Canada: Why Is A Tech Company Worth Three Times Revenue?

Last Updated: April 12 2012
Article by Derek Van Der Plaat

Of course you can't generalize when it comes to assessing the value of a business, but there are two items of note in the title: (i) the valuation metric; a multiple of revenues and (ii), the notion that technology companies are somehow different from other companies.

Why do people speak of a multiple of revenues when they are referring to the value of a technology company? Two main reasons; first, if there are no earnings to speak of (i.e. the company is in a loss position/operating with a burn rate), then a multiple of earnings would be meaningless; and, second, what if the profit margin is at a very low level, much lower than the long term expected average? A fast growing company, operating at near break-even might technically be valued at 50 times earnings. In a case like this revenues are a much more stable metric to use.

What we are really describing here are two early stage phases that many technology companies go through. The first stage is the start-up phase where companies incur a burn rate and the second stage is the initial growth phase, where they enjoy rapid growth but have not yet achieved the economies of scale to cover their relatively large product development (R&D) and marketing (product/service launch) costs. In cases like this, while it doesn't account for many possible differences in business models, the multiple applied to revenues is used as a proxy of future normalized Earnings Before Interest, Depreciation and Amortization ("EBITDA").

Many established software companies generate very healthy margins. EBITDA Margins of 40% - 50% are not unusual (both Microsoft and Google EBITDA margins approximated 40% in recent years). Equally revenue growth can be very strong, particularly in the early stages. So what does a growth multiple combined with strong margins translate to, in terms of a revenue multiple? It could well be three times revenues. Three times revenues with 50% EBITDA margins equates to six times EBITDA, not that different from traditional company metrics.

But how does one rationalize even higher multiples? Say 10 times revenues? (for example Goldman Sachs buying into Facebook at a $50 billion valuation - over 30 times run-rate revenues, and HP buying 3PAR in 2010 for 11 times revenues). In cases like this companies are paying a scarcity premium. The argument being that, either by way of market position (i.e. if all your friends are on Facebook there is no point being on Orkut) or by way of proprietary technology, these targets have something the acquirer can only attain by buying them.

At this point a buyer is paying beyond the notional value and is encroaching on the value to the buyer. The notional value is a company's value independent of the potential strategic benefits to a particular buyer. The value to the buyer is that amount of value the acquirer can produce with the target. Not something they typically pay for unless forced to in a competitive situation.

To consider this by way of an example, let's assume a billion dollar revenue company is paying 10 times revenue for an early stage company generating $1 million in revenues. The target company's technology will allow the billion dollar revenue company to increase its market share by 10%; a value of $100 million in revenues. You can understand why the acquirer might pay $10 million for this company.

The conclusion is that a buyer paying a price below the value to the buyer makes economic sense, even though the multiple of revenues or earnings may sound astronomical.

Are Technology Companies Different?

At this point traditional manufacturing, service, retail and distribution income statement ratios are all in well established ranges but technology companies can typically achieve stronger margins, quicker growth and, in some cases, generate sticky recurring revenues which reduce the risk associated with these revenues.

There are consumer product innovations from time to time that are low-tech and achieve tremendous growth (think of infomercial products like Sham-wow or Spanks) but in general the growth sectors in the North American economy are technology sectors like Software as a Service (SaaS) and Platform as a Service (PaaS) as well as social media, search/comparison engines, e-commerce, and mobile applications. Companies in these sectors can leverage digital distribution (where the cost of manufacturing and delivering an incremental copy is negligible) and the reach of 80% broadband and 90% mobile consumer penetration to generate very robust growth.

So are technology companies different from other companies? In a word, yes. Many are venture funded and achieve substantial market penetration, creating tremendous value while still unprofitable and therefore, while nowhere near perfect, a multiple of revenues can be used as a common metric for technology companies in various stages of growth.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Derek Van Der Plaat
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