Can trees grow to the sky? How to accurately assess the value of an IT business — guest column

In the coming years, the trend of declining demand in the IT sector and, as a result, a decrease in company value will persist. Serge Hancharevich, Managing Partner of Capital Times, discuses in his guest column for AIN how to accurately assess the value of an IT business in times of recession.

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Years of IT sector development have led both company owners and investors to believe that this trend will continue for the next decade – the sector will steadily grow, and valuations and demand will remain consistently high. However, the development of any sector is cyclical, and IT is no exception. In recent years, there has been a general international decrease in demand for IT products and, consequently, a correction in the value of IT companies.

The Ukrainian IT sector has demonstrated continuous growth, even in the first year of the full-scale war, along with the export of IT services, which has set new records annually over the last decade.

The sharp decline in Ukrainian IT exports by 8.5% in 2023 marked a turning point: the profitability of IT companies is decreasing, and the share prices of some giants have halved (for example, EPAM’s shares dropped from $670 in 2021 to $309 in 2024, ENDAVA’s shares even more—from $167 to $37, and the valuation of private companies has been significantly adjusted. It is primarily due to the decline in profitability due to decreased demand for IT services not only in Ukraine but worldwide.

As early as 2022, American and European companies began reducing their workforce, although national companies experienced 2022 and 2023 relatively stable, showing slight profitability growth. However, by 2024, the overall downturn caught up with Ukraine, so almost the entire IT sector experienced a decline in revenue and profitability, resulting in a decrease in the valuation of companies.

The next few years will be particularly challenging for small companies with less than 200 employees. While market giants may survive the turbulent period due to long-term contracts and strong partnerships, small players should find a unique growing segment (such as robotics). With reduced demand for IT services, clients will primarily refrain from continuing support for the development of some products.

Shortly, it will not be about growth but more likely about the possibility of business preservation. Those owners who sold their companies in 2021 at the maximum price got a “winning ticket.” Today, large companies have decreased in value by 2–5 times; we have seen the shares of some firms drop by 20–30% in a day, with smaller IT companies experiencing even more declines.

The analysis of public deals in the IT market also shows a decline – previously at 7–8 EBITDA, today we only have 5–6. Business margins have significantly decreased, and this countertrend and market reshaping will persist in the coming years. 

With Capital Times’s presence in the markets of Poland, Romania, and Moldova, we see differences in company valuations. The most expensive companies in this sector are in Poland, where the valuation is at 7–9 EBITDA, while Romania is similar to Ukraine, and Moldova is even cheaper.

Experts at Capital Times see that today, the IT sector is more than ever willing to merge and acquire. Large IT companies will acquire small ones to consolidate expertise and expand client portfolios. At the same time, small firms will receive support for their business through M&A tools.

That’s why, today, it’s more important than ever to approach the valuation of companies intelligently, moving away from old, established methods. Previously, the valuation of IT businesses was essentially a valuation of the future. In the optimistic year of 2021, it seemed that “trees could grow to the sky,” so the values of some IT companies reached tens of millions. The global decline in demand and the war in Ukraine require different approaches to valuation, as Ukrainian companies face increased risk factors that affect the final value. 

For example, the first question clients ask – is the physical location of the development team. The presence of the development team in Ukraine in 2024 is a factor reducing demand.

So, let’s consider how to evaluate the value of an IT company. Two of the most common indicators for this assessment — EV/EBITDA and EV/Revenue. These are integral parts of analyzing companies’ financial health.

Indicator EV/EBITDA

EV/EBITDA is an indicator used to evaluate a company’s financial efficiency. It takes into account the overall value of the company, including debt and equity, compared to its earnings before interest, taxes, depreciation, and amortization (EBITDA).

The formula for calculating EV/EBITDA: Total company value / EBITDA.

• Total company value (EV) = Company’s market capitalization + Total debt — Cash and cash equivalents. 
• EBITDA = Earnings before taxes + Interest on loans + Depreciation + Amortization.

Indicator EV/Revenue

EV/Revenue is a financial metric used by investors and analysts to assess a company’s value compared to its revenue.

The formula for calculating EV/Revenue:

Total company value / Revenue

• Total company value (EV) = Company’s market capitalization + Total debt — Cash and cash equivalents.
• Revenue = Total income generated by the company from its core operations.

It is important to understand that the valuation of service-based and product-based IT companies is based on different principles. For IT service companies, it is essential to assess the business value considering profitability, often using the EV/EBITDA ratio. The applies to companies providing software development, consulting, technical support, and similar services. In these cases, the focus is on profitability, and the EV/EBITDA ratio allows us to compare the value of companies based on their potential to generate profits.

On the other hand, for early-stage IT product companies, where it is more important to assess the business value considering revenues from software sales or other products, the EV/Revenue ratio is often used. The indicated may relate to companies developing and selling software, games, web services, etc. In such cases, revenue reflects the volume of income the company generates from selling its products and allows us to evaluate the business value based on these revenues.

Therefore, the choice of valuation metric for an IT company depends on its specificity, business direction, 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 mergers and acquisitions have significantly changed. Now, it is a business support tool for small companies and expertise consolidation for large ones. Valuing an IT company will play a pivotal role in the decision-making process. It will help determine an objective price during the purchase or sale of a company, assess potential synergies and risks associated with business combinations, and prevent price dumping during market turbulence.

Author: Serge Hancharevich, Managing Partner of Capital Times