by Charles Plant
Why Growth? Let’s look at two Canadian companies that were founded in 2004 and went public in the last couple of years. The first is Shopify, an e-commerce company, and the second is Real Matters, which provides services for the mortgage-lending and insurance industries.
Shopify went public in May of 2015 with a valuation of $1.27 billion. Over the previous year, their revenue had grown 104% to $105 million, making their valuation 12 times their revenue. As of June 12, 2018, their shares have grown from $17 at issue to $163, and they now have a market cap of $17.3 billion. Their revenue multiple in July was 25.7 times, based on 2017 sales of $673 million — up by 73% in the past year. (Although in the end of July their valuation was under attack due to declining growth rates.)
Real Matters went public in April of 2017 with a valuation of $1.1 billion. Their 2016 revenue was up by 46% at $248 million, meaning their revenue multiple was 4.4 times. Since going public, their stock has dropped by 57% to give them a market cap of $462 million. With revenue of $302 million — up 22% — their revenue multiple is now only 1.53 times. This chart shows the dramatic difference between the two companies:
So, what’s the difference? Simple — it’s the growth rate. Shopify is growing like gangbusters and Real Matters has good, but not stupendous, growth. And as a result, Shopify is rewarded with an eye-popping valuation.
Valuation of Companies
There are lots of theories about how companies are valued, but you can boil them down into a few distinct ones:
- Book Value — The value of assets minus liabilities
- Discounted Cash Flow — Discounting future cash flows into current dollars
- Profit Multiple — A multiple of the company’s EBITDA (earnings)
- Revenue Multiple — A simple multiple of the company’s revenue
A high-growth technology company doesn’t have much in the way of assets or liabilities to make book value relevant. They typically consume mountains of cash to fuel their rapid growth, so they don’t generate enough profit to base a discounted cash flow or profit multiple valuation on. For these reasons, fast-growing technology companies are usually valued using a revenue multiple.
The faster a company’s revenue grows, the higher its growth rate will be. The market loves growth, so the more it expects a company’s growth to continue, the more it will bid-up a stock price. Take Facebook, for example. They are a virtual behemoth, with a market cap of $557 billion based on revenue of $40.6 billion and a growth rate of 47%. Their revenue multiple was 13.7 times. (Although their valuation declined 19% in July 2018 due to falling growth rates.) Meanwhile, Microsoft has a value of $775 billion from a revenue of $90 billion, up 5% over the last year. Their revenue multiple? A mere 8.6 times.
What’s the difference between Facebook and Microsoft? You guessed it — it’s their growth rate. Growth rate creates value in a technology company and it has a dual effect: firstly, higher growth rate results in higher revenue, which increases one dimension of the valuation formula. And secondly, the increased growth rate increases the revenue multiple, which is the other dimension in the formula:
Revenue x Revenue Multiple = Valuation
Growth rate increases revenue multiple
In terms of Shopify and Real Matters, the public stock markets are anticipating consistent future growth from Shopify so they accord the company a high revenue multiple. Real Matters, whose growth rate is substantially lower, is not expected to generate high growth so its revenue multiple is correspondingly lower.
This post originally appeared on Medium.