Can trees grow to the sky? How to correctly estimate the value of an IT business

The trend of falling demand in the IT sector and, as a result, falling company values will continue in the coming years. Serge Hancharevich, Managing Partner of Capital Times, tells how to correctly assess the value of an IT business in a recession in his column for AIN.UA.

The long years of growth in the IT sector have led business owners and investors alike to believe that this will be the case for decades to come: the sector will grow steadily, with valuations and demand remaining consistently high. However, the development of any sector is cyclical, and IT is no exception. In recent years, there has been a general international decline in demand for IT products and, as a result, an adjustment in the value of IT companies.

Ukraine’s IT sector has shown steady growth, even in the first year of the full-scale war, as has the export of IT services, which has set new records every year over the past decade.

The sharp decline in Ukrainian IT exports by 8.5% in 2023 became a point of reference: the profitability of IT companies is declining, the share prices of some giants have halved (for example, EPAM shares fell from $670 in 2021 to $309 in 2024, ENDAVA shares fell even more – from $167 to $37, and the valuation of non-public companies has been significantly adjusted. This is primarily due to a drop in profitability due to a decline in demand for IT services, not only in Ukraine but globally.

As early as 2022, American and European companies began to reduce staff, although national companies survived 2022 and 2023 more or less steadily, showing a slight increase in profitability. However, in 2024, the general downturn caught up with Ukraine, so almost the entire IT sector experienced a drop in revenue and profitability and, as a result, a decline in the valuation of companies.

Small companies with up to 200 employees will have a particularly difficult time in the coming years. While the market giants can survive the turbulent period thanks to long-term contracts and strong partnerships, small players will have to find a unique and growing segment (e.g., robotics). As demand for IT services declines, customers will first refuse to continue supporting the development of certain products.

In the near future, it will not be about growth, but rather about the possibility of saving the business. Those owners who sold their companies in 2021 at the highest price received a “winning ticket”. Today, large companies have fallen in price by two to five times, we have seen shares of some companies fall by up to 20-30% per day, and smaller IT companies have fallen even more.

An analysis of public deals in the IT market also shows a decline: compared to seven to eight EBITDAs earlier, today we have only five to six. The business margin has significantly decreased, and this anti-trend and market reformatting will continue in the coming years. Thanks to the presence of Capital Times in the markets of Poland, Romania, and Moldova, we see a difference in the valuations of companies. Thus, the most expensive companies in this sector are in Poland. There, the valuation is seven to nine times EBITDA, while Romania is similar to Ukraine and Moldova is even cheaper.

Capital Times experts see that the IT sector is more eager than ever for mergers and acquisitions. Large IT companies will buy small ones to consolidate expertise and expand their client portfolios. At the same time, small firms will use M&A as a tool to support their business.

That’s why it’s more important than ever to take a competent approach to valuing companies, moving away from the old established methods. Previously, the valuation of an IT business was actually an assessment of the future. In the optimistic year of 2021, it seemed that “trees could grow to the heavens,” so the value of some IT companies reached tens of millions. The global downturn in demand and the war in Ukraine require different approaches to valuation, as Ukrainian companies have more risk factors that affect the final value. For example, the first question that customers ask is where the development team is physically located. The presence of a delivery team in Ukraine in 2024 is a factor that reduces demand.

So let’s look at how to estimate the value of an IT company. Two of the most common indicators for this assessment – EV/EBITDA and EV/Revenue – are integral parts of the analysis of the financial condition of companies.

EV/EBITDA is a metric used to assess a company’s financial performance. It takes into account the total cost of the company, including debt and the cost of equity, compared to its earnings before taxation and depreciation.

Formula for calculating EV/EBITDA:

Enterprise Value (EV) = Company Capitalization + Total Debt – Cash and Cash Equivalents.

EBITDA = Earnings before interest and taxes + Interest on loans + Depreciation and amortization.

EV/Revenue is a financial indicator used by investors and analysts to estimate the value of a company compared to its turnover.

Total company value / Revenue

Total Company Value (EV) = Company Capitalization + Total Debt – Cash and Cash Equivalents.

Revenue = Total revenue generated by the company from its core business.

It is important to understand that the valuation of service and product IT companies is based on different principles. For IT service companies, it is important to estimate the value of the business taking into account the profit, and the EV/EBITDA indicator is more often used. This applies to companies that provide software development, consulting, technical support, etc. In these cases, the focus is on profitability, and the EV/EBITDA ratio provides an opportunity to compare the value of companies according to their potential to make a profit.

In contrast, for early-stage IT product companies, where it is more important to assess the value of the business based on revenues from the sale of software or other products, EV/Revenue is more commonly used. This may apply to companies that develop and sell software, games, web services, etc. In such cases, Revenue reflects the amount of revenue the company receives from the sale of its products and allows you to estimate the value of the business based on these revenues.

Thus, the choice of an indicator for assessing the value of an IT company depends on its specifics, line of business, and main sources of income.

Conclusion and recommendations: The IT sector will remain the most active in terms of M&A, but the reasons for M&A have changed significantly. Now it is a business support tool for small companies and a consolidation of expertise for large ones. Valuation of an IT company will play a key role in the decision-making process. It will help to determine an objective price when buying or selling a company, assess potential synergies and risks associated with business combinations, and prevent price dumping in times of market turbulence.

Author: Serge Hancharevich, Managing Partner of Capital Times. Source: ain.ua

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