Valuation story for North American software companies

Solution type

Average Latest Twelve Month (LTM) revenue

(US $MM)

Gross margin (%)

EBITDA margin (%)

Historical revenue growth

(%)

Forecast revenue growth

estimate (%)

Total Enterprise Value (TEV)/LTM revenues

(Revenue Multiple)

Application software 240.7 68.2 9.8 10.8 10.5 3.8

Internet software and services

164.7 61.6 0.9 13.9 12.1 2.3

Systems software 222.6 73.4 5.0 15.8 13.6 2.9

What’s driving value at North American software companies?

We recently did an analysis of over 200 US and Canadian publicly traded software companies to see how solution type, revenue growth, margins and size impact valuation.1 What we found was in some cases surprising.

Solution type: application software vs. internet software and services vs. systems softwareSoftware companies have traditionally been segmented as application software, for example customer relationship management (CRM) or enterprise resource planning (ERP) software; internet software such as search engines and online market places; and systems software, which is software designed to provide services to other software such as operating systems.

Based on solution classification, application software companies, including software as a service (SaaS) companies, were the highest valued group at 3.8 times revenues. This might be viewed as an unexpected result, as internet companies could be interpreted as being exclusively cloud whereas the other classifications include on-premise solutions.

What we think is happening here is that these classifications were designed when hosted solutions were emerging and today many traditional on-premise solutions are now, at least partially, cloud. Today, these classifications overlap in terms of revenue model and market potential. And, it is our view that this categorization is not very defining as a value driver.

1 As defined by S & P Capital IQ, for companies with revenues greater than US $15 million. Analysis performed January 2017.

Growth: historical vs. forecastHistorical results are often used as proxies for expectations. According to our analysis, historical growth company multiples were close to forecast growth company multiples. And, in either case, growth had a substantial impact on valuation. Companies with forecast growth expectations of greater than 15% were valued on average at 4.8 times revenues whereas companies with forecast growth below 15% were valued at 2.8 times revenues. The top 30 highest growing companies were expected to generate average growth of 43.5% and were valued, on average at 5.6 times revenues.

Margins: Gross margin vs. EBITDAWe expected that many companies would be investing in growth thereby depressing current EBITDA margins. Our analysis found that gross margin was a more robust driver of value than EBITDA. The 30 highest gross margin companies generated an average gross margin of 86.7% and were valued, on average, at 4.8 times revenues. The 30 lowest gross margin companies generated an average gross margin of 25.8% and were valued, on average, at 1.4 times revenues. In contrast, there were 93 companies that generated negative EBITDA, yet their average valuation was 3.2 times revenue.

Size: large vs. smallSize is always a factor in company valuations, as larger companies benefit from easier access to capital, in many cases a well-recognized brand driving strong margins, and generally highly diversified suppliers and customers. Smaller companies typically have higher customer concentration, and less access to funding, either from banks or equity investors. The 30 largest companies had a TEV/LTM revenue multiple of 4.7 times versus 1.2 times for the 30 smallest companies.

So what does this mean?Generally speaking, North American software companies are valued higher than most other companies based on their attractive revenue qualities, growth prospects and margin profiles. Other factors to be considered include market potential, competitive environment, private company discounts and control premiums.

However, when looking at a company’s valuation, it is now more relevant to delineate companies by revenue quality, size, margins and growth prospects rather than just solution type.

All data provided by S&P Global Market Intelligence, a part of S&P Global.

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2210864 ED 00This publication contains information in summary form, current as of the date of publication, and is intended for general guidance only. It should not be regarded as comprehensive or a substitute for professional advice. Before taking any particular course of action, contact Ernst & Young or another professional advisor to discuss these matters in the context of your particular circumstances We accept no responsibility for any loss or damage occasioned by your reliance on information contained in this publication.

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ContactDerek van der Plaat Technology, Media and Telecom Transactions Leader+1 416 943 4485derek.vanderplaat@ca.ey.com

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