“Only when the tide goes out do you discover who’s been swimming naked.” – Warren Buffett
I came across an interesting tweet on e-commerce revenue multiples and the wide disparity seen in the business model:
Ecom: where fast growing businesses can be valued at 5-10x annual revenue and slower growing ones 0.5-1.0x annual revenue.
— Greg Bettinelli (@gregbettinelli) January 7, 2016
It’s not a surprise to see revenue multiple decline when growth slows. Businesses don’t have infinite addressable markets and it’s normal to see valuation multiples come down as the business matures. In tech though, declines in valuation multiple are anything but gradual. Declines can be especially volatile and dramatic for companies with “growthy” multiples (10x to +20x) that experience slowing growth. The reason valuations are so volatile is growth has a way of exaggerating the fundamental strengths and masking the fundamental weaknesses of a business. Things can go from extremely optimistic to extremely gloomy as a result.
So the question is how are tech businesses valued once the growth tide goes out?
The answer is complicated, but if put on the spot and made to pick a single factor I’d say it’s the sustainability of cashflow generated by the company’s business model.
How Business Model Impacts Valuation
If you’ve read my post on revenue multiple this may be a bit redundant, but the table below illustrates on how business model impacts valuation.
Transaction based businesses (i.e. hardware, services, e-commerce) command substantially lower valuation multiples compared to businesses with recurring revenue (all else being equal). In the absence of growth, it is no surprise e-commerce businesses can collapse to 0.5x to 1.0x revenue. This doesn’t mean being in the e-commerce business is awful, but highlights how important understanding a company’s strategic and competitive positioning is and why many new e-commerce businesses are not only trying to grow fast but attempting to build recurring subscription revenue businesses.
Key Levers Of Business Model
One of my favorite frameworks to identify the key levers of a business is the DuPont analysis. DuPont breaks down a company’s return on equity into 3 components: Profitability, Operational Efficiency, and Leverage.
It’s a simple framework, but DuPont helps distill the numerous metrics investors and operators utilize to analyze a business down to a few key levers. For this post I’m going to ignore leverage and focus on the operational components of DuPont. The key levers of a business model are 1) Improve Margins and 2) Improve Operational Efficiency.
Improving margins and operating efficiency long-term can be accomplished by:
- Selling products with better gross margins
- Selling products with recurring revenue and/or with revenue per customer growth runway
- Improving customer acquisition costs and payback period on acquiring customers
There are several tactical and strategic initiatives a company can pursue, but what’s important to understand is how these decisions will ultimately improve margins, operating efficiency, and the sustainability of the business long-term.
But what about growth?
Growth is absolutely important and should be pursued. A hallmark of tech is its ability to have superior operating efficiency versus legacy models and its ability to quickly identify and cater to market demand to outgrow the market and generate superior profits. Just be mindful that growth which degrades the long-term margin or operating efficiency of the business can have a material negative impact on valuation. Even companies with a great core business can see their valuation multiple fall off a table if they materially dilute their business returns in pursuit of growth.
How Business Model Impacts Strategy
In general, tech is looking to optimize towards higher margins and recurring revenues. Companies are also pushing for speed, operating efficiency, and scale. There can be a lot of risks and costs associated with transitioning towards higher margin, recurring revenues but companies are willing to take that risk to move up the valuation multiple axis.
For the sake of brevity, I’ve put together an arbitrary matrix to highlight the various (general) strategies tech companies pursue based on their business model (broadly based on their revenue type and margin profile).
Commoditized Zone: Generally don’t want to be here. If possible, differentiate towards higher margin and/or recurring revenue products. The key to compete here is to have outstanding speed and/or scale. The ability to efficiently identify demand and be first to market allows a company to thrive.
Differentiated Zone: Businesses in this zone can be cyclical (perpetual software upgrade cycles, semiconductors) so capital allocation discipline is important. If the product is mission critical with sticky customer base, there may be an opportunity to shift customers to recurring revenue models or sell incremental new products into the customer base.
Analog Platform Zone: Analog (aka real world) zone businesses typically sell lower margin “real world” products and services through a differentiated platform that is built on recurring revenues (or recurring buying behavior). Many strategies revolve around land grab and finding ways to further monetize a captured customer base.
Digital Platform Zone: Also known as “The Internet”. Home to 800 pound gorillas looking to acquire the world, and terrific niche quasi-monopolies. Smaller players exist with this business model, but typically must land grab towards significant market share or stay relatively small. The attractiveness of this zone makes smaller players vulnerable to 800 pound gorillas but also attractive acquisition targets if their business proves resilient against intense competition.
Overall, it’s important to note that a business model can be high margin but the company purposely keeps reported margin down as it redeploys the profits back into the business to drive market share gains.