The share prices of SaaS (software-as-a-service) companies have risen massively over the past year. Even after the sharp pullback many of them experienced in late-February and March this year, the share prices of SaaS companies still trade at relatively higher multiples than they did in the recent past.
The chart below by venture capitalist Jamin Ball shows current SaaS company valuations:
The blue line on the chart shows that the median EV-to-NTM revenue (median enterprise value to the next twelve months revenue) multiple for SaaS companies has risen sharply in the last two years. And despite the sell-off over the last couple of weeks, SaaS companies still trade at a higher multiple than they did at any other time before mid-2020.
This has led to some investors assuming that SaaS company valuations are still too high.
On the surface, that may seem the case but it could also be that valuations for SaaS companies were simply way too low in the past.
Venture capital firm Bessemer Venture Partners (BVP) has an index of emerging cloud-computing companies – many of which are SaaS companies – that are listed in the US stock market. The chart below shows the performance of the BVP cloud index (EM Cloud) relative to other major US stock market indexes.
The blue line shows the BVP cloud index. Since tracking began, the BVP cloud index has significantly outperformed the rest of the market. It has even outperformed the tech-heavy NASDAQ by 3.6 times.
Part of the cloud index’s growth was undoubtedly fueled by an expansion in the aforementioned EV-to-NTM revenue multiples that SaaS companies have experienced. But a big part of the growth is also due to the relatively faster revenue growth in SaaS companies.
Doing some quick math and assuming that revenue multiples contract from 14 to 5 times (what they were in 2015), the BVP cloud index would still be outperforming the NASDAQ – the BVP cloud index outperformed the NASDAQ by 3.6 times while the multiple expansion in SaaS companies included in Jamin Ball’s graph was just 2.8 times*.
Given all of this, rather than assuming that the current valuations of SaaS are too high, it could be that historical valuations were actually too low.
Market participants in the past may have underestimated SaaS companies’ growth potential and the sustainability of that growth.
Today, the market may have wisened up to the immense addressable market opportunity of cloud companies and are beginning to better price in their immense potential.
SaaS companies are currently still trading at higher EV-NTM revenue multiples than they were in the past. Just taking this fact alone, one may assume that valuations are stretched now.
But if we take a step back, we can see that SaaS companies may have been mispriced in the past. The pace and sustainability of revenue growth should have warranted a higher valuation back then.
The market may now be smartening up to the wonderful economics that SaaS companies offer. Not only do best-in-class SaaS companies offer a long growth runway, but they also address a huge and growing market.
If their revenues continue to grow as fast it has in the past, SaaS stocks will likely keep going higher.
Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
Want to stay abreast of the latest investing news, analyses, and stories for FREE? Subscribe to our weekly email, Smart Reads, now to receive a curated list of our top articles weekly. CLICK HERE to subscribe now!
Disclosure: Jeremy Chia does not own shares in any of the companies mentioned.