Australian start-up company Canva’s value has catapulted to AU$8.7 billion, almost doubling last year’s AU$4.7billion valuation. Canva is part of a new breed of tech companies providing ‘software as a service’ – also known as SaaS.
These companies use cloud computing to allow users to access a software product from any device with an internet connection. Popular examples include Australian offerings like Canva and Deputy, or their more established international counterparts like MailChimp, Dropbox and Slack.
SaaS products are incredibly compatible with the modern world, as more people work from their phones and laptops, and more businesses need solutions that are accessible, easy to use and customisable.
For investors, SaaS offerings are also popular due to their enormous growth potential, sky-rocketing valuations, and disruptor status.
SaaS products are typically sold through a subscription model, which is widespread for good reason. Like the – now ubiquitous – streaming service Netflix, once consumers subscribe and begin to enjoy a software service, renewal is automatic, resulting in lower churn rates.
This is one of the many reasons why SaaS firms present as attractive investment opportunities. Many of them have high gross margins, low capital requirements to scale and huge global addressable markets.
SaaS firms however pose a challenge for investors seeking to understand and measure their value. When it comes to SaaS, the usual approaches may not suffice.
A widely-used valuation method for mature companies is the application of an earnings multiple to the company’s maintainable earnings. SaaS businesses, though, are often loss-making or have a lower earnings base initially due to upfront costs to support an aggressive growth plan. For this reason, current profitability may not be a good indicator of value.
As a result, many SaaS businesses trade on a value to revenue basis, or ‘Revenue Multiple’. Valuations are derived from the revenue multiple of comparable companies applied to the business being valued. However, there are often stark differences between companies and the markets in which they operate.
This is particularly so with software companies. While all SaaS providers use technology to drive their business model, they generally serve different markets and have divergent business models, value drivers and growth trajectories.
Sometimes there are more differences than commonalities between two companies which appear comparable on paper.
In the absence of context, revenue multiples in isolation are meaningless. As a result, business values derived from revenue multiples of ‘similar’ companies may differ, potentially significantly, to the underlying intrinsic value of the SaaS company at hand.
Where these values diverge considerably, the stakes are raised for winners and losers.
Investors in SaaS companies should always consider undertaking a discounted cashflow valuation, or DCF. While this method is more complex and time-consuming than a revenue multiple approach, it is tailored and customised with more granular value drivers. A DCF valuation is particularly suited to businesses that have many factors at play.
Astute investors can also use DCF valuations to understand the mix of assumptions required to underpin the asking price and evaluate the plausibility of these value drivers.
Pitcher Partners Sydney recently conducted a valuation of a SaaS business for an incoming investor with interesting results. The investor was quoted a pre-valuation estimate of 5x revenue sourced from ‘similar’ companies.
We performed the DCF valuation using best estimates of forecast operating and financial metrics, applying a range of assumptions to cater for the areas of greatest uncertainty.
Our DCF value amounted to just 3x revenue, protecting the investor from paying a substantial – and avoidable – premium.
While the revenue multiple approach is quicker and easier, it clearly has significant shortcomings. Investors should be aware of the broad-brush nature of this approach and, where possible, conduct a DCF valuation to provide greater clarity and precision on deal pricing.
Alan Max is a Corporate Finance Partner at Pitcher Partners Sydney.