Mr. Market And The SaaS World

by: Tomasz Tunguz

Summary

Has the halving of SaaS multiples the work of an irrational Mr. Market or a change from the voting machine to a weighing machine?

Assuming the market is moving according to rational motives, then there seems to be a broad, widespread selling of high-growth SaaS companies irrespective of their bottom lines.

Perhaps this is fueled by concern that the growth rates of these businesses are not sustainable and consequently multiples should compress dramatically.

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Mr. Market is a fictitious character imagined by legendary investor Benjamin Graham in The Intelligent Investor. Graham describes Mr. Market as emotional, irrational, moody - and is in the short run a voting machine, in the long run a weighing machine. It might sound like a children's story, but Warren Buffett lauded the book as the greatest book ever written on investing. So, has the halving of SaaS multiples the work of an irrational Mr. Market or a change from the voting machine to a weighing machine?

One of my partners suggested answering this question by correlating the declines in stock price to key financial metrics: annual revenue growth, net margin (net income/revenue) and cash flow margin (unlevered free cash flow/revenue).

The chart above shows the stock price declines correlate with -0.59 R^2 to revenue growth. In other words, the faster the company is growing, the harsher the stock price decline. That's counter-intuitive. Normally, it's the inverse: the faster the company is growing the smaller the price contraction.

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A company's profitability, or net margin, has no impact on the valuation drop. The R^2 is -0.06, completely uncorrelated.

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Equally so, unlevered cash flow margin is similarly uncorrelated. So the price movements in these names seemingly aren't influenced at all by the profit and cash flow characteristics of these businesses, positive or negative.

What could this mean? Assuming the market is moving according to rational motives, then there seems to be a broad, widespread selling of high growth SaaS companies irrespective of their bottom lines. Perhaps this is fueled by concern that the growth rates of these businesses are not sustainable and consequently, multiples should compress dramatically. LinkedIn's (NYSE:LNKD) less-than-rosy outlook certainly weighed heavily on their stock price.

Even as growth may fall, 30 of the 44 companies analyzed demonstrated positive cash flow and 17 of them posted profits. For the public market over the past few days, these attributes haven't mattered, indicating Mr. Market may be voting more than he is weighing.