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Amit Ashkenazi is VP Business Strategy at Fiverr, and also formerly a Partner at Viola Growth. This post was written during his tenure at Viola.
When it comes to valuating your company, growth matters. At the same time, growth is best achieved without compromising on efficiency so that you can keep your company profitable, or at least have path to profitability when you either reach scale or face moderate growth rates.
And since growth is such an important factor in determining the value of a business, one of the most important goals for Private Equity investors and advocates of value creation like my colleagues and me is to help our portfolio companies accelerate their growth.
To demonstrate just why we prioritize growth so much, here’s a table that illustrates the impact of growth on valuation on two indexes:
1. NASDAQ 100 Index (100 largest non-financial companies traded on the NASDAQ)
2. NYSE Software and Services (90 software and services companies traded on NYSE)
We divided the indexes of the top 20% growing companies and the 20% least growing companies in the last year and in the last 3 years. Then we checked the multiples of these data sets.
Source: CapitalIQ (December 2014)
Definitions: EV, EBITDA,P/E, CAGR
As the chart demonstrates, the top 20% growing companies got a significant premium in their value. For example, the top 20% growing companies in the last 3 years traded under the NYSE Software and Services index were valued at 7.1 times their revenues, while the least growing companies were traded at 80% their revenues.
As important as growth is to the valuation of a company, it’s important to note that it’s is not all that matters. Investors and other shareholders are eventually left with the profits the companies are making so all efforts made to boost growth should be driven by the ultimate goal of maximum profits.
Sometimes shareholders are willing to look away and invest in companies even during periods when they are not profitable because they believe these companies to be compromising on short term profitability in order to invest in technology and operations that will enhance and accelerate their long term growth and market dominance. But despite their willingness to ‘forgive’ temporary lapses in profitability even in promising companies, investors still need visibility and path to long term profitability.
A good example of such a company is Amazon.com (see below 5 years share price performance).
The company’s share price saw a significant rise as long as Amazon’s revenues continued to grow by 20%-40% annually, and many investors were willing to look past its margin issues. Now that the company’s growth is cooling down, many investors are looking again at profit margins that remains very low (less than 1% operating margin). In the last 12 months (ending September 2014) the company’s revenues reached over $85 billion and the company’s loss was over $200 million.
As the Yahoo! Finance graph above shows, the share price has declined by approximately 25% since the beginning of the year.
So how does profitability impact on the company’s valuation?
The table below demonstrates how valuation is impacted by both revenue growth and profitability (EBITDA margin).
Source: CapitalIQ (December 2014)
Definitions: EV, EBITDA
We took the same NYSE Software and Services dataset presented above and checked the EV/REV multiples for different growth rates in the last three years and different EBITDA margins.
As you can see, profitability impacts the valuation but mainly for companies with more moderate growth rates. For example, companies that grew between 5%-15% in the last 3 years were valued at only 1.4 times their revenues when their EBITDA margin was below 10% vs. 3.5 times their revenues when the EBITDA margin was over 20%. This magnitude is less viable in companies that grow very fast (as in the Amazon example).
To sum up, make sure that your company is growing fast, but always aim to stay “lean and mean” to reach significant profitability once you reach scale. This is especially important if your growth rates cool down.
