PVC SaaS Index™ | Q4 2022 – Where Will SaaS Multiples Bottom Out?

Practical Summary:

• Companies in our PVC SaaS Index™ now trade at an average 6.8x EV / LTM revenue, slightly down from the 7.6x multiple observed at the end of Q2 2022.
• SaaS multiples now trade at levels that haven’t been seen since the 2016 “SaaS crash.”
• Valuations today have just about normalized. Ignoring the 2020/2021 “COVID bubble” and ensuing Q1 2022 hangover, multiples are back in line with (or lower than) the prior 5-year averages.
• Interest rates explain a LOT of the movement in the median EV / TTM revenue SaaS multiple. Movements in an index of BBB bond yields explain over 65% of the quarterly fluctuations in the median SaaS multiple.
• SaaS companies are now performing better – with faster growth, better profitability, and larger TAMs – than in 2016.

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This post is an update in an ongoing series of posts that track the PVC SaaS Index™, a basket of publicly traded US-listed SaaS companies.

Background: SaaS Multiples in Public Markets

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 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 123 pure-play SaaS/cloud companies in our proprietary PVC SaaS Index™. These companies all trade on the NASDAQ or the NYSE. They derive the large majority of their 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, OneSpan Inc., Sumologic, Agora Inc., Presto, and Weave Communications Inc. That leaves us with 118 publicly traded SaaS companies in the US.

Q4 2022 Valuation Update

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

The multiple of 6.8x in Q3 2022 is exactly the same as the median SaaS multiple in 2017, which mean that the SaaS index has fully retraced all of the gains made over the past five years.

The top quartile of SaaS companies now trades at 10.2x, just slightly higher than in 2017. That elite group has fallen by about 65% from its peak in Q4 2020, about the same as the median. However, when compared to 2017, the top tier has resisted some of the downward pull, holding at 10.2x now versus about 9.4x then.

Impact of Interest Rates on Valuations

As interest rates rise, the valuations of growth stocks typically go down.

Rising rates usually act to slow economic growth, which in turn results in slower future revenue and earnings growth for companies and their shareholders. As interest rates move higher, stock investors become more reluctant to bid up stock prices because the value of future earnings will look less attractive versus bonds that pay more competitive yields today. This reality affects “growth stocks” the most – those stocks where the majority of enterprise value is represented by future cash flows, five years out or more.

The present value represents the value of all anticipated cash flows in the future, discounted by the cost of equity in order to ascertain what an investor would pay today in order to receive all of those future cash payments. The higher that cost of equity, the lower the present value – and the lower the value of the stock.

As rates rise, the cost of equity rises, and valuations fall as a result.

The Federal Reserve Bank raising rates has been a strong depressor of valuations. Rates on the 10-year Treasury Bond (the “on the run” US Treasury note with a 10-year maturity) correlate at -0.48 R^2 with valuations, meaning yield changes explain about half of the forward multiple’s movement since 2019.

Even more powerfully, the prevailing yield on a basket of Triple-B corporate bonds explains a stunning 68% of movements in the median SaaS EV / TTM revenue multiple since 2016. That is, the correlation between the quarterly median PVC Index SaaS multiple and the effective yield of the ICE Bank of America BBB US Corporate Index (a subset of the ICE BofA US Corporate Master Index tracking the performance of US dollar denominated investment grade rated corporate debt publicly issued in the US domestic market) is -0.68. See figure below.

How Low Could Valuations Go?

With the Fed continuing to raise rates, it’s possible that BBB bond yields keep drifting higher in sympathy and valuations for high-growth SaaS companies keep falling. The table below shows where a simple regression might suggest that valuations land:

This simple model doesn’t consider any other factors, but it does show how sensitive valuations are to interest rates.

Could BBB bond yields rise to over 7? Absolutely. It last happened in July 2008 and persisted through June 2009. And before that, 2002.