How to Predict the Forward Multiple of a Software Company

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High growth software companies are valued based on forward revenue multiples. In other words, to calculate the enterprise value of a business, you multiply the revenue by the forward multiple. But, how does the market set the multiple? What predicts the forward multiple, or correlates with it?

I pulled together the data for the basket of the roughly 60 publicly traded SaaS companies and ran a linear regression to understand the predictive power of the many key metrics reported by public companies.

The answer: revenue growth and sales efficiency dominate the model. Cash flow margins, net income margins (profitability), gross margins, and many other metrics are largely irrelevant.

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Revenue growth correlates with forward multiple at 0.81.

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Sales efficiency isn’t far behind at 0.75.

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If you’d like to predict the forward multiple for the next software company to file their S-1, use this formula.

Forward Multiple = 6.3 + 38 x Revenue_Growth + 2 x Sales Efficiency.

It should get you within 20% of the forward multiple observed in the market today.

By popular demand, here are definitions:

  1. Revenue growth – year over year growth in revenue
  2. Gross margin – gross profit divided by revenue
  3. Cash flow margins – cash flow from operating activities divided by revenue
  4. Net income margin – net income divided by revenue
  5. Sales efficiency – (gross_profit_this_year – gross_profit_last_year)/selling_and_marketing_expense_last_year

 

This blog was originally authored by Tomasz Tunguz of Venture Capitalist at Redpoint. Republished with permission.

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