Considerable differences in valuation levels between the technology companies we monitor

Translation: Original comment published in Finnish on 6/27/2023 at 7:46 am.

We reviewed the valuation levels of the technology companies we monitor using earnings- and sales-based multiples for 2023 and 2024. The group of companies is very diverse and includes companies in different development stages and varying growth and profitability profiles, which means that the methods used are not fully optimal indicators for reviewing the valuation of every individual company. There are significant differences in the valuation levels between the companies, but we believe there is a clear link between growth and profitability outlooks and acceptable valuation multiples.

Eyes turn more towards earnings multiples

With the rise in interest rates, the valuation picture of technology companies, especially those aiming for strong growth, has changed considerably over the last 18 months or so. With the increase in discount rates, investors have become increasingly interested in results generated in the present time, and not just promises of cash flows far in the future. Thus, the focus of valuation has shifted more toward earnings-based multiples, whereas a few years ago, the valuations of technology companies were mainly examined through sales-based multiples.

The median 2023 EV/EBIT ratio of the examined group of companies is 17x. However, for all companies, earnings-based multiples are not particularly useful. The multiples may appear high or negative, e.g., if the company invests in growth in the short-term clearly at the expense of profitability (e.g. Efecte and WithSecure). On the other hand, there are also companies with a very high ratio because the short-term performance level does not yet reflect the company's full earnings potential (e.g. Remedy). The group also includes companies that are priced at very low ratios on an earnings basis, like Media and Games Invest (MGI), Starbreeze and Tecnotree. For MGI, the low valuation is partly explained by the company's leveraged balance sheet and the uncertainty of how the company copes with it while dark clouds gather around the growth outlook for digital advertising as economic environment cools down. Starbreeze's earnings-based valuation is very low due to the release of Payday 3 and the related exceptional accounting items more information on which can be found in the recent initiation of coverage report. As far as Tecnotree is concerned, we believe the valuation is particularly depressed by uncertainty about cash flow repatriation.

Source: Inderes, data collected on June 26, 2023

The sales multiple reflects a combination of growth and profitability

Measured with the EV/S ratio, there are significant differences in the valuation of the companies we monitor, as the multiples of the group of companies examined vary between 1x and 10x. However, most companies fit into a range of 1x-3x. The group's median for 2023 is 2.5x. The big differences are mostly explained by the different growth and profitability profiles of the companies, and it is generally not sensible to focus only on the sales multiple. The better the company's growth outlook is and the higher the profitability with which the growth is achieved, the higher sales multiple can in principle be accepted for the company. The group’s highest sales multiples are, therefore, found in Qt, Admicom, Remedy and Lemonsoft, who all have good profitability potential and growth outlooks. F-Secure, with a slower organic growth outlook, is also priced at a rather high level with the sales multiple due to its very strong profitability.

Correspondingly, the lowest sales multiples are found in companies, whose combination of growth and profitability is expected to remain low in the near future or the company's outlook involves clear risks. For example, QPR, WithSecure, MGI and Starbreeze are priced at sales multiples below 1.5x. All of them have their company-specific reasons for why the short-term growth and profitability combination looks modest or the risk profile is otherwise elevated. If companies can improve their profitability, accelerate their growth, or reduce the risks associated with their balance sheet or outlook, there is upside potential in the low sales multiples in the longer term.

Source: Inderes, data collected on June 26, 2023

Finally, we examined the included technology companies based on the 2023 sales multiples and the sum of the estimated revenue growth % and profitability (adj. EBIT-%) for 2024. We see a clear correlation between these, but no fully straightforward interpretation can be made. Typically, growth in the combination of growth and profitability is given a higher weight in value creation in industries with good growth outlooks. This is logical, as e.g., a company that can grow at an average rate of 35% over the next 5 years with a 15% profitability is much more valuable than a similar company that grows at an average rate of 15% with a 35% profitability. The underlying assumption here is that the profitability potential of the companies would be in the same ballpark in the long term.

However, examining the combination of growth and profitability presents challenges and should be seen more as a "fudge factor". For example, the examination does not automatically reflect the productivity of investments in the business (i.e. ROIC), which plays a key role in the long-term value creation of companies. A company can, e.g., invest heavily in growth and thus obtain a high combination of growth and profitability, but if the company's business never becomes profitable, these growth investments have in practice destroyed value.

Source: Inderes, data collected on June 26, 2023