This post is an update in a quarterly series of posts that tracks the PVC SaaS Index™, a basket of publicly traded US-listed SaaS companies.
Software as a Service (“SaaS”) has been around longer than the cool new cloud. The SaaS category shares some aspects of cloud computing, but its focus tends to be clearer: SaaS is the delivery of software applications over the Internet from a server hosted by the SaaS provider somewhere far away.
The first big SaaS IPO was Salesforce (NASDAQ: CRM) in 2004. Almost 20 years later, we have 104 pure-play SaaS/cloud companies in our proprietary PVC SaaS Index™. These companies all trade on the NASDAQ or the NYSE. They derive most of their recognized revenues from long-term contractual commitments (12 months or greater) and recognize those revenues periodically over the life of those contracts.
In this index, we have removed several SaaS companies that have gone below $1B market cap, essentially becoming broken IPOs or “zombies” in the public markets, with low liquidity, high volatility, and uncertain public company prospects: Agora, Bandwidth, CS Disco, and Presto Automation. That leaves us with 102 publicly traded SaaS companies in the US.
The figure below shows the historical EV / TTM (“Enterprise Value” to “Trailing Twelve Months” of revenue) going back to 2015.
The multiple of 7.1X in Q4/23 is exactly the same as the median SaaS multiple in late 2017. The top quartile of SaaS companies (i.e., those whose multiples are higher than 75% of the group) are now at nearly 12X, higher than they were back then, when the elite group was around 9-10X.
The multiples of that elite group have fallen by about 60% from its peak during the period from Q4/20 to Q2/21.
Interestingly, you can draw a fairly flat line back through Q4/17. Back then, the median company in the PVC SaaS Index was at about an 8X EV / trailing sales multiple. That multiple stayed fairly steady throughout 2018 and 2019, and all the way through the brief 5-month “COVID recession” (and ensuing market panic) that began in March 2020, when large-cap public market indices dropped by about 30% from mid-February to the end of March.
A big valuation jump began in April 2020, when the median EV / trailing revenue multiple increased from a COVID bottom of 9x to over 18x. Those multiples lingered for just over a year, and the market peaked in Nov 2021, when companies in the top decile changed hands at above 30X revenues.
The PVC SaaS Index peaked on November 9, 2021. Pandemic beneficiaries led the charge here, including companies like Zoom and Netflix, which saw huge influxes of new customer ARR (annually recurring revenue) to drive their top line, then gave up some of those gains as the economy normalized in late 2021. Generally speaking, the increase in multiples was broadly felt by almost every SaaS company.
However, since the start of 2022, those multiples reverted back to pre-pandemic levels. The current multiple of 7.1X is just slightly below the 5-year average of 9.4X and 10-year average of 9.0X.
One metric that we like to track is how much these SaaS companies add each quarter in net new ARR, which is the sum of 3 components that drive growth for SaaS companies. It is calculated as follows:
Based on Q4/23 results, cloud companies in the US added a record amount of ARR. The next figure shows the net new ARR from the companies in our index reporting on this metric so far in Q4 results.
It appears from these results and the accompanying commentary in earnings calls that the macro headwinds against cloud stocks is easing. During 2023, a lot of the major buyers of SaaS licenses reduced their spend because of the seat reduction that accompanied layoffs and workforce consolidation. SaaS companies typically charge their customers for a per-seat license, so if you are a SaaS company selling to Meta or Twitter, your net new ARR decreases as those companies reduce workforce and the number of seats goes down.
SaaS stocks now seem relatively cheap on a historical basis – their EV / sales ratio is below where it’s been on average for the last 5, 10, or 15 years.
Meanwhile, US stocks more broadly have recently entered what we describe as a “Danger Zone.”
Seven stocks drove almost all of the gains in the S&P 500 in 2023. The market cap of all US stocks is now about $40T, which is $5T higher than it was at the start of the 2023. But just 7 stocks – Apple, Microsoft, Google owner Alphabet, Amazon, Nvidia, Tesla, and Meta — contributed most of those gains. These “Magnificent Seven” stocks have ripped higher, gaining between 40% and 238% in 2023, while the remaining 493 companies were up just 12%. In aggregate. Nvidia alone added over $1.1T of that $5T in appreciation during 2023.
Top-heaviness in the US isn’t new. There was a “Nifty Fifty” period during the 1960s, and a period during the 1970s when oil companies dominated the index. But this level of market cap concentration by large cap tech feels extreme; Apple is worth more than the entire Russell 2000 of smaller US companies. When market breadth breaks down like this, it usually doesn’t end well. For instance, the end of the 1960s ended with a whimper, and most of the 1970s generated meager or zero real returns.
Because of their risk and volatility, equities typically offer a premium over fixed income securities, an equity risk premium that provides additional reward for investors in exchange for the higher risk. Compare the Earnings Yield of the S&P 500 (which is the sum of retained earnings for those stocks, plus the dividends that they pay out, on a trailing 12-month basis) to the Effective Yield of BBB-rated corporate bonds in the ICE Bank of America Index, and you can see that, on average, equities provide an advantage over bonds. We call this advantage the PVC Equity Risk Premium®.
As corporate bond rates soared in 2023, the PVC Equity Risk Premium® has dropped to the lowest reading since 2007. In the US, the stock market had a strong Q4, giving the NASDAQ Composite a total return of 45% and the S&P 500 a total return of 26%.
Equity Risk Premium is the difference between the S&P 500 Earnings Yield and the BBB bond yield.
S&P 500 Earnings Yield (or inverse price-earnings ratio) equals the trailing 12 month earnings divided by index price.
BBB bond yield’ is the effective yield of the ICE BofA BBB US Corporate Index.
Startups should be aware of what’s happening in the public markets – in particular, the tech-heavy NASDAQ Composite Index, because historically there is a 90%+ correlation between movements in the NASDAQ and round sizes, and a nearly 1:1 correlation with dollars invested into venture capital.
Over the past decade, the NASDAQ Composite Index has experienced 5 corrections, which I have defined as a 10% or greater drop from its prior intraday high. The chart below shows round sizes for Series A companies; these round sizes dipped only very slightly (if at all) during the corrections yet generally continued climbing. On a quarterly basis, the correlation between the NASDAQ closing value and the median series A round size is 0.93. Over the past six quarters, Series A round sizes have fallen by 14%.
Finally, this figure shows round sizes for Series D or later companies. Later-stage round sizes dipped during these corrections. On a quarterly basis, the correlation between Series D+ round sizes and the NASDAQ closing value is 0.86. Over the past 6 quarters, round sizes have adjusted much more quickly and by 52% from the peak in Q4 2021.
