Comparing the Valuations of the ASX SaaS "Royalty" using the "Rule of 40"

With recent results in from the quality SaaS companies valuation ($ALU, $PME, and $WTC reporting; $TNE & $XRO-not reporting), various SM threads over the last week or two have discussed valuations and changes in SP. In this straw I present some comparative analysis. It is an illustration of how I try to use different lenses to "triangulate" my own valuations. 

Generally, I focus my valuation efforts in trying to understand what the future may look like. Like many long-term investors, I believe my edge over the market lies in my long term horizon and unwillingness to be swayed by short-term noise. To do this, I invest a lot of effort in trying to understand how the value of a company changes under different scenarios for the future, including thinking about what is happening in the markets in which it competes and what competitors might do. So the analysis is the post is a departure from that.

However, I also find it helpful to "triangulate" my valuations by looking at various valuation multiples and comparing firms that might be loosely considered as “peers” – whether because they are competing in the same market or because they share other qualities.

For SaaS companies, a long-standing challenge has been to understand their quality and valuation. The challenge arises because many are reinvesting a lot of their profits to scale as they compete for share in large global addressable markets. Just as many have emerged relatively rapidly over the last decade so, I think it is fair to say, it is hard to imagine what their competitive landscapes will look like in another 10 years.

Rule of 40 and Value

One of my favourite ratios, is to compare a valuation multiple with what is referred to as the “Rule of 40”.

The “Rule of 40” says that the quality of a growing SaaS firm can be considered according to the extent to which the sum of its % EBITDA Margin + % Revenue Growth exceeds 40. i.e.:

 % Score = EBITDA / Revenue x 100%.  +  % Revenue Growth > 40%, 50%,… etc is good

 Both Aram at $ALU and Richard at $WTC last week referred to this measure in their presentations. It has been used a lot by US analysts in trying to value fast-growing SaaS firms which do not yet generate a meaningful NPAT, which makes the P/E useless.

As a quality measure, the metric has some intuitive merit. A company with a lower EBITDA margin, but a higher revenue growth rate should be expected to grow its cashflows faster (assuming positive operating leverage!), whereas a company with a higher EBITDA margin compensates for a lower revenue growth rate with more of the revenue growth falling to the bottom line. Ideally, you want both metrics to be strong!

I plot this metric against a valuation multiple. The valuation multiple I prefer is EV / EBITDA.

I choose Enterprise Value because this removes the excess cash held on the balance sheet and it is also independent of the capital structure, so it focuses on the operating business.

There are lots of problems with EBITDA, but for companies early on their growth journey, and in particular for capital-light SaaS firms, EBITDA is a good proxy for operating cash flow – the engine of value generation.

The "Peer Group"

The Peer Group I have chosen for today’s analysis are ASX SaaS companies considered leaders in their sector, with all going after large regional or global addressable markets.

·      $ALU

·      $PME

·      $TNE

·      $WTC

·      $XRO

Given discussion here in other straws recently about $XRO (Disc: I have sold out recently), I’ve also thrown in $INTU.

The Analysis

On the graph below I have plotted two datapoints for each stock:

Blue: is based on the FY23 results. In the case of companies on different reporting cycles ($TNE and $XRO) I have used FY22, being the latest results. The reference share price used in the EV is the average SP on the date of reporting of results.

Orange: is based on the current forecast period so, FY24 (or FY23 for those yet to report). In this case the SP is the SP at close of 25 August.

In both cases, I have plotted the trend lines through each population.

It follows to expect an upward sloping relationship because the higher the “Rule of 40 score”, the higher the expected valuation multiple.

Because the datasets are limited (n=6), if there is a fundamental relationship between % EV/EBITDA vs “% Rule of 40 Score”, we can’t argue that the trend line is a good indicator. However, I have highlighted a shaded blue band which takes both trend lines into consideration, and proposed a potential “band” in which a correlation might lie.

My next leap of logic is to say that any datapoints lying above the blue band indicate stocks that, given their current margins and growth rate, may be under-valued. And stocks lying below the blue band, by the same logic, are stock that may be over-valued.

The Findings

$WTC:

In the run-up to the FY23 result, $WTC was potentially getting over-valued. (Note: this aligns with my own analysis based on my DCF going into the result!) Given the forecast FY24 EBITDA and the large share price correction, the graphs indicates that the value of $WTC has fallen back within the broad peer group trend. Indeed, the SP close of $71.65 on Friday puts it well below my updated estimate of expected value of $79. (Having sold a portion of my holding recently at $88, I have restored my full portfolio holding at what I consider is once again an attractive price,... independently of this analysis I must emphasise.)  

$TNE and $ALU:

Forecasts for both $TNE and $ALU keep both stocks broadly in trend zone – again this aligns with my current valuations of each. $ALU’s response to the recent result does not look over-done. And while $TNE is getting a little toppy again, I don't think it is anywhere near full value.

$XRO and $INTU

I’ve plotted both $XRO and its New York-listed competitor $INTU.

In the case of $INTU, despite its strong result on Friday morning and positive recent SP response, it remains squarely within the trend “band”.

$XRO is consistently located well below the blue band, indicating that it may be potentially over-valued based on the current forecast.

So, what would it take to bring $XRO back within the overall trend zone? This would require combined (TDA margin + %Revenue growth) outcomes for FY24 to be c.10-20% better in aggregate than current forecasts at the current shareprice. Alternatively, at the current forecast revenue and EBITDA, for SP to fall back to around $70. Or, some combination of the two.

This analysis aligns with my own risk-reward assessment in DCF modelling of $XRO. For me, there is a question-mark over expected subscriber growth rates in the increasingly competitive international markets of UK, Canada, and USA – where $INTU (among others) is focused. Based on Friday’s result, $INTU is getting good traction internationally. If there are going to be more headwinds on subscriber growth, then $XRO has to do the heavy-lifting on pricing and cost control. The market is expecting both and, so the question mark for me is whether these can deliver the outperformance that is required to justify the valuation.

Of course, an alternative thesis is that the market potential in international cloud accounting is so great that the competitive headwind isn't blowing yet. Of course, that cannot be said for ANZ whether total penetration is high, and if it is true in the USA - then neither the results of $XRO or $INTU in that market support that.

I recognise that I may be forcing the narrative to fit my perceptions, but I only did this analysis this weekend for the first time and I am interested how well the insights align with my own DCF-scenarios modelling – largely, an independent method.

$PME

I want to finish with a brief discussion on $PME. $PME – as we all know – is clearly an outlier given its outstanding quality. The graphs shows it to be in a league of its own. If the correlation has any validity, then it indicates that $PME’s valuation may be reasonable. While there might not be the margin of safety to call it a “buy” now, a correction of 10-15% probably moves it far enough outside the trend zone to be of interest. These kinds of swings seem to happen every year.

Of course, we don’t know whether the “true” relationship indicated in this analysis is linear. For example, it could be upward sloping or downward sloping, and with $PME at one extreme of the dataset, even more care should be taken drawing a valuation relationship from the analysis.

In any event, this picture says that $PME's quality justifies its value.

Conclusions

The “Rule of 40” score vs. valuation multiples provides an interesting way to compare the great ASX SaaS firms.

It would, of course, be possible to model a theoretical “fair value” curve on this graph. I haven’t turned my hand to that yet. But maybe that is for the future.

It would be tempting to conclude from this analysis that $XRO is over-valued. But care should be taken on this front. However, recent years have indicated there is now a limit to the subscriber growth it can achieve y-o-y, so ongoing expense control is going to be important, as is pricing. Equally, $XRO has not been able to show that it can create value from acquisitions, whereas $ALU, $INTU and $WTC have all demonstrated success in doing this.

I will update this analysis from time to time, and may augment it by adding some of the quality international SaaS firms to get a better handle on the trend band.

Finally, I am not presenting this as some magic bullet on valuation. Far from it - the analysis is highly limited. The only forward-looking data in the analysis beyond the short-term next Revenue and EBITDA forecasts is implied in the EV - the market's view. So, I would never base a buy, hold or sell decision based on this analysis. To do so would be to just be following the market – which is not how I invest. Nonetheless, it offers food for thought and I am interested in what fellow StrawPeople think.

Disc: I hold $TNE, $ALU and $WTC in my RL ASX portfolio. (I would like to own $PME, and one day maybe will.)

Hi Chagsy

The Rule of 40 is quite prevalent in the USA. I did an exercise several months back where  i looked at a basket of SAAS Companies ranging from the tech darlings on the ASX to some of the newer prospects (again ASX). So those that had cracked profitability after years of investment in R&D in pursuit of growth as well as those chasing growth at considerable cost (investment). Used an even weighting between Revenue Growth and EBITDA growth (even if the growth was positive off a negative base). So a natural dilution of heady Revenue  growth numbers which in most cases, cannot be sustained. Best if measured over past 3 to 5 years. Done graphically, actually depicts the Company's journey.

Once ranked, seemed to align quite well on what I perceived ( in other words subjective) to be a fair investment grading for each Company on a relative basis. Maybe I can re-create at the end of the reporting season. Just need to decide on the basket. 

Rokewa

Seems my EV/ebitda multiple for valuing early SaaS and tech firms was a bit outdated. I was using 12.6x whereas this year it is more like 19:

                                Avg EV/EBITDA

All                                 19.1x

US only                        29.3x

$10m - $50m               19.0x

$50m - $100m             18.8x

$100m - $200m           19.9x

I will update my own records and valuations for my portfolio over the coming days and also edit the IHR valuation to reflect what the market is offering, using the described method.

This does not mean that these companied are worth paying a multiple of 19x, but that is what the market is pricing them at.