An Ode to Correlations
For our 7th Edition of Vertical SaaS, Today — we have an amazing special edition for all you Vertical SaaS Nerds.
First, I’d like to introduce Rohan Sharma who reached out to me after following along on social media and medium when we first launched the tracker (Thanks Rohan!) Rohan is a student at MIT with a passion for all things SaaS — and will join Alpine Software Group this summer. ASG, backed by Alpine Investors, is a unique and fast-growing software business that buys, builds, and operates market-leading vertical SaaS companies. Their recent acquisition of ThinkLP in the loss prevention space marked their 50th acquisition across 12 verticals. Rohan is a special guest for the next few editions and will help us dig deep into our Vertical SaaS tracker.
In the past, this tracker has always been about following a set of public comps that we believe set the stage for the entire vertical SaaS market (public and private.) Multiples often trickle down from the public markets and impact how we price and evaluate private companies in the sector.
In some markets, however, correlations between different variables can be more interesting to analyze than just changes in multiples or market cap growth/decline. There are obviously several correlations you can run with public market data — but we wanted to simplify our analysis to three core correlations (the three we deem most interesting for the vertical SaaS market broadly):
- The correlation between EV/LTM and LTM Revenue Growth Rate
- The correlation between EV/LTM and EBITDA margin, and
- The correlation between EV/LTM and Rule of 40
To set the stage, the quick definitions of each are as follows:
- LTM Revenue Growth Rate is a measure of a company’s revenue growth over the last twelve months.
- EBITDA margin is a measure of a company’s profitability, calculated by dividing EBITDA by revenue.
- The Rule of 40 is a metric that combines these two measures into a single metric: Revenue Growth Rate + EBITDA Margin >= 40
So what did our data show?
(1) Negative correlation between Multiples and Revenue Growth: There is a negative correlation between EV/LTM and LTM Revenue Growth Rate (R value of -0.079) for public vSaaS companies (set of 20 as of April 25th 2023). This was a surprise to us. We knew from analyzing the general software market in the past, that growth rates are more correlated to EV/LTM Revenue multiples when the economy is doing well. But in a market like today’s, we assumed there would be a moderate or weak correlation, not a negative correlation! The negative number is so low that we still attribute it to “no correlation” based on statistics. As an example, nCino’s (NCNO) LTM Total Revenue 1 year Growth was 49.09% and it currently trades at 6.4x. On the other hand, Toast’s (TOST) growth was a huge 60.18% but trades at 3.0x.
To verify our assumption that strong market conditions do indeed lead to a stronger correlation between growth and multiples — we went back to the same day four years ago (April 25th 2019) to view what the correlation looked like (from a sample of 13 active companies). On April 25th 2019, the correlation between EV/LTM and LTM Revenue Growth Rate was positive and relatively strong (r value of 0.621), indicating that investors at that time placed a higher value on companies with higher revenue growth rates.
(2) Moderately positive correlation between Multiples and EBITDA Margin: the moderately positive correlation between EV/LTM and EBITDA margin (r value of 0.556) suggests that as EBITDA margin improves, the valuation multiple tends to increase as well. This means that investors are placing a higher value on companies that are generating more profits relative to their revenue. Take Veeva Systems (VEEV), which currently trades at 11.9x with a 34.6% margin, and Envestnet (ENV), 3.5x with a 7.6% margin.
Running a regression model gives this a Beta of 7.2, with a significant t (value of 2.916), indicating that there is a strong positive relationship between the EV/LTM multiple and EBITDA Margin. Specifically, a 1% increase in EBITDA margin is associated with a 7.2% increase in the EV/LTM multiple
(3) Moderately positive correlation between Multiples and Rule of 40: The moderately positive correlation between EV/LTM and the Rule of 40 (r value of 0.500) suggests that companies with higher overall financial performance, as measured by the Rule of 40, tend to have higher EV/LTM multiples. A t-value of 6.036 is associated with this rule. According to a statistical analysis, a 1% increase in the Rule of 40 would result in a 6% increase in the EV/LTM multiple. Since the Rule of 40 considers both revenue growth rate and EBITDA margin, this result supports the idea that EBITDA margin is a key driver of valuations, but this correlation is brought down slightly due to growth rate being part of the equation.
So how does this help you if you are an entrepreneur building in vertical SaaS? Obviously metrics are different for public companies versus private — and investors do expect an indication of fast growth when you are sub $10M-$15M ARR. However, as a founder, you should always know what you’re measured against — and that is other private companies and of course public company performance.
In strong economic periods, the market highly values growth as a proxy of positive performance. But when the economy is weaker, and there is tightening across sectors — Wall Street values strong EBITDA margins as a proxy of strong long term performance and sustainability. In fact, our data shows that you can get a 7% increase in your multiple with just a 1% increase in EBITDA margin, and a 6% increase in your multiple with just a 1% increase in Rule of 40. Unfortunately, there is little correlation or t-value with an increase in growth rate. TL;DR, don’t grow against all costs and destroy your Rule of 40 or margin. Investors are looking at burn very strongly. But if you can grow efficiently, you will be grouped with a rare breed of companies that will be valued well in the public markets.