As I looked through the list of public SaaS companies this morning, I read their forward multiples. ZScaler: 23.1x; Okta: 21.8x; Veeva: 18.8x; Coupa: 18.6x; Shopify: 17.0x. Those multiples are calculated by dividing the enterprise value today by its projected future revenue of the company. But what do they mean? What do they imply?

First, we need to set some context. There are two kinds of companies: those valued on growth and those valued on profits. All of the companies mentioned above and the vast majority of startups are valued on growth. That’s because most of the value creation of the business is yet to occur. Companies valued on profits typically grow at rates of -15% to 15% annually are likely to be valued on profits, typically EBITDA.

Since high growth companies are valued for their future potential rather that current profits, growth rate is the predominant driver of valuation (highest correlation)[1]. In other words, growth companies are valued on their future revenues, also called forward or NTM revenue for Next Twelve Months revenues.

To estimate a business’ value, we need two numbers. The revenue and the multiple. For a startup to increase its value, it must grow revenues or the market must increase its multiple. Multiples may increase for many reasons. Better efficiency, good stock market conditions, belief in the management team, net dollar retention, etc.

I’ve been tracking forward revenue multiples for SaaS companies over the past 17 years or so. The median across all businesses is about 5.5x and the top quartile was around 9x. Today, we’re at elevated levels approaching a 10x median. The top quartile trade at 20x forward.

Now let’s talk about what the multiple implies. Assume we have a company generating $200M in revenue, growing at 50%, then 45%, then 40%, then 35%. The revenue ramp will be $200M, $300M, $435M, $609M and $822M. How much is this business worth?

If we were using the historical median, it would be worth $300M x 9 or $2.7B. Using today’s multiples, it’s worth $300M x 20 or $6.0B. Those figures assume the company will execute its plan for the next year: one year of “perfect execution[2].” If it underperforms, the multiple will fall. If it outperforms, the multiple may increase.

Another thought experiment: Suppose you believe the stock market today is going to revert to the mean. That means the top quartile multiple falls to the historical top quartile multiple of 9x. The value of our business will compress to $2.7B this year.

And to be worth $6B+ , the company would need to execute perfectly for the next three years. It would need to trade on $822M in forward revenue at a 9x multiple, and it would trade that way in three years, when it generates $609M in revenue.

If an investor believes the long term historical median is the right multiple to value a business, then today’s valuations price in a lot of risk: three years of perfect execution. If on the other hand, you believe SaaS companies should trade higher than historical averages, and they are correctly priced, then you are assuming one year of risk. How much risk an investor assumes, that’s all up to them!

So what does the multiple imply? How many years and months an investor of perfect execution an investor is willing to believe.

[1] When a startup so IPOs, some are quick critique the business’ lack of profits. If the business is growing quickly - 30% or more - profits matter less. A business growing 50% per year will grow to 2.25x in two years. Investors wager those profits will come as the business matures. Of course, a credible path to profitability is important to ensure the business is viable long term.

[2]Perfect execution: by this I mean the company hitting its plan. Most public companies have internal plans and street plans, and significant margin for error between them.