Software companies are generally valued for their high growth while profitability measures are often overlooked. Twilio, a recent software IPO, is currently trading at 17x it’s next twelve months estimated revenue. In an effort to “ground” software valuations, I backsolved fundamental indicators which enable us to observe a company’s fall from the sky towards a valuation closer rooted to traditional fundamentals.

The model works as follows:

- Share price x basic shares outstanding
- Adjust for capital structure (add cash, subtract debt) to arrive at enterprise value
- Input a required rate of return (we’ll use 15%, for our example)

[iframe src= “http://kfguiang.co/xls/Software/Theorems/RequiredIRR.htm” width=”100%” height=”400″]

Here, we observe Twilio’s financial profile. We analyze its current growth rate, and its current cost structure. There are two possible drivers of returns:

- High growth, low margins
- Low growth, higher margins

As we see here, companies with a higher rate of growth typically have lower margins

[iframe src= “http://kfguiang.co/d3/scatter/index.html” width=”100%” height=”420″]

Furthermore, our analysis reveals that at below $1.0bn in annual revenue, growth is typically expected in the range of 15 – 20%

[iframe src= “http://kfguiang.co/d3/growth/index.html” width=”100%” height=”420″]

At this point, we can start rationalizing our target’s growth rate: for how long can it sustain its current growth? Once we determine this, we can observe how aggressively our target is currently investing in growth:

[iframe src= “http://kfguiang.co/d3/barchart/index.html” width=”100%” height=”420″]

We can further refine our analysis by observing cost structures across all companies within the software universe to ground expectations in where costs can be optimized or whether certain cost structures are sustainable:

[iframe src= “http://kfguiang.co/d3/boxplot/index.html” width=”100%” height=”420″]

Here, we can “sanity check” where we believe growth will come from. The following table sensitizes margin achieved versus implied revenue:

[iframe src= “http://kfguiang.co/xls/Software/Theorems/GrowthImplied.htm” width=”100%” height=”420″]