You can read the first and second instalment before diving into this post if you’d like some background.
The Property Analogue
You could look at a growing software company the same way that you would look at a property company that has a large plot of land to develop. You wouldn’t expect it to build just one building and return capital when it could potentially develop 100. You’d expect the developer to finish one project and reinvest that capital into developing the next project. Only when we’re getting close to project 100, would you expect the capital to be returned to the initial investors.
Of course, this depends on the opportunity cost, if the company is able to generate a higher return on equity than an investor, you would hope that they continue to reinvest that capital. If we’re talking about publicly listed companies, then an investor could sell their holding if they have an opportunity to generate a higher return.
In Practice
It could be useful to see what this would look like in practice with a couple of examples. Firstly, let’s look at Alteryx, a provider of a data analytics platform that “enables analysts and data scientists alike to discover, share and prep data, perform analysis — statistical, predictive, prescriptive and spatial — and deploy and manage analytic models.” Its financials look like the below:
· Gross margin: Alteryx is able to generate a 90% gross margin, which is at the top end mentioned at the beginning of the article.
· Research and Development: Spend on R&D as a proportion of sales is similar to other tech names, significantly above what old-world companies spend on R&D. We’ll keep this ratio consistent to account for the maintenance capex. This will mean that the operating expense ratio will be similar to old-world.
· Sales and Marketing: A large proportion of sales is being spent on sales and marketing. If this company wasn’t growing 2x year-on-year and spending as much on growth, we could assume that the S&M and G&A expenses would come in in-line with more mature businesses.
· General and Administrative: G&A is ~2x S&P500 companies, this could be reduced in a steady state as noted above.
At face value, it looks like Alteryx is a US$7.2bn market cap company that’s generating US$22.9m in net profits. This would put it on a P/E >300x but doesn’t take into consideration the differences in accounting treatment of the old-world vs new-world businesses. If we make the relevant adjustments, it looks more like a business that’s trading on a 55x P/E while doubling the top line. This would translate into a .5x PEG assuming no operating leverage in the business and doesn’t look that unreasonable considering the size of the potential market and the technical challenges that it’s tackling.
When do you sell?
If we’re willing to suspend belief and accept that some adjustments to the accounting are required to get some idea of what a New-World business would look like in a steady state, then we need to have some way to appreciate when the steady state is nearing. For this purpose, I’d suggest looking at the relative changes in the Sales Efficiency defined as the Revenue Growth Rate / Sales and Marketing Expense.
As long as the company is able to generate more than $1 in marginal sales for each dollar of sales that it costs, then it’s likely still growing into an unsaturated market. If the Sales Efficiency begins to drop, then that suggests that either the proportion of sales being spent on marketing (denominator) is increasing or the rate of sales is declining (numerator), all else equal.
Summing up
The accounting paradigm that we have historically used to evaluate businesses is sorely lacking. A number of changes to the existing accounting framework are required to make it more applicable to technology companies. This requires some assumptions to be stretched but at the same time gives us an alternative perspective. It’s inappropriate to continue to apply the same lens when the operating mechanics of businesses have changed so substantially from when the accounting rules were adopted.
Read more at endeavor ventures.
