Fact bite #3. Robustness of the enterprise software industry: valuation of profitable growth companies

In fact bite #3 we discuss the valuation of listed software companies and the importance of profitable growth profiles.

Main Software 50
Main Capital Partners

Last year we wrote an article about the size and impact of the software industry in the Netherlands. Based on our research and discussions with domain experts from Dialogic we estimated that the direct contribution of software to the Dutch economy alone is about 4-4.5% of the Gross National Product (GNP). Now, less than 12 months later, the economic situation is significantly different: supply and demand is unbalanced – and resources are scarce – in many industries. This, in combination with the Russian aggression in Ukraine, negatively impacts consumer confidence and drives inflation. At the same time, Forrester reports a continued revenue growth rate of 12% for the global enterprise software market. How come? In this blog series Bram Kaashoek, head of Main’s Market Intelligence practice, highlights 3 fact bites that reflect the robustness and consistent contribution of the enterprise software market to the overall economy.

In fact bite #3 we discuss the valuation of listed software companies and the importance of profitable growth profiles.

Valuation over the years: the impact of SaaS business models and digital acceleration during the Covid pandemic

The public character of listed companies and the increased information transparency on company-level and market dynamics make that investors react swiftly on both uncertainty and sunny outlooks. Therefore, valuation metrics, like the Enterprise Value (EV)/Sales ratio or EV/EBITDA ratio, tell how the market responds to expected future performance of assets. Back in 2010, when we were still recovering from the financial crisis, the median of the EV was just slightly above the 1 times revenues for all listed companies. Investors, however, already recognized the attractiveness of software company profiles, leading to a higher median EV/Sales of 1.5x in our industry: a “41%-premium” versus the median EV/Sales valuation on the stock market in general (See Timeframe 1 in the figure below, in which we compare valuation of software companies with the overall median valuation on the public market. We split the profiles of loss-making and profitable companies for further analysis – see below).

Fast forward to early 2020, right before the Covid break-out, and this picture completely changed. Not only the general valuation increased significantly (from 1.1x EV/Sales to 1.7x): investors were willing to pay a notable premium for listed software companies. Kaashoek: “In the previous blogpost we already highlighted the change in the proven delivery- and business model of enterprise software companies in the last 10-15 years. By delivering software solutions through the cloud, the scalability of software companies became undeniable. This, combined with the sticky role that enterprise software plays in mission-critical work processes of end-users across verticals and the adopted SaaS models, led to recurring revenues streams. Recurring revenue streams means: certainty that future revenues and cash will come in. This predictability is valued highly by investors”. Consequently, pre-Covid the median EV/Sales in our industry was more than twice as high as the industry-agnostic EV/Sales multiple. Furthermore, the data show very clearly that investors, back then, noticed the powerful combination of both growth and profitability.

When Covid started in March 2020, the global public market got shocked and valuations dropped immediately (Timeframe 2 in the figure below). This downturn, however, had a temporary character and the stock market recovered quickly once we all got familiar with working from home and doing business digitally. The uplift of valuations, already at the beginning of the Summer of 2020, marked the start of interesting times: although the EV/Sales ratio of all listed companies was rather stable (bandwidth of 1.5-2x), valuation of software companies kept on elevating. Multiple industries were hit hard by Covid, like the catering industry and aviation, but enterprise software companies benefited from the digital acceleration trend contrary. Software became an even more important enabler of all type of work processes in our digitalized world. The result: all-time high valuations of software companies at the peak in July 2021. Kaashoek: “Many start-ups saw the sunlight and this period was characterized by software scale-ups that grew incredibly fast. In my opinion there were three drivers for that: (i) low interest rates and the abundance of freely available capital for investments, (iii) new use cases that popped up and needed software to enable those (just take the adoption of Zoom and Microsoft Teams as a perfect example), and (iv) shortened – and predominantly digital – sales cycles for enterprise software, and the success of Product-Led Growth tactics (see our latest CTO Day on this topic). As a consequence, valuation of growing software companies, despite profitability, went through the roof. Surprisingly, loss-making software companies, that were ‘buying’ revenues and market share, were valued even higher than solid, profitable software companies in those days” (Timeframe 3 in the figure).

This era came to an end early this year, when the economic situation changed. Uncertainty took over and the impact on the stock market was very much visible. Valuations, in all categories, came down extremely. Initially the valuations in the software industry converged towards a median of approx. 3x EV/Sales. In recent months, nevertheless, we noticed an early bounce back of profitable growth software companies (Timeframe 4 in the figure). This reflects the shift in focus of investors: from focus on growth (despite profitability) in 2021 to focus on profitable growth in late 2022. Valuation of profitable software companies, despite the drop in valuation compared to the peak one year ago, is still twice as high (+129%) as the median valuation of all listed companies. This, once again, shows the robustness of (enterprise) software companies that have a clear product-market fit and the proven ability to bring solutions to the market in a profitable way.             

Figure 1 Valuation of listed companies: relative median valuations of software companies (+ split in profitable and low-making companies) versus the overall median valuation of listed companies (source: S&P CapitalIQ, 2022. Analysis: Market Intelligence Main Capital Partners, 2022)

Main Software 50: facts & figures on the industry

The Market Intelligence team of Main executes research on the enterprise software market continuously. We do also collect our own data, for example for the Main 50 Ranking.

Are you a software entrepreneur and interested in hearing more about the statistics of and developments within the enterprise software industry? Please join our Main Software 50 industry event in November. The Benelux edition will be hosted for the 11th time this year and we are coming to Germany too. Read more here: https://mainsoftware50.com/.


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