Profitability Over Growth: A Shift After 4 Years

The Shift in Investor Preference: Profitability Over Growth

Over the past ten years, a consistent inquiry from leaders within private companies has been directed towards us.

The central question posed is: “Do investors in the public market prioritize profitability or expansion?” Determining a definitive answer is complex, but recent data reveals a distinct pattern.

Profitability Gains Prominence in 2021

In 2021, within the software industry, profitability – specifically assessed through free cash flow (FCF) margins – demonstrated a stronger relationship with positive stock returns than did revenue growth.

This marked a departure from a four-year period where revenue growth was the primary determinant of stock performance for software companies.

This change represents a significant adjustment. The change in how investors feel is readily apparent.

Record Highs and Lows in Correlation

Beyond simply reversing the four-year trend, the data indicates that the correlation between profitability and stock returns reached a seven-year peak at the close of the previous year.

Conversely, the correlation between revenue growth and stock returns approached a seven-year low.

As the market experienced further declines, the correlation of revenue growth fell substantially below its seven-year historical minimum, while profitability correlation remained at unprecedented levels.

This suggests a fundamental re-evaluation of what drives value in the software sector.

Current Market Trends

Throughout 2022, the S&P 500 and Dow Jones Industrial Average have demonstrated stronger performance compared to the Nasdaq, which is heavily weighted with technology stocks.

Furthermore, several recently launched, high-growth, yet unprofitable companies have seen their stock prices fall below their initial public offering (IPO) prices. Examples include Hashicorp, Sweetgreen, Rivian Automotive, and Rent the Runway.

Cloud Index Performance

The Bessemer Emerging Cloud Index, comprised of leading SaaS companies, has experienced a decline of over 30% since reaching its highest point in November 2021.

Certain high-valuation companies within the cloud sector, such as Cloudflare and HubSpot, have seen their values decrease by approximately 50% from their respective peaks.

Overall, SaaS valuation multiples have adjusted downward from a high of roughly 17.5x Next Twelve Month Enterprise Value to Revenue (EV/Rev) in November 2021 to around 10.5x.

Investor Behavior and Sector Rotation

Currently, investors are shifting their capital away from high-growth, high-multiple software companies and towards sectors like finance and insurance.

These sectors are expected to benefit from the ongoing increase in interest rates.

It’s also noteworthy that larger, more established, and profitable technology companies – including Microsoft, Google, and Facebook – have experienced corrections, but to a lesser extent.

The Speed of the Shift

This market transition has been characterized by its rapid pace, decisiveness, and substantial magnitude.

Why are Investors Adjusting Their Positions in High-Growth Stocks?

Rising Interest Rates are a Key Factor

A surge in inflation has prompted the U.S. Federal Reserve to indicate potential interest rate increases, possibly three to four times throughout 2022. Consequently, the yield on the 10-year treasury has risen from approximately 1.5% at the start of the year to around 1.9%, representing an increase of roughly 40 basis points.

As interest rates climb, investor attention shifts towards profitability, or metrics derived from it, such as the Rule of 40 or the Magic Number.

Companies characterized by high growth but currently unprofitable are particularly susceptible to these rate fluctuations. Their valuation relies on projected cash flows extending into the future, which are then discounted using the cost of capital. Higher rates translate to a greater cost of capital, impacting valuations over time.

It’s important to note that the decline in interest rates over recent years significantly contributed to the substantial increase in valuation multiples, especially for high-growth stocks often valued on revenue multiples rather than earnings.

Capital Allocation is Becoming More Diversified

The year 2021 witnessed 68 initial public offerings (IPOs) in the software sector, alongside unprecedented levels of late-stage venture capital investment. This indicates a broader distribution of capital across a larger number of public equities and increased investment in private technology firms.

With shifting market conditions and increased volatility, investors tend to gravitate towards familiar investments. This preference is built over time, leading to a rotation into established companies with longer public track records and generally higher margins, such as Salesforce and Palo Alto Networks.

Consequently, high-growth companies with lower profitability and less established reputations are often the first to experience selling pressure. This underscores the importance of cultivating strong relationships with long-term investors prior to an IPO, fostering comfort and connection before entering the public market.

The Balance Between Profitability and Growth

Historically, growth has been the dominant factor in investment decisions. However, investors now prioritize evaluating the sustainability and durability of that growth.

They seek assurance that a company can maintain its growth trajectory even as it progresses towards achieving substantial profitability. Companies demonstrating this capability are poised to deliver the most significant returns.

Understanding Profitability Focus

A company’s ability to efficiently allocate capital for growth serves as a key predictor of its future profitability.

Analyzing trends in a company’s return on investment provides investors with valuable insights into potential for further gains.

A clear relationship exists between how much of a market a company reaches and the costs associated with expansion, customer acquisition, or increasing sales to existing customers. Typically, as market penetration increases, the cost of growth also rises. If growth becomes disproportionately expensive early on, it may challenge claims regarding market penetration or the overall addressable market size.

Quantifying this efficiently is complex, and forecasting presents further challenges. Companies often employ varying methods for calculating return on investment. A simplified metric alone is insufficient; it’s crucial to consider return on investment within the context of the company’s developmental stage, including categorizations, customer segments, repeat purchase rates, sales channels, and experimental initiatives.

When a thorough analysis is possible, we aim to consolidate data into a comparable metric for benchmarking against other organizations. While direct comparisons can be difficult, the following metrics are particularly useful when evaluating the interplay between profitability and growth:

Lifetime Value to Customer Acquisition Cost (LTV/CAC)

LTV represents the predicted revenue a customer will generate over their relationship with a company, while CAC denotes the cost of acquiring that customer. Although we approach this metric with caution due to potential manipulation, the underlying principle is a vital indicator of scalability and sustainable growth.

This ratio demonstrates a customer’s overall profitability. Tracking this metric for both current and newly acquired customers is essential. The projected LTV/CAC ratio should guide all spending decisions, determining the efficiency of each dollar invested. A ratio of 3:1 or higher is generally desirable, but we always scrutinize the underlying calculations.

The Rule of 40

This metric is commonly applied to Software-as-a-Service (SaaS) businesses, but its principles can be extended to other industries.

The Rule of 40 provides a valuable assessment of spending effectiveness, accounting for both increases and decreases in growth expenditures.

The calculation is straightforward: each percentage point of top-line growth is balanced by a percentage point of expansion in Free Cash Flow (FCF) or Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) margin. If a company increases spending to accelerate growth, the Rule of 40 integrates both the growth increase and the resulting profitability change.

Efficient spending is reflected when a company’s Rule of 40 remains stable, indicating that growth gains are comparable to profitability reductions. A larger decrease in profitability than increase in growth will lower the Rule of 40 score. Conversely, reduced spending may slow growth, but can maintain the Rule of 40 if profitability improves accordingly. A target of at least 40% is recommended, with any lower score requiring justification.

The Magic Number

This metric, primarily used by SaaS companies, assesses sales efficiency.

The Magic Number is calculated as follows: (Current quarter revenue – previous quarter revenue) * 4 / previous quarter sales and marketing spend.

A Magic Number of 0.75 or higher suggests continued investment in customer acquisition is warranted, while a number below 0.75 indicates a need to re-evaluate spending strategies.

Companies frequently inquire about the relative importance of profitability versus growth, as if investors collectively agree on a definitive preference. In reality, investor success hinges on diligently evaluating how responsibly a company allocates capital for growth, and predicting its future ability to generate profit.