Every six months or so, I take a look at how the public markets are valuing next-generation software companies. There's been quite a bit of volatility over the last five years, and this update is no exception. As of mid-June, the public markets value software companies at all-time highs.
The chart above shows the total enterprise value (TEV)/forward revenue multiple for the basket of public software companies. Just a quick reminder on these metrics. Enterprise value equals market capitalization plus debt minus cash and short-term equivalents. Forward revenue is the sum of the projected revenues over the next 12 months.
The blue line the chart is the median over the period which is approximately 5.7x. The red line shows the median across the stocks in that particular month. In 2014, the median touched 7.7x forward before falling by about 60% to 3.3x two years later. Since then, we've seen an incredible bull run that brought the forward multiples to 9.5x. A correction followed to 7.1x at the end of 2018. Next, a resurgence back to 9.6x forward. In short, we are in the priciest valuation environment of the last seven years.
Let's break this down by stock. Zoom tops the list at 44x forward, followed by ZScaler and Okta at around 25x. Then Veeva and Atlassian at 21x. These are numbers we've never seen before. On the other hand, these are also some incredibly efficient businesses growing at incredible rates in very large markets. And investors understand these businesses at a deeper level than they have in the past because companies disclose key metrics like net dollar retention.
So a question arises: is the market indiscriminate in the way values companies? The answer is no. About half of the stocks have witnessed declines in multiples in the last 12 months, some very significantly. On the other hand, others have seen massive expansion, nearly doubling of multiples.
In other words, the variance of valuations has exploded. The chart above shows that the variance of the forward multiple has increased from about 3x to about 7.6x in the last six months. It's another way of saying that multiples have expanded at the upper end of the spectrum quite significantly. We've always seen some software businesses trade at 3x and 5x, but we've rarely seen businesses trade at more than 20x.
The most attractive companies have become much, much, much more expensive relative to their peers. The chart above is a correlation chart between the change in forward multiple over the last 12 months and the current forward multiple. If a stock had a big multiple 12 months ago is very likely that the multiple has expanded by 50% or greater since then. The R squared is 0.83, indicating a very strong relationship.
This multiple expansion is great news for public companies. It means they can raise capital at lower and lower costs, and smaller and smaller dilution. These multiples imply investors believe these businesses can continue to execute very well in massive markets for years to come. But they do raise questions about whether we will see reversion to the mean in the near future.