As part of it In the Metrics That Matter series, we’ve written about three analytics to track the path to profitability and two metrics to calibrate retention and expansion. These measurements serve as both outputs and inputs. They are products of the activities of people in companies who work hard to create compelling products, deliver them to customers, and drive the business forward. They are also evidence of valuation, a hot topic in today’s market.
Now, in early December 2023, we are on the second anniversary of an all-time high for the S&P 500 in November 2021, and valuation levels have reset with some pressure on price-to-earnings (P/E) multiples:
Image Credits: Index Ventures
Given the reset, founders, operators, investors and analysts are beginning to revise expectations and adopt a first-principles approach to valuation amid a rising interest rate environment.
Over the years, there has been some widely praised and well-researched classic literature on valuation, but these guides can be hundreds (or thousands) of pages long, often leaving founders needing more clarity on how they should think about valuation.
With this in mind, here are three practical observations about valuation:
- Interest rates govern the valuations of public and private companies.
- Focus on sustainable, high-quality revenue growth.
- Valuation is driven by sentiment in the short term and fundamentals in the long term.
Interest rates govern the valuations of public and private companies
High performance coaches advise clients to “control the controllable.” Unfortunately, interest rates are not one of those controllable.
Founders, operators, investors and analysts are beginning to revise expectations and adopt a first-principles approach to valuation amid a rising interest rate environment.
When interest rates rise, it becomes more attractive for individuals to save than to spend. The same goes for investors. If investing in risk-free government bonds is more profitable, investors expect higher returns to invest in risky stocks.
When it comes to valuation, the market usually talks about earnings multiples. For example, a price-to-earnings (P/E) multiple of 20 means that a company with $1 in earnings per share is valued at $20. A 20x P/E multiple implies an earnings yield of 5% (1/20). If a company doesn’t yet have earnings, analysts will look to other proxies for earnings, such as revenue, gross profit or EBITDA.
When interest rates rise, multiples fall because investors demand a higher return to invest in stocks rather than bonds. We can see this by looking at the S&P P/E multiple of the 10-year Treasury note over time:
