comes to a company’s “valuation”.
Market capitalization: is the total value of a publicly traded company's outstanding shares.
Market Cap = current price/share * number of shares outstanding
Private company headline valuations are similar to market cap but can be much more deceiving depending on the level of “structure” (i.e. favorable terms for VCs) in the preferred stock.
Enterprise value (EV): is more comprehensive than market cap. EV includes the market cap of a company but also includes debt and any cash on the company's balance sheet. EV (not market cap) is used as the basis for financial ratios
EV = Market Cap + Debt - Cash
A lot of people get confused on the EV calculation… Why add money a company owes to its value and subtract their cash? Isn’t a company with more cash more valuable than one with less?
Enterprise value is a financing calculation and represents the amount you would theoretically need to pay to acquire a company. An acquirer would have to pay those who own equity (shareholders) and everyone who has loaned it money (lenders). In other words, you get the company’s cash upon acquisition but need to pay off the debt. That’s why you add debt but subtract cash.
Problems with Revenue Multiples
Revenue multiples are a shorthand valuation metric that allows investors to quickly compare all cloud companies to each other.
But its simplicity is also what can make it so problematic. There are a lot of assumptions that are baked into a revenue multiple — revenue growth, growth endurance, gross margins, profitability, moat, TAM, etc.
The biggest issue with revenue multiples is the time horizon it considers — one year. Most investors are looking at the revenue multiple on an NTM (next twelve month) basis. Whether LTM or NTM basis, revenue multiples are only based on near-term revenue amounts of one year.
But 90%+ of the value of cloud companies isn’t created in just the next year. The vast majority of cloud company value is created in all of the outer years from continued revenue growth and profit margins. Many cloud companies are unprofitable or barely profitable for a long time until they hit some level of scale with the expectation that they will turn into a cash printing machine.
Many years ago using revenue multiples as the single metric to compare companies was more appropriate:
Revenue was stickier and more durable
High profit margins of 20%+ was more realistic for most cloud companies
Less variability in cloud unit economics
Today, however, is different. There absolutely should be a greater degree of revenue multiple separation between cloud companies because the underlying economics vary much more today.
Public Cloud Metrics
Revenue Growth
Below are the public cloud companies with the biggest revenue multiple rank changes since August 2022. Palantir for example, went from the 35th highest revenue multiple in 2022 to the #1 highest revenue multiple (jumping 34 spots).
The biggest revenue multiple losers since 2022 is below. Bill.com still tops the list by falling a massive 52 spots in just 2 years.
As I said at the beginning, revenue multiples are a shorthand valuation metric that allow investors to quickly compare software companies, but there is a lot that goes into this single metric. The times investors have got into the most trouble (and lost lots of money) is when they forgot/ignored that not all cloud companies are created equal.
These two year movements in revenue multiple rankings are HUGE. It makes you think that investors have no idea what they are doing….
So what is driving the huge revenue multiple swings?
As you might expect, it’s a combination of revenue growth and profitability.
Below are the companies with the highest revenue growth endurance since 2022. 8 of these companies also had the largest revenue multiple increase over the same time period (from the biggest winners chart above). This makes sense because those that can maintain their revenue growth more than expected (and relative to others) should be valued more. The big question is…which companies will have the strongest revenue growth endurance 2 years from now?
A similar pattern can be seen with the companies with the lowest revenue growth endurance. Bill.com’s revenue growth endurance was only 7%…so of course it’s revenue multiple tanked - very few thought its endurance would be so weak back in 2022.
Profitability
Revenue multiples work great for comparisons when the population of companies is very similar. But “cloud” has taken on a much looser meaning and AI is throwing another wrench into the equation.
Not all “cloud” companies will be 25%+ FCF earners or grow as fast as many have historically. And that is OK. Money can be made from different business profiles as long as the investor entry valuation makes sense. If we treat all cloud companies the same, then it just becomes a game of hot potato to see what investors are holding the bag once valuations correct (remember 2021?).
Chasing Premium Valuation Multiples
So what does a company need to do to receive a top revenue multiple of 10x+ at scale?
High revenue growth that is durable for many years
Strong unit economics. If at scale, then the company should already have strong and improving FCF margins. If still in hyper-growth mode then it needs strong efficiency metrics.
But the real question is should every company be able to achieve a high revenue multiple?
The answer is no. At least not when comparing to the highest revenue multiple of all cloud companies. But rather it should be relative to a company’s specific financial profile.
Not all cloud businesses are the same so just looking at revenue multiples of top tier companies may not be helpful.
Gross margins are so important because they put a ceiling on a company’s profitability. A 60% gross margin company usually shouldn’t be able to achieve the same revenue multiple as an 80% gross margin company (assuming similar growth rates).
It is important for companies to accept these differences so private companies can plan for what a realistic revenue multiple will be when they are public.
Many private company valuations have been bid up with an assumption of very durable high growth and improving margins. But the public markets right now are less optimistic and less generous about your future prospects — they want high growth and profits today to get a high revenue multiple.
Footnotes:
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