PVC SaaS Index™ | Q2 2022 – SaaS Multiples Are at a 4-Year Low: Where Do They Go From Here?

Practical Summary:

• Our PVC SaaS Index™ companies trade at just over 8x EV / LTM revenue, lower than at any time since the Q1 2020 market panic that followed the onset of the COVID pandemic. They are trading around where SaaS multiples were in 2017-2018.
• The median company multiple in our index is down 54% from the peak in late 2020 / early 2021. The top quartile multiple has compressed even further, by 65% (from 31x to 11x).
• If you go back to Q4 2017, you can draw a fairly flat, straight line connecting the median and top-quartile SaaS multiples over time. Valuations today look like they just have just about fully normalized, if you ignore the 2020/2021 “COVID bubble” and the ensuing Q1 2022 hangover.
• Even though SaaS multiples are back to early 2018 levels, SaaS companies are performing better, with faster growth, better profitability, and larger TAMs.
• For any investor with a longer-term horizon, now is the least expensive time to buy in the extremely overpriced past 2 years.

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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 category shares some aspects of cloud computing, but its focus tends to be clearer: SaaS is simply 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, and now we have over 120 pure-play SaaS/cloud companies in our proprietary PVC SaaS Index™. These companies…

• trade on the NASDAQ or the NYSE
• derive the large majority of recognized revenues from long-term contractual commitments (12 months or greater) and recognize those revenues periodically over the life of these 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: Blend Labs, SumoLogic, OneSpan Inc., Agora Inc., and Weave Communications Inc.  That leaves us with 117 publicly traded SaaS companies in the US.

Q2 2022 Valuation Update

The figure below shows the historical EV / LTM (“enterprise value” to “last twelve months” of revenue) going back to 2013.  

Multiples Have Reverted to 2017-2018 Levels

Interestingly, you can draw a fairly straight, flat line back through Q4 2017. Back then, the median company in our index was at about an 8x EV / trailing sales multiple. That multiple stayed fairly steady throughout 2018-2019 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.

Of course, we then had a huge run-up in multiples – up to historic highs of 17-18x in late 2020 and throughout 2021. A handful of pandemic beneficiaries led the charge here (companies like Zoom and Netflix, which saw huge influxes of new customer ARR to drive their top line, and then gave up some of those gains as the economy normalized in late 2021), although the increase in multiples was broadly felt by almost every SaaS company.

Since the start of 2021, however, those multiples have reverted back to pre-pandemic levels, with the median SaaS multiple compressing by 54% and the top-quartile multiple compressing by about 65%, from 31x at the peak to 11x today.

Performance vs. Valuation

All of the SaaS companies have now reported Q4 2021 earnings. The median company had a blistering YoY revenue growth rate of +29% YoY for the full fiscal year. A total of 58 of the 117 companies had growth rates north of 30% annually, with a trailing multiple of approximately 12x.

As a category, these public SaaS companies are generating over $366B in ARR and a total enterprise value of over $4T.

This kind of annual performance from such a large public market sector – showing top-line growth of nearly 30% with expanding profit margins, now through several straight quarters that include a US recession – is unheard of.

How Did We Get Here?

To put in context where we currently are, SaaS companies are now trading at 2017-2019 levels. Some adjustment from the levels we saw in late 2020 and 2021 was inevitable … and healthy … because asset prices have been distorted by two government actions:

1. The monetary stimulus, characterized by the Fed buying financial securities (Treasury bonds, then mortgage-backed securities), which has now increased traditional measures of the money supply by approximately 26% since February 2020 (that’s the largest annual increase since 1943)
2. The fiscal stimulus, quantified by a federal deficit that came in at 12.5% of GDP in 2020, the largest since WW2.

Monetary Stimulus: Treasury Operations since April 2020

Over the past two years, I’ve lost count of how many times I’ve heard the words “unprecedented times” inappropriately applied to the pandemic. In fact, we’ve had many pandemics in the US before … most recently, 1969, 1958, 1918, but also repeated outbreaks of smallpox (which wasn’t wiped out in the US until 1972, thanks to a large vaccination initiative), yellow fever, and cholera.

What is truly unprecedented is the government response, with the Federal Reserve going on a bond-buying spree and expanding the money supply by 26% in just 24 months.

As the economy went into a recession in March 2020, the Federal Reserve started buying securities in order to stabilize the financial markets, which had gone into a freefall that endangered the balance sheets and reserves of lending institutions. When the Fed purchases securities from non-banks, which is its normal practice, it gives the seller a check or payment, credited to the seller’s bank deposit account. This increases the money supply, which is basically the currency and coins held by the non-bank public, plus checkable deposits / travelers’ checks (the “M1”), plus savings deposits and money market accounts (in total, that’s the “M2,” which is the Fed’s broadest measure of money). The Fed did the same thing (only to a lesser extent) for the first time ever in 2008. During that financial crisis, the Fed began what it called its “Quantitative Easing” program and expanded its balance sheet. But at the same time, commercial banks were busy shrinking their loan books and writing off losses from mortgage debt and securities.

The Fed was really only offsetting the contraction of commercial bank balance sheets. From 2010 to about 2019, the Fed’s broadest money measure, the M2 money supply, averaged only 5.8% a year.

The experience this time around has been very different, with the M2 money supply growing by 26% in 2020, then another 12% in 2021. The figure below illustrates the increase in the Federal Reserve over the past 12 years.

Fiscal Stimulus

The other driver of inflated asset prices has been the federal “fiscal stimulus,” which is basically what the federal government adds to GDP annually by spending more money than it raises in taxes. Historically, the federal government had run budget deficits in times of recession in order to increase aggregate demand and help the economy to recover. But as the chart shows below, in 2020 the amount of fiscal support far exceeded anything that the US federal government has ever done to combat a recession.

Private Market Valuations vs. Public Markets

Startups should be aware of what’s happening in the public markets – in particular, the tech-heavy NASDAQ Composite Index – because historically there is over 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 five 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 but generally continued climbing. On a quarterly basis, the correlation between the NASDAQ closing value and the median series A round size is 0.93.

The figure below shows round sizes for Series D or later companies. It shows clearly that round sizes dipped during these corrections. On a quarterly basis, the correlation between Series D+ round sizes and the NASDAQ closing value is 0.92.

Conclusion

After nearly two years of a government-fueled expansion, public markets have adjusted quickly and tech multiples for SaaS have corrected back to 2018-2019 multiples. The companies are generally performing extremely well, so we see this as an inevitable and indeed healthy correction in valuations, as the Fed has signaled the start of a normalization process.

Historically, private markets take 3-6 months to adjust to the new valuations. Contracted multiples mean fewer and smaller IPOs, and startups hoping to go public this year may have to wait for a while. Some companies that don’t need to raise will simply wait until they grow their revenue to achieve desired valuations and exits. Acquirers benchmark their purchases to the public markets, and with comparable prices down by 30-50%, that’s going to be felt by the private markets – most significantly at the later private equity stages.

But for any investor with a longer-term horizon, now is the least expensive time to buy in the extremely overpriced past 2 years.