2016 has been a rocky year for the technology industry. The S&P North American Technology Software Index dropped by 22% in single month earlier in the year. While a handful of technology companies have recently had successful debuts, for the first six months of 2016, there were only two VC-backed technology companies to go public including Matrix portfolio company, Acacia Communications. Finally, there was a broad shift in mentality from growth at all costs to the need for sustainable growth and a path to profitability.
Given we are nearing the end of the year, I wanted to share a few charts on the software space which I feel highlight this key theme and illustrates where we are today.
The charts below contain an index of public software companies, including players like Box, Workday, HubSpot and Zendesk. I pulled their current valuation multiples, their projected three-year growth rates and their expected forward EBITDA margin as well as these statistics from last December.
Takeaway 1: Growth continues to be a driver of value, although the direct correlation is less pronounced today.
There has always been a strong positive correlation between growth and valuation multiples for technology stocks. However, it is interesting that the r-squared between the two variables is lower today than it was at this time last year. Growth creates value but it is not a direct one-to-one relationship.
Takeaway 2: Profitable growth is more closely correlated to a company’s multiple than just growth alone. Furthermore, this correlation is stronger today.
First, the r-squareds between EBITDA + growth to EV / sales are significantly higher than the r-squareds in initial charts. This difference demonstrates that margin clearly factors into the value of a company and public markets do not solely reward companies on growth alone. Second, the December 2016 chart above depicts an almost linear relationship between the two variables and a significantly higher r-squared (0.73) than the number in December 2015 (0.46). This shift highlights the change that has occurred over the course of the year: shareholders have become increasingly focused on sustainable vs. absolute growth. Discipline matters.
What does this all mean for entrepreneurs?
As we look ahead to 2017, we expect this the renewed focus on sustainable growth to continue.
Entrepreneurs should certainly not stop optimizing for growth and investing in their businesses. However, particularly as a company scales, capital efficiency and unit economics will matter for its private and potentially eventually public value. Focusing on sustainable growth early may reap significant dividends over the long-term.