Why software valuations could drop more if things don’t change soon – TechCrunch

Startups have seen better years. Last year, for example.

We’ve worked to highlight bits of good news where possible (signs of resilient software revenue growth, indications that valuations can partially recover and that a good number of startups have oodles of cash on hand), but today we are working in the opposite direction.

A good question to ask today is whether tech stocks, particularly shares of software companies, are being sold too readily. If so, we could expect their revenue multiples to rise on the public markets in time. For tech startups being compared to their public counterparts, this would be an enormous relief.

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There is reason to believe that this could happen. Altimeter Capital partner Jamin Ball, whom we consider to be a pro-bono data journalist, wrote earlier this week that the “median software multiple is now 5.7x,” which is “close to 30% below the long-term pre-COVID average for the cloud software universe.” (Note that Bessemer Venture Partners’ Mary D’Onofrio and Andrew Schmitt arrived at a 6.6x median ARR multiple for public cloud companies this week, which is close enough to give extra weight to Ball’s mathematics.)

If you feel cloud and software stocks should not trade for less than their historical average, then you have cause to cheer. But is that a valid perspective? Should we expect cloud and software stocks to trade at a discount to their pre-COVID revenue multiples? Let’s find out.

The bear case

The Federal Reserve is expected to raise rates sharply today, perhaps by as much as 75 basis points. The hike will come in the wake of a 50-basis-point raise back in May, which was the first time the Fed increased rates by that much in 22 years. The Fed is tightening not only interest rates — the price of money — it is also allowing its total asset base to descend.

Rising rates are generally anticipated to be inversely correlated with the value of highly priced assets, including stocks that traded at richer-than-average revenue multiples. That means tech and software stocks. There were several reasons for the huge ascent in the value of software revenues last year, but their descent and the resulting market hangover are inversely correlated to the price of money, which is about to go up. Again.