David Cummings on Startups

SaaS Company Valuations Will be Cut in Half

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David Cummings

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Earlier today Jason Lemkin tweeted that a 50-70% correction is coming to Software-as-a-Service (SaaS) companies:

I agree.

Last week Fred Wilson wrote a post The Bubble Question about it where he attributes overvalued tech stocks to interest rates near zero and the desire for growth companies.

Today, many SaaS companies are trading at 10-12x trailing twelve months revenue, and have no profits. So, why do I think they’re 50% overvalued? Easy. SaaS companies typically spend 40-60% of revenues on sales and marketing to acquire customers (growth is incredibly important). Assuming these sales and marketing costs could be pared back relatively quickly, the theory goes that these companies would quickly achieve 30-40% profit margins.

The average historical price to earnings (PE) ratio is around 15 for a public company. That is, the company is worth roughly 15x profits (right now the average PE ratio is almost 20).

If a public company is worth 15x profits, and a SaaS company can quickly achieve 33% profit margins, that results in the same valuation as 5x revenues (15*.33 = 5). 5x revenues is half of the 10x revenues many SaaS companies are trading at now, thus long term, the valuations should be cut in half.

Of course, this is simplistic in that it isn’t accounting for growth rates, gross margins, renewal rates, total addressable market, premiums for a public company over a private company, etc. But, as an example, if a company is valued based on a function of its future profits, and SaaS companies can become extremely profitable due to the nature of the business model, making a guess as to profit margins results in a straightforward valuation.

What else? What are your thoughts on SaaS company valuations being cut in half?

Comments

3 responses to “SaaS Company Valuations Will be Cut in Half”

  1. Christien (@CLouvi) Avatar
    Christien (@CLouvi)

    David…what is the timeline that you’re thinking it will get cut?

    I do think a cut is coming, but I don’t think it’s anytime soon; and I also don’t think it will be an immediate drastic 50% hit. New platforms based on content proliferation and mobile are just now starting to get their legs under them. Sub-ecosystems will branch up from those quickly. Plus, the big boys (SF, Oracle, etc.) haven’t even really begun to acquire these types of companies yet. When they do, they’ll bring the bank.

    Reply
  2. Bill Scott Avatar
    Bill Scott

    This is a reasonable approach to looking at what SaaS companies should really sell for. Don’t forget, however, that the numbers used are an average and values may go well below those quoted as a reaction to a bubble. This might mean that at a reactionary trough in valuations, they mat be as low as 5 or ten percent of bubble highs. I came through the bubble of 2000 and 2001. It can happen!!

    Of course everyone always says, “it’s different this time” but really it’s probably not going to be.

    Reply
  3. joshaustdotin Avatar
    joshaustdotin

    It will be interesting to see what the qualifiers are in this prediction. Some SaaS companies are like utilities and it’s nearly impossible for their customers to operate without them, but others can be easily replaced or their usage reduced. When computing the present value of the first type my guess is that valuations will stay high, for the second type I could see them coming down due to the increased risk.

    Reply

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