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Balancing Growth, Quality, and Valuations
Last week, software valuations finally overcame interest rate and inflation fears to post their first positive week of 2022.
Where does that leave valuations after the sustained pullback, and where could they go from here?
If the correction remains in place and sustains itself for a long time, the private markets will also react.
In the last 24 months, several startups raised at valuations requiring 10-20x revenue growth to achieve a healthy (2x) valuation increase. When multiples contract, the revenue growth target increases, but the cash runway remains the same.
Below is a quick snapshot of where the market currently stands and how investors react to various growth levels and cash-flowing software businesses.
The average software multiple currently stands at 10.4x next-twelve-month (NTM) revenues, roughly 10% over the 5-year trailing average and well down from the 100% increase we saw at the same time last year.
There are three ways to view this correction.
We still have some correction territory to navigate, especially in quality names that haven't fallen back down to the trailing 5-year.
We're back to normal, and software stocks have undergone an appropriate correction. The biggest caveat to this narrative is that corrections aren't created equal and affect segments and companies differently, as highlighted below.
We could go up from here. As Marc Andreessen famously said, "software is eating the world," and software is just getting started in many of the world's biggest industries meaning there's a lot of achievable growth still on the table.
Market corrections don't affect all companies equally. The chart above illustrates how high-growth companies have also fallen over the last few months but remain strong when benchmarked against their 5-year trailing average.
This effect trickles down into the private markets as well. We see a flight to quality in times of market correction. Like public investors, private ones tend to allocate capital to the best companies where it can allocate to repeatable growth motions.
Net, capital markets are likely to tighten for companies that don't fit the clear growth narrative.
The unfortunate casualty of this movement to quality is the mid-growth company. These companies often don't fit the high-growth narrative or margins that make them strong bets in tighter capital markets.
Investors don't take bets on these companies because they are still too expensive to be strong value plays and could still potentially be exposed to higher costs of capital.
During a market correction, companies that are less reliant on outside capital and run efficiently are always priced at a premium, and this correction is no different. If growth at all costs was the trend over the last 36 months, efficient growth is likely to be the trend of the next 12 - although from where I sit, efficient growth next goes out of style.