Software Valuation Multiples
The concept of software valuation multiples will be broken down into parts in this article.
SaaS (software as a service) is a rapidly developing sector of the software market that has its own set of challenges and opportunities when it comes to sales. Valuations of publicly traded software companies have skyrocketed in recent years. Small privately owned software companies have similarly robust valuations, which may fluctuate widely across transactions. Executives understand that not all valuation techniques are created equal. The reliability of an analysis is proportional to the precision of the predictions upon which it is based. The method of using a set of “valuation multiples” is one example of this kind of analysis.
Software valuation multiples
Late in 2022, the worldwide SaaS industry was estimated to be worth $186.6 billion. This figure is projected to reach $720.44 billion by 2028, growing at a CAGR of 25.25% from 2022 to 2028. In 2022, the worldwide SaaS market was driven by the large-scale enterprise segment, and this pattern is projected to persist beyond the forecast timeframe. SaaS systems may provide businesses with a competitive edge by giving them access to flexible, controllable, and scalable cloud-based infrastructure.
There has been an uptick in interest in reputable SaaS companies, and that trend seems set to continue into the decade. For startup founders, investors, and advisers, the question of how to put a price on a SaaS company represents one of the most heated and perplexing discussions of recent times.
What are valuation multiples?
Valuation multiples are used in finance to determine a company’s worth by comparing several metrics, often expressed as a ratio. The market value is calculated using multiples of relevant metrics such as profits, share price, value per share, sales, and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). The ratio used to evaluate many elements in determining a car’s mileage per gallon is a popular example of multiples.
Software valuation multiples may be used by financial professionals including advisors, analysts, brokers, and bankers to estimate a software’s worth. It’s a useful tool for stock trading, investing, and merger proposals. To determine software valuation multiples and develop a strategy to reach financial targets, businesses may also use the services of consultants.
Types of multiples used in valuation
Valuation multiples may be broken down into two broad classes: enterprise value and equity multiples. Whether an equity multiple or an enterprise multiple is used depends on our evaluation of the most relevant measure and the information at our disposal. Analyzing equity multiples requires looking at ratios. These ratios compare one measure of a company’s success to its share price. Profit, revenue, book value, or an equivalent measure can be included in this category.
The price-earnings (P/E) ratio and the price-earnings-to-growth (PEG) ratio are two examples of equity multiples. Other ratios include price-to-book and price-to-sales. Equity multiples may be affected by a shift in capital structure. This is true regardless of whether or not the Enterprise value (EV) changes.
Multiples of a company’s earnings before interest and taxes, or EBIT, are also used to express its enterprise value (EV). Using enterprise value multiples, businesses may be compared side by side. It makes no difference how the capital is structured. That’s why these methods are superior to equity multiples as valuation tools.
The impact of accounting discrepancies on enterprise value multiples is minimal. This is because the denominator is calculated at a more elevated level of the income statement.
Following are some types of valuation multiples used to assess a company’s worth:
- EV/Sales – Enterprise Value to Sales Ratio describes the proportion of a company’s total sales to its total value.
- EV/EBITDA – The Enterprise Value-to-EBITDA ratio reveals this information. It’s popular because it makes it simpler to draw comparisons across businesses in the same sector regardless of capital structure or asset.
- EV/EBIT – It is a ratio that shows how much a business is worth about its profit. This is a multiple that is quite comparable to the EV/EBITDA which doesn’t take into account D&A. (thus the asset structure).
How to do multiple analyses
The basic idea behind the method is to compare the results of comparable businesses by using a ratio rather than a raw number for anything like sales or earnings before interest and taxes.
Because of their comparable operations and business environments, it is reasonable to presume that similar organizations can apply these ratios to one another to arrive at a realistic value estimate.
This method is extensively utilized by professionals in the field of valuation in part because it is easy to implement. The difficulty is in identifying appropriate software valuation multiples to employ when comparing companies. There are several phases in multiples-based valuation, and they are as follows:
- The first step is to find assets that are analogous to those you’re looking to compare. It is then important to compile the current market prices of these similar assets.
- The assets’ market values are normalized to provide a consistent valuation system. As direct comparisons of absolute costs are impossible, they are presented with a relevant indicator. By using these uniform criteria, software valuation multiples are produced.
- At this step, you may use the strategy on the asset’s most important metrics. It regulates variations between the valued item and similar assets. But, if the assets are different, the multiple may change.
Factors to do multiple analyses
Several different SaaS indicators may be used to conclude that a company is worth between four and ten times its yearly earnings. In the preliminary evaluation, it is helpful to narrow these factors down to the handful that have the greatest impact on determining whether a software valuation multiple is on the low or high end of the valuation range. Transaction multiples are affected by several variables, including:
- Size – Firms with a bigger market share often get higher multiples.
- Revenue Mix – Some businesses get income from a combination of their software and their services or a combination of their subscription and perpetual license sales. Software valuation multiples are only appropriate for the software subscription model. Unlike dependable recurring SaaS income, one-time perpetual license money is often unpredictable and hence generates a lower multiple when applied to service revenue.
- Revenue Growth – Rapid expansion of sales is one indicator of a successful business model.
- Profitability – Investment firms will want to see a road to profitability and excellent profit growth, but if the firm is effectively investing its earnings towards quick expansion, that scenario might be appealing to purchasers.
- Customer Churn – The percentage of customers who no longer make purchases from a company should ideally be lower than 10%. Long-term and loyal customers are essential to increasing your company’s value.
- Customer Diversification – Risk is mitigated by having a big, diverse client base rather than a small number of high-value customers.
- Competitive differentiation – Sophisticated algorithms, patent protection, or industry expertise make a firm more desirable. An increased value is associated with long-term market dominance.
- Addressable market size and growth – The size of the addressable market for a software firm in an industry where every company currently uses a comparable product is low. The potential for growth of software products may be higher in less competitive marketplaces.
Why do multiples change over time?
In 2020 and 2021, owing to cheap money and a surplus of capital, commercial and public software transactions saw increased costs. In the second half of 2021, the average multiple for a privately held software business increased to 6.0x Sales and 23.9x EBITDA. When investors consider the impressive software valuation multiples, they may feel as if they can afford to overpay for investments.
First-quartile growth was even more spectacular, with the top 25% of firms fetching well over 50 times annual profits from investors during the initial half of 2022.
The next year, though, attitudes began to shift. The Federal Reserve started increasing interest rates in early 2022. The discount rate is a key factor in any valuation that takes into account future cash flows. The valuation of a failed SaaS company that was previously valued at a very high sales multiple plummeted overnight.
The median Enterprise Value to Revenue ratio fell to 5.1x by the second quarter of 2022, moving closer to the long-term average of 3x. When it comes to public SaaS valuations, the boom and bust cycles were even more extreme. The factors contributing to such changes in software valuation multiples are discussed here.
Geography effect on valuation multiples
The company’s market worth is heavily influenced by its location. Software valuation multiples of US firms are higher at 4.3x Sales and 21.4x EBITDA. U.S. firms are setting their sights on the world’s biggest consumer market because of its enormous growth potential. Yet, software companies based in countries where English is not the native language tend to be small, regional, and challenging to internationalize and expand worldwide. Software businesses in France and Germany, for example, are often valued at a multiple of two times their annual revenue. Similarly, the size of the Chinese software market, together with its potential for expansion, seems to be comparable to that of the American market.
Size effect on valuation multiples
The size of the company is a major component in the value estimation process. In the software industry, larger firms are valued at a greater multiple of sales and profit than smaller ones. When a corporation rises in status, its EBITDA multiple increases by a factor of two to three. These days, most investors work under a specific mandate. Most financiers aim for a certain minimum annual income or minimum investment amount. To attract such strategic investors, a firm must be sizable enough to have a meaningful impact on its industry. When a software company grows in size, it attracts a broader range of investors, which in turn drives up both competition and value throughout the selling process.
How will software valuation multiples change in the recent recession?
You can expect software valuation multiples to continue falling from their H1 2021 highs to the long-term levels of roughly 3.0x Sales or 16.0x EBITDA by 2023 when the economy enters a recession. It’s remarkable to observe how consistent the median values were before the 2020-21 spike. This suggests things will settle back down to normal soon.
Investors in the software will need higher returns to offset the increased risk associated with a Federal funds rate that is expected to hit 5% in 2023. As investors shift their attention back to a company’s ability to generate cash flow, the EBITDA multiple may rise in popularity in the coming years.
You may also anticipate a significant slowdown in merger and acquisition activity among publicly traded corporations as a result of falling market capitalizations. Private equity investors, meantime, will have a lot of cash to spend after raising a large sum in 2021 and ’22.
Although some seek public market acquisitions, other investors choose to purchase privately held businesses. Software will continue to be one of the most highly valued industries even though it may take a long time to approach the peak valuations seen in 2021. This is because there will be no lack of interest in emerging technologies.
Choose Eqvista to value your software!
With so many variables impacting the worth of your digital, software, or internet business, it’s important to engage with an advisor who knows the sector and has experience selling firms to develop a strategy for determining the company’s worth and taking actionable efforts to raise that worth before selling. You may get an estimate of your software’s valuation in a matter of minutes using Eqvista’s cutting-edge technology. Our trained and qualified valuation experts are available around the clock to respond to any concerns and provide you with the most precise value reports possible. Have any questions? Get in touch with us immediately!