SaaS Valuation Outlook Amidst Interest Rate Changes

RESEARCH NOTE

Interest Rates and Their Double Effect on SaaS Valuations

Interest rates play a pivotal role in SaaS valuations, primarily through two critical pathways:

1. The Impact on Cost of Capital and Valuation Multiples: SaaS companies, due to their reliance on long-term growth prospects and future cash flows, are especially sensitive to interest rate changes. When interest rates fall, the present value of future cash flows increases because they are discounted at a lower rate. This drives up valuations as investors assign higher multiples to future revenues and profits.

2. Influence on the Startup Ecosystem and SaaS Demand: A second, equally important effect of lower interest rates is their impact on venture capital markets and startup ecosystems. SaaS companies are major suppliers of tools and infrastructure to startups, which themselves are heavily reliant on venture capital funding. In an environment of lower interest rates, there is typically an increase in venture capital activity as the cost of equity capital decreases. This, in turn, leads to the creation of more startups, which drives up demand for SaaS products, further supporting revenue growth for SaaS companies.

These two factors result in SaaS companies benefiting from both sides of the equation: a lower cost of equity increases current valuations, while an increase in venture-backed startups fuels greater demand for their products, thus enhancing their growth prospects. This combination of factors supports higher valuation multiples in a declining interest rate environment.

The above chart illustrates this dynamic, showing that during periods of low interest rates, SaaS companies achieved much higher EV/NTM revenue multiples, with peaks around 20x during the pandemic when rates were near zero. We have used the Bessemer Cloud Index to create the average NTM revenue multiples. Notably, we are still about 30% below pre-pandemic average valuations.

Recent Federal Reserve Interest Rate Cut and Outlook

On September 18th, the Federal Reserve implemented a 50 basis point cut, reducing the target federal funds rate to 4.75% to 5%. This marks a notable shift from the aggressive rate hikes that characterized the post-pandemic recovery phase, reflecting the Fed’s growing confidence that inflation is moving toward its target of 2%.

Several factors contributed to the Fed’s decision:

• Inflation Moderation: The Fed has expressed growing confidence that inflation is on a sustainable path towards its 2% target, though it remains somewhat elevated.

• Labor Market Considerations: With job growth slowing and the unemployment rate increasing slightly to 4.2%, the Fed has shifted towards a more balanced approach to maintain maximum employment.

• Economic Projections: The Fed adjusted its forecasts for unemployment and inflation, signaling a more cautious approach to managing economic growth and price stability.

Looking ahead, the Federal Open Market Committee (FOMC) has signaled the possibility of further rate cuts by the end of the year, with projections indicating an additional 50 basis point reduction. The Fed’s longer-term projections suggest a gradual easing cycle, with up to one percentage point in cuts by the end of 2025. This easing cycle is expected to provide further tailwinds to SaaS company valuations.

The Role of Growth, Profitability, and Sentiment

While interest rates are a significant driver of SaaS valuations, they are not the only factor at play. Several other considerations will also influence valuations, including growth rates, profitability, and market sentiment:

• Growth Rates: SaaS companies often trade at high multiples due to their potential for rapid growth. A lower interest rate environment that encourages venture investment could stimulate the creation of new startups, driving demand for SaaS products. This improved growth outlook, in turn, can support higher valuation multiples as investors reward companies with strong revenue expansion.

• Profitability and Cash Flow: As SaaS companies mature, profitability metrics such as free cash flow and EBITDA become increasingly important. Companies that can demonstrate strong margins and efficient cost structures are likely to see higher valuations, even in a more volatile macroeconomic environment.

• Market Sentiment: Investor sentiment can have a profound effect on SaaS valuations. During periods of optimism, when investors are more willing to take on risk, valuations can expand rapidly. Conversely, during times of uncertainty, valuations may contract even if underlying business fundamentals remain strong.

Valuation Recovery Coming

We believe the SaaS valuation outlook is poised for a potential recovery as we enter a rate-cut cycle. The overall aim is that the Fed will likely take rates back to pre-pandemic levels.

Lower interest rates' dual effect of increasing the present value of future cash flows and stimulating demand from a growing startup ecosystem positions the SaaS sector for valuation growth in the coming months/years. It is very plausible that SaaS companies could see their valuation multiples rise by as much as 20-35%, returning to pre-pandemic average levels.

How To Get Investment Exposure?

An ETF could be a way for someone to get direct exposure to broad SaaS valuation increases. The BVP Nasdaq Emerging Cloud Index has an ETF, which is obviously highly tilted toward SaaS companies. One could obviously also look into direct investments in public SaaS companies. High-growth companies that have most of their value far out in the future could likely yield an even greater valuation increase than their low-growth counterparts. In the BVP Cloud Index, Samsara ($IOT), Klaviyo ($KVYO), Monday.com ($MNDY), Appfolio ($APPF), and SentinelOne ($S) are the companies that have the highest revenue growth rate when looking at trailing twelve-month numbers. 

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