Metrics that matter: 3 practical observations on valuation from an Index Ventures partner

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As part of the Metrics That Matter series, we’ve written about three analyses to track the path to profitability and two metrics to calibrate retention and expansion. These metrics serve as both outputs and inputs. They are outputs from the activities of people at companies working hard to create compelling products, distribute them to customers, and drive the business forward. They are also inputs to valuation, a topic especially pertinent in today’s market.

Now, in early December 2023, we are at 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 alike are beginning to rebase expectations and take 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, often leaving founders needing more clarity on how they should think about valuation.

With that in mind, here are three practical observations on valuation:

  1. Interest rates govern public and private company valuations.
  2. Focus on durable, high-quality revenue growth.
  3. Valuation is driven by sentiment in the short-term and fundamentals in the long-term.

Interest rates govern public and private company valuations

High-performance coaches recommend that clients “control the controllables.” Unfortunately, interest rates are not one of those controllables.

Founders, operators, investors, and analysts alike are beginning to rebase expectations and take a first principles approach to valuation amid a rising interest rate environment.

When interest rates increase, it becomes more attractive for individuals to save rather than spend. The same is true for investors. If investing in risk-free government bonds is more advantageous, investors expect higher returns to invest in risk-bearing stocks.

Regarding valuation, the market typically talks about multiples of earnings. For example, a price-to-earnings (P/E) multiple of 20 means that a company with $1 of earnings per share is valued at $20. A 20x P/E multiple implies a 5% earnings yield (1/20). If a company does not yet have earnings, analysts will refer to other proxies for earnings, such as revenues, gross profit, or EBITDA.

When interest rates increase, multiples decrease because investors demand a higher yield to invest in equities rather than bonds. We can see this by looking at the P/E multiple of the S&P versus the rate of the 10Y Treasury bill over time:

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