Everyone is worried about valuation. That’s great there should be worry. If there wasn’t worry, I’d worry about that. Here’s how I explained valuation. You tell me what you disagree with!
The kind of companies that we are investing in now never existed before! Look, ten years ago I searched for companies growing at 15% or 20% a year. And 25% was a dream come true. Now I don’t even bother looking at a company with 20% or 25% revenue growth.
Okay, anyone disagree with this? Anyone still searching out companies with 15% or 20% growth? Nope? Okay, let’s go on!
We are investing in a new model of enterprise. Our companies have very high revenue growth year after year. I’m talking about 40% to 65% per year for most of them, but some even higher. These are also very high gross margin companies (70% to 92% for the most part). Their revenue is almost all recurring, on software subscriptions and thus largely locked in, and their dollar-based net retention rates are generally greater than even 120%. This means that last year’s customers buy a lot more this year than they bought last year instead of having an attrition rate, or forbid-the-thought, being companies whose customers make one time purchases, or sell hardware, and thus don’t even have ANY revenue guaranteed next year at all.
Okay, do you disagree with any of this? These are a different kind of company! I’ve never seen companies like ours before. Have you?.. Think how different this is from companies that sell “things” and have to go out and sell them again next year to the same people or different ones. And think how low capital intensive our companies are. No factories to be built to expand sales! Just lease more software.
Of course a company growing revenue 50% per year, with 95% recurring revenue, 92% gross margins, and a 130% dollar-based net retention rate is worth a much, much, higher EV/S than the old model of company, with fairly low revenue growth, low gross margins, and with little or no visibility into revenue for the next year and beyond!
Do you disagree with any of that? No. Okay, let’s go on! This next part is key.
Revenue that has very high gross margins is worth more per dollar of current revenue (in other words, it’s worth a higher EV/S) than revenue with lower gross margin. Here’s why! EV/S, which is traditionally used for evaluation, puts Sales (Revenue) as the denominator. But that’s silly! On $100 million of sales Alteryx, with gross margins of 90%, keeps $90 million, while a grocery chain, with gross margins of 5% or 10%, keeps just $5 million or $10 million on the same $100 million of sales. Revenue by itself doesn’t tell you much of anything. It’s the gross margin dollars that should go in the denominator, not total revenue.
If you understand that key part, you are on your way! Have you got it? Disagree with any of it?.. Okay, good. Next we come to revenue growth. That’s the MOST important factor. You need to grasp this:
Why is the rate of growth of revenue important for comparing EV/S? There’s a heck of a good reason! Next year our SaaS company growing at 50%, will have $150 of revenue instead of $100, and with its 92% gross profit margin, it will keep $138 toward covering operating expenses… Now let’s say our conventional company is growing at a nice steady respectable 10% per year. Next year, it will have just $110 of revenue, and with its 23% margins it will keep just $25 towards operating expenses. So now we have $138 versus $25… one year later!
The difference in compounding is enormous and grows each year. If we go just one additional year later, our SaaS company will have $225 in revenue and will keep $207… while the conventional company will have revenue of $121 and keep $28. Look at that again! Both companies started two years ago with revenue of $100. Now our company is taking home $207 in gross profit , while the conventional company is taking home $28!!! Just two years later!.. In the third year, our SaaS company growing at 50% will keep $310 in gross profit, which is ten times the $31 the conventional company will keep in gross profit. That gives you an idea of the enormous power of the combination of high growth and high gross margins (that our companies are blessed with).
Do you disagree? Do you still think it makes sense to base your valuation of these companies on current revenue? If the conventional company is trading at an enterprise value of let’s say, four times its revenue, isn’t our SaaS company worth four times THAT! Or six times that, … or who knows, ten times that?
Now let’s consider that our company has almost all recurring revenue, and a dollar based net retention rate of 130%, which means that it is enormously more certain that our SaaS company will have increased revenue next year than that the conventional company will even have the same revenue next year. How much is that worth in increased EV/S? Is that security of our revenue worth another 30% tacked on? Or 20%, or 40%. I don’t know. But it becomes clear that, by simple arithmatic, the reason that our SaaS companies are exploding in EV/S is that the market is starting to do the same arithmatic that I just did.
And are you with me on that? Any disagreement. Hard to quantify the advantage of recurring revenue like you can for gross margins and rate of growth, but it’s there nevertheless…
And as for comparing this to the internet bubble, if you were there you’ll know that it’s just not the same ballgame. Then many IPO’s didn’t even have revenue yet. Just a great idea. All of our companies are thriving businesses, growing at great rates, and the majority are category crushers, with little or no effective competition. And famous analysts were saying, sure ABC is 200 times revenue, but comparables are 400 times revenue, so ABC is cheap. Now we have everyone telling us how expensive Zoom is, and how it’s overpriced. That’s good. That’s what we want to hear.
Best,
Saul