Public Startups

Gross Margins, Revenue Multiples, And 2019 IPOs

Hard financials are back in vogue after a focus on growth brought major venture-backed players to the public markets only to have their debuts rocked by falling share prices. What gives? Some private companies that met venture criteria (fast growth, etc.) were valued as if they were technology shops, and when they went public investors decided that they were more tech-enabled than anything.

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The difference might seem slight, but, in practice, a technology business can trade for as much as 10 times its revenue. A tech-enabled business probably won’t. Why? Because technology companies enjoy stronger-than-average gross margins. A simpler way of thinking about the point is to say that technology companies have higher quality revenue than other companies. The fact is part of why they are sought after by investors looking to bet on companies that may deliver huge valuation gains. (Why not bet on the companies that get to keep more of their revenue?)

To illustrate the point that gross margins (a key revenue quality metric) can shift how a market views a stock, let’s examine a group of formerly-private, recently-public companies and compare their gross margins to their revenue multiples. It will be fun!

We’re looking for a loose connection between the two numbers; that’s to say that we expect that higher gross margins, in general, to lead to higher revenue multiples. Of course, we’re obviating things like revenue growth rates, and varying operating leverage. But we said a loose connection between the two, so let’s hit up the data.

Today we’re leaning on some data from YCharts, who can provide quarterly gross margin metrics, and who have done the work of calculating trailing price/sales multiples. Click on each companies’ name for its Crunchbase profile if you need more information. Ready? Let’s go:

  • PagerDuty: Gross margin of 84.9 percent, trailing price/sales of 13.6 (P/S via Yahoo Finance)
  • Zoom: Gross margin of 80.9 percent, trailing price/sales of 39.8
  • Slack: Gross margin of 78.5 percent, trailing price/sales of 23.5
  • CrowdStrike: Gross margin of 70.8 percent, trailing price/sales of 25.7 
  • The RealReal: Gross margin of 64.9 percent, trailing price/sales of 4.6 (Investing.com says 7.6)
  • Medallia: Gross margin of 63.5 percent, trailing price/sales of 7.7
  • Pinterest: Gross margin of 59.6 percent, trailing price/sales of 16.2
  • Fastly: Gross margin of 55.0 percent, trailing price/sales of 10.6 
  • Uber: Gross margin of 45.0 percent, trailing price/sales of 4.0
  • Lyft: Gross margin of 27.3 percent, trailing price/sales of 3.2
  • Chewy: Gross margin of 23.6 percent, trailing price/sales of 2.8

You can see a general trend there, as we expected. As we intimated earlier, there is a lot more going on in the above than merely gross margins impacting multiples, but it’s impossible to understand the latter without the former.

Notably, you can also see the tech-iness of the companies rise as you go from the bottom of our list to the top. At the bottom, a unicorn selling pet supplies using ecommerce. That’s a tech-enabled business, and a good one, investors think. At the top, PagerDuty provides a SaaS service to developers. That’s pretty techy.

As the 2019 IPO cycle — currently utterly moribund — picks back up at some point, the above math will be at play. Be smart, check the gross margins of any business as soon as you can. The easiest way to differentiate between a tech company, and a tech-enabled company, is to check and see how much it can charge above its cost of revenue.

Illustration: Li-Anne Dias.

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