When to catch a falling knife
How to make sense of tech stock valuations when prices have dropped 50%+
Probably comes as no surprise that widespread concerns over inflation (no longer considered temporary), slower economic growth (and depending who you ask, a recession), not to mention the war in Ukraine, and the ongoing waves of COVID-19 variants (we’re now in the 5th wave), have collectively caused the public markets to take a nose dive.
It’s June 2nd, we’re five months into the year, and the equity markets have been down and to the right. Year-to-date performance for the major US public equity indices are all down double-digits — the DJIA: -10%, the S&P500: -13%, NASDAQ: -23%.
But wait, it’s worse (for tech)
To be honest, those numbers don’t look great, but they are far healthier than the decline observed for technology and growth stocks, which have performed even more poorly than the broader market indices. A somewhat prescient blog post (from back in February!!!) from the Prof G, Scott Galloway, highlighted the long list of tech/growth stocks that had dropped 65-93% from their 52-week highs.
Not all of these companies are gold-plated winners, but several (at least IMO) are “best of breed” companies, making their rapid price declines even more astonishing. Just to highlight a few:
- Zoom, everyone’s favorite video meeting platform since the pandemic…down 71% from its 52-week high, is down 39% year-to-date.
- Block, the fintech formerly known as Square…down 66% from its 52-week high, is down 47% year-to-date.
- Twilio, the humble but dominant CPaaS platform (Communications Platform-as-a-Service)…down 65% from its 52-week high, is down 58% year-to-date.
Fintech, SaaS, Insurtech, D2C, Proptech, consumer internet/apps, biotech, gaming…you name it, no tech sector has been able to hide from the equity market sell-off.
Contagion now spreading to the private markets
While the public equity markets have pulled back for the past several months, dating back to Nov’21, the private markets have lagged. Valuations in the private markets are not updated every second on a Bloomberg screen. Instead, they are (typically) determined every 9-18 months when a start-up raises a new primary round of financing. A lead investor comes in, sets the valuation for the round, and the market is informed of this new price. This process often takes several months. So the valuation for a company that announced its Series F financing in Jan’22 was probably set in a term sheet that was signed back in Nov’21 (back at the public market peak).
As a result, it has taken several months for the private market to start feeling any contagion from the public markets.
- In March, Instacart announced that it had cut its valuation to $24 billion, a 38% decline from the $39 billion post-money valuation set just one year earlier by the company’s Series I financing.
- In April, Forge Global reported that prices of private companies on its secondary market platform had declined by 19.9% in Q1.
- And just yesterday, Fidelity disclosed that it had marked down the value of its positions in Reddit and Stripe by 33% and 12%, respectively.
With several tech stocks in the public equity markets down more than 65% and private companies on Forge Global down only 20%, it appears that the private markets have not yet fully priced in the valuation pullback.
However, it is important not to confuse price movement for valuations.
Just because Peloton is down 79% doesn’t mean it’s undervalued. Similarly, just because Stripe is down 12% doesn’t mean that it’s too expensive. Which is why valuation fundamentals have become increasingly critical in this current market environment.
The return of valuation fundamentals
As valuations of venture-backed tech companies in the private markets continue to find their floor, it becomes increasingly important to think about:
- Valuation multiples relative to the public comp set and the long-run historical averages prior to the bull market run.
- Adjusting valuation comparisons for not only relative growth, but also relative profitability.
Example #1: Klarna (private) vs. Affirm (public)
Klarna and Affirm are both leaders in the BNPL (buy-now-pay-later) segment of the fintech space. Affirm successfully IPO’d in Jan’21 and now trades on NASDAQ. After a strong run-up in price to a peak of $164/share in Nov’21, Affirm now trades at $26/share, which implies an enterprise value of $8.2 billion, which implies a 7.3x multiple of the company’s CY2021 revenue of $1.2 billion.
Meanwhile, Klarna last raised a Series H financing in Jun’21 at a pre-money valuation of almost $45 billion. Recent rumors have suggested a new round of financing could value the company at closer to $30 billion.
At first glance, a 33% decline in valuation appears to be a bargain. Any private market investor looking to buy shares of Klarna is probably too eager to jump in at a $30 billion valuation, especially since Klarna traded in the secondary markets, in late 2021, at valuations above the Series H price tag of $45 billion.
However, a quick look at valuation multiples suggests otherwise — if you were to assume the $30 billion rumored valuation, it would imply a 19.5x multiple of Klarna’s CY2021 revenue of $1.5 billion. Comparing Klarna to Affirm, even if Klarna’s valuation were marked down by 33%, it still appears to be more than twice as expensive as Affirm!
This is an example of the proverbial “falling knife.” If Affirm, a direct public company comparable with liquid, tradeable shares (and more than double the growth) trades at only 7.3x revenue, why shouldn’t Klarna trade down further to a lower multiple?
Example #2: Private Fintech (name withheld)
For simplicity, I’ll refer to this company as “StockF,” a high-growth fintech unicorn with a revenue model dually supported by SaaS subscriptions as well as interchange fees. StockF recently raised a late-stage venture round in Q4 last year at a valuation multiple of 60x revenue.
At this stage, in this current market environment, 60x revenue seems egregious. However, one of StockF’s close comparables, Bill.com, traded at over 45x revenue at its peak in Nov’21.
Why did these multiples make any sense? Well, for the last several years, valuation multiples of this magnitude were not that uncommon because they were often growth-adjusted — higher growth companies were assigned higher valuation multiples. And like Bill.com, StockF boasted market-leading growth. It had grown its revenue by almost 100% in 2021 and had the potential to grow by another (almost) 100% in 2022.
Fast forward to today, Bill.com trades at a more modest 15x revenue and the market appears to balance its thirst for growth with a greater need for profitability. By building a regression of StockF’s public comp set (which includes a mix of similar fintechs and high-growth SaaS companies), we observe a fairly high correlation between valuation multiples and the “Rule of 40” metric, which is the sum of (i) each company’s growth rate and (ii) each company’s EBITDA margin.
Two key-takeaways from the regression analysis below:
- The r-squared in the below regression is fairly high at 0.65, meaning that the public market now assigns higher valuation multiples to companies with a higher Rule of 40. By comparison, a regression of valuation multiples to growth alone results in a lower r-squared of 0.41…not bad, but not as good.
- With a Rule of 40 estimate of roughly 30%, StockF should probably be valued at only 10x-11x revenue.
Notably, Klarna and StockF are just two of the many examples in the current private market, where valuation fundamentals suggest caution, even as significant valuation drops appear enticing.
Not to worry! It’s not all doom and gloom, there are counter-examples —the opposite of the falling knife — companies in the private markets whose valuations have fallen too far and actually are attractive investment opportunities. Unfortunately, and as you can imagine, this second list of names is confidential :)
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Disclaimer: The views expressed here do not necessarily reflect those of my employer.
