As the start of school and university rolls around after an already autumnal summer, we’ve had several conversations that have reminded us of textbooks and corporate finance lectures, on how to think about debt and public tech valuations. The theory would be that a certain level of debt can optimise the WACC and gear returns to equity, especially if there are relatively predictable, recurring cash flows. We thought to look at what we currently see in the market.
For our Tech universe of UK publicly-listed stocks, we’ve run the finnCap Tech 40 and Next 50 indices for the past 7 years, which gives us an ample source of data to look at. As we break out in more depth on our recently launched Tech Hub, our indices look at the 90 largest Tech stocks with a market cap of under £1.5bn in London, and on the site we chart the valuation, growth rates, and price performance for the indices and their sub-sectors. That’s alongside Demos of what our corporates do, our free-to-all research on all our corporates, a calendar of upcoming and past events for all of the companies we follow, and a library of our previous tech chats.
When we freeze the valuation data as of yesterday, the chart below highlights that leveraged tech stocks within the Tech 40 and Next 50, are typically facing a ceiling on their 12-month forward EV/EBITDA. (Net cash/EBITDA is negative on the x-axis below, Net debt/EBITDA is positive, and we only include stocks with 12-month forward forecasts):
What is noticeable is a) the relative lack of companies that have any gearing at all, such as the current preference for the ungeared balance sheets, but also b) that most companies with net debt/EBITDA, as opposed to net cash, have EV/EBITDA multiples of <15x against the finnCap Tech 40 average of 20x.
Admittedly, the range of UK tech stocks with leverage is limited, so to highlight the situation for larger stocks from the predominantly tech-exposed Nasdaq-100:
If we included private equity within the above, we might find a different valuation story on debt and EV/EBITDA; and the listed valuation will reflect other factors such as the structural position and expected growth. But in general, for publicly-listed tech, it looks like investors start to limit their readiness to pay a premium as the role of leverage increases: we think we can see that perfectly in CentralNic, an exciting company enabling the internet, and yet hampered by perceived gearing, we believe – in fact strong cash generation should pay that net debt down to 1.3x by FY22, per consensus. When the continued cash generation reduces that gearing, albeit that it is highly affordable, so too is the equity premium likely to return, and lift multiples.
Going back to lectures, there could be several theories as to why this relationship exists, like increased equity risk premia when tech companies touch debt. Or perhaps, it could just be that with many tech stocks to look at, some public tech investors choose to filter out those with net debt. Before we set ourselves a homework project for the current term, do let us know if you have any other questions on valuation topics you’d like us to explore. In the meantime, have a look around the Tech Hub. We’re very proud of it.