Warsaw Equity Group

Valuations of public growth companies – not as attractive as you might think?

Authors: Jan Szumada, Adam Łata

The news of declining global stock market valuations in 2022 has reached everyone. As interest rates have risen in most developed economies, major indices around the world have fallen. A common perception is that growth companies’ valuations (and the correlated VC market valuations) are currently attractive due to the stock market decline. Such a conclusion can be reached by analysing probably the most widely used valuation benchmark in the VC world – the Cloud Index developed by Bessemer Venture Partners.

The EV/ARR multiple shown in the chart above appears to be at a historical low, similar to 2014-2017 levels. Comparing the current value of around 6.0x with the 2020-2021 values, which were close to 20.0x, one could get the impression that valuations are now at a really attractive level. Is this really the case?

A major limitation of the above index is that it only goes back less than 10 years, so it lacks data on the 2008 financial crisis or the internet bubble bursting in 2000. Therefore, it does not give a full picture of how deep the valuation declines may still be. To answer this question, we can look at another index that measures the price-to-earnings (P/E) ratio of growth companies (this is a different group of companies to the BVP Cloud Index, but their characteristics are similar, and the indices are highly correlated).

The chart clearly shows that the P/E multiple of growth companies was significantly lower in 2008 and 2009 than it is today. During the financial crisis, it fell below 12x and compared to the current level of 20x it was more than 40% lower. The BVP index only covers the right-hand side of the chart above, giving the false impression that valuation multiples today are at historically low levels.

This shows that there is still a large potential for the valuations of growth companies to fall – by as much as 40%. Frequently used valuation benchmarks do not cover a long enough time horizon and can give a false impression that growth companies are currently trading cheaply. In reality, valuation multiples have only adjusted from the levels seen during the ZIRP (zero interest rate policy) years and could still fall by up to half if a recession hits.

Are private companies getting cheaper? It seems that not all

The consequences of falling public market valuations can also be felt in the private market. The more mature the company, the more similar it is to a listed company and the closer it is to becoming one.

Looking at Pitchbook’s data on the CEE VC market, one might get the impression that the sector has come through 2022 with relatively dry feet. While the number of investments made dropped significantly last year, their value remained at the same level as in 2021 – and thus, the average round value increased (either relatively more later-stage rounds were closed, or the average round value at the same stage increased, and presumably so did the valuation).

Source: Pitchbook

The situation is similar for VC fundraising, with the same number of funds closing in 2022 as in 2021 but with an almost 15% increase in value.

Source: Pitchbook

The situation in the private equity market in the region was very similar, with both the value of investments and funds closed increasing while the number of investments decreased (there is no data on the number of funds closed).

Source: Pitchbook

Based on the above data, one can hypothesise that the market has been ‘cleansed’ and only the fittest have survived – both the funds and the startups (or founders) that have proven their ability to deliver the highest returns to their investors are still able to raise the necessary funds. As a result, both LPs and funds are taking a much more selective approach to their investments: lengthening the duration and thoroughness of due diligence, placing more emphasis on the financial health of companies (at the expense of a frantic pursuit of growth), and taking a more restrictive approach to offered valuations.

In our view, the least noticeable decline (if any) will be at the pre-seed and seed stages, where valuation is a function of round size and dilution. And both are unlikely to change significantly – the same amount of money will be needed to reach the respective milestones (i.e. usually raising Series A) as before, and the average dilution will not increase so as not to ruin the cap table at the very beginning of the company’s existence. But with each successive letter in the round (Series A, B, etc.), the valuation of a company becomes more closely tied to its performance and closer to the expected value of acompany at exit. So, if investors today can expect a valuation of 8x revenues in a Nasdaq IPO, rather than 20x as was the case not too long ago, valuations in later rounds should come down significantly. The situation will be similar in the PE market, which increasingly competes with the stock market for exits. Falling investor activity and public market valuations should allow these funds to acquire companies at lower valuations than a year ago.

All told, there has been a sharp correction in public market valuations, which has also led to declines in private company valuations. However, we believe that this is in fact an adjustment of valuations to the new conditions (the end of zero interest rates), but further declines in company prices – even to the level of post-crisis multiples in 2008 – cannot be ruled out. In the private market, the situation is unlikely to change dramatically in the early stages, and in later rounds valuation declines will correlate with stock market movements.