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

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

SaaS multiples in public markets

Software as a Service?(“SaaS”) has been around longer than the cool new “cloud.” It shares some aspects of cloud computing, but its focus tends to be clearer: SaaS is simply the delivery of software applications over the Internet from a server that’s 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?, which includes:

1.????Are now trading on either the NASDAQ or the NYSE: and

2.????Derive the large majority of recognized revenues from long-term contractual commitments (12 months or greater), and which recognize those revenues periodically over the life of these contracts.

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

Chart 1

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.?

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

The top quartile of SaaS companies (those whose multiples are higher than 75% of the group) are now at 10.2x, just slightly higher than they were back in 2017.

That elite group has fallen by about 65% from its peak in Q4 2020, about the same as the median. But 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.

For one, rising rates usually act to slow economic growth, which in turn results in slower future revenue and earnings growth for companies and their shareholders. For another, 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” … stocks where the majority of enterprise value is represented by future cash flows, five years out or more … the most.

Remember Finance 101 : The current value of any asset is the present value of all future cash flows. 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 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. The rates on the 10-year Treasury Bond (by which I mean, the “on the run” US Treasury note with a 10 year maturity) correlate at -0.48 R^2, 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.

Chart 2: SaaS Multiples vs Bond Yields

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 that valuations for high-growth SaaS companies keep falling. The table below shows where a simple linear regression might suggest that valuations land:

10-year Treasury Rate????????BBB bond yield????Implied TTM SaaS multiple

4.00%?????????????????????????????????????????6.32%???????????????????????6.8x

4.50%?????????????????????????????????????????7.00%???????????????????????5.4x

5.00%?????????????????????????????????????????7.50%???????????????????????4.3x

5.50%?????????????????????????????????????????8.00%???????????????????????3.1x

?This simple model doesn’t consider any other factors (such as economic growth, the changing profitability of these companies, or other macro 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.

Could SaaS multiples drop to around 3x sales? We saw lows of 3.4-3.8x during the "SaaS crash" of late 2015 / early 2016 but that I think given TAM expansion and investor adoption of the category sine then, this would be unexpected.

Aman Verjee, CFA, is a co-founder and General Partner at Practical Venture Capital, a secondary venture capital firm headquartered in Palo Alto, California.