Software Multiple Corrections: Time is a Natural Form of Diversification

The past 2 years have seen great volatility in the software (and broader) markets. As shown below, COVID unknowns, digital adoption accelerating, and then a hype bubble popping have caused troughs and peaks in valuation multiples for software companies.

Looking at the following charts below from Goldman Sachs and you can see that we are still near all-time highs for these software multiples. There are a few narratives going around to be bearish on software stocks over the coming year, that could drag these multiples down even more:

1- interest rate increases. Software stocks tend to be about long-term investments with distant payoffs. Interest rate increases increase discount rates on those future earnings, lowering present valuations.

2- uncertainty in budget direction. Are we going back to the office? Hybrid? What IT systems should corporates invest it today? This uncertainty may hurt purchases for enterprise-scale software purchases.

3- distraction of outliers in growth rates. Some large software companies (Snowflake, for example) have re-accelerated sales above the $500M revenue level. This is a rare feat. These companies get major multiples (40x+ run-rate revenue) and become a beacon for other firms… and receive a lot of coverage in the press. However, most firms below 60% do ultimately fall in the 8-12x revenue multiple range.

My takeaway here is that we still may see more multiple contraction in the coming year(s). But, as the pandemic proved, software businesses are the most resilient to system shocks, and therefore have the staying power to live and grow through cycles.

A mentor frequently tells me “time is a natural form of diversification” – meaning to invest at a consistent cadence regardless of current position in the cycle. At Energize, we are maintaining our cadence, but continue to model out-year exit outcomes at historical multiple averages so that there is no multiple appreciation required to hit our targets.