What public cloud software companies are rewarded for has changed, reports show
Rational or not, are public markets where consensus is formed about how much publicly traded companies are worth, which affects the value of private companies in the process. But in a downturn, like the one everyone suddenly agreed we’re going through, that consensus can quickly shift.
Most stock fluctuations tend to hit publicly traded companies whose performance is somewhere in the middle. Great is still great. Not great is still not great – and more often now. But what about companies that do well on the one hand and less so on the other? That’s where there’s room for a shift in preferences.
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When it comes to cloud software inventory, preferences have changed particularly rapidly in recent weeks. This prompted investment company Battery Ventures to replace its annual report with a quarterly report that better reflects market volatility.
The first issue of Battery’s new report, The Cloud Quarterly, gives us interesting insights into what types of SaaS companies have seen their valuation fall – or resist – in recent months and what they have in common. Let’s investigate.
Rule of 40 101, and why it matters
The key conclusion of the report, from our perspective, is that investor preference for software (SaaS) companies has moved from a growth-promoting weighting to a greater focus on profitability. Sure, there’s been talk of this “return to fundamentals” in startup land as technology stocks fell in early 2022, but how things have shifted — and how far — is illustrative and critical of today’s technology and startup markets.
In simple terms, investors now value software companies that meet the rule of 40, but with a greater focus on free cash flow than pure revenue growth. The rule of 40 states that a software company’s growth rate added to its profitability should equal 40. So if a company grows 25% year over year and has 15% profit margins, that’s great – it satisfies the rule of 40. Not a company with 20% growth rates and 5% margins, to take another example.
To understand what we are talking about, we need to get to the heart of a few charts. Trust us this will be worth your time. We’ll start with what the line of 40 looks like in graph form, starting with the line on the left.