**Enterprise Value to Sales** – Have look at the above Box IPO Financial model with forecasts. What we note is that BOX is making losses not only at the Operating but also at the Net Income Level. How do you value such companies that grow fast but are free cash flow negative?

In such cases, we cannot apply valuation multiples like PE ratio (due to negative earnings), EV to EBITDA (if EBITDA is negative) or DCF approach (when FCFF is negative). The valuation tool that comes to our rescue is **EV to Sales.**

In this article, we will dig deeper and understand EV / Sales.

- What do we mean by Enterprise Value to Sales Ratio?
- Enterprise Value to Sales Formula
- EV to Sales Examples
- When to use EV/Sales?
- Which is Better – EV to Sales vs Price to Sales?
- Using EV to Sales for Box IPO Valuation
- Limitations of Enterprise Value to Sales
- In the final analysis

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## What do we mean by Enterprise Value to Sales Ratio?

EV / Sales is an interesting ratio. It takes into account the enterprise value and then the enterprise value is being compared with the sales of the company. Now why should we calculate EV / Sales ratio? By calculating EV / Sales Ratio, we get an idea how much it costs to investors relative to per unit sales.

From investors point of view, there are two interpretations that are most important –

- If EV / Sales is higher, then it is considered that the company is costlier and it’s not a good bet for investors to invest into because they won’t be getting any immediate benefit out of this investment.
- If EV / Sales is lower, then it is considered to be a great investment opportunity for investors; because when EV / Sales is lower, it is perceived as undervalued and then if the investors invest, they would get good benefit out of it.

So if you are an investor and thinking of investing into a company; but don’t know whether it’s a good bet or not, calculate Enterprise Value to Sales ratio and you would know! If it’s higher, stay away from investment; and if it’s lower, go ahead and invest into the company (subject to the other ratios because as an investor you shouldn’t take any decision on the basis of only one ratio).

## Enterprise Value to Sales Formula

Let’s start with Enterprise Value (EV). To find out the enterprise value, we need to know three specific things – market capitalization, the debt that is yet to be paid and the cash and bank balance.

Here’s the formula of Enterprise Value (EV) –

**EV = Market Capitalization + Outstanding Debt – Cash & Bank balances**

Now, we need to find out how each of them should be considered.

Market Capitalization is the value we get when we multiply the outstanding shares of the company by the market price of each share. How should we calculate it? Here’s how –

Let’s say Company A has outstanding shares of 10,000 and the market price of each of the share at this moment is US $10 per share. So, the market capitalization would be = (outstanding shares of the Company A * market price of each share at this moment) = (10,000 * US $10) = US $100,000.

**Outstanding debt** is the long-term liabilities the firm needs to pay back in the long run.

And **cash & bank balances** are the liquid assets of the company which needs to be deducted from the sum total of market capitalization and outstanding debt. (Also, look a detailed article on Cash & Cash Equivalents)

We have understood all the components of Enterprise Value (EV) which we can now calculate. Let’s now talk about Sales.

What would we consider as “sales” in this ratio?

When we would take sales, **it is net sales, not gross sales.** A gross sale is a figure which is inclusive of the sales discount and/or sales returns. We would take the net sales and that means we need to exclude sales discount and sales returns (if any) from the gross sales to get the right figure.

## EV to Sales Examples

Let’s look at few examples to understand how to calculate the enterprise value to sales. We will look at a simple example first and then we will illustrate the ratio with two complex examples.

**EV to Sales – Example # 1**

**We have the following information – **

Details |
In US $ |

Market Price of Share |
15 / share |

Outstanding Shares |
100,000 shares |

Long term liabilities |
2000,000 |

Cash & Bank balances |
40,000 |

Sales |
1,000,000 |

Compute the Enterprise Value and the ratio of EV / Sales.

This is a simple example and we will just follow along as we have explained before.

First, we will calculate the market capitalization by multiplying the outstanding shares with market price per share.

Details |
In US $ |

Market Price of Share (A) |
15 / share |

Outstanding Shares (B) |
100,000 shares |

Market Capitalization (A * B) |
1,500,000 |

Now, let’s as we have the market capitalization, we can compute the enterprise value (EV).

Details |
In US $ |

Market Capitalization |
1,500,000 |

(+) Long term liabilities |
2,000,000 |

(-) Cash & Bank balances |
(40,000) |

Enterprise Value (EV) |
3,460,000 |

We know the enterprise value and the sales is already mentioned. So now, we can ascertain EV / Sales.

Details |
In US $ |

Enterprise Value (EV) |
3,460,000 |

Sales |
1,000,000 |

EV / Sales |
3.46 |

Depending on the industry, investors need to understand whether 3.46 is a higher or lower ratio and then the investor can decide whether to invest into a company or not.

**EV to Sales – Example # 2**

**Let’s look at the following information – **

Details |
In US $ |

Market Price of Share |
12 / share |

Book value per share |
10 / share |

Book Value of Shares |
2,500,000 |

Long term debt |
3,000,000 |

Cash & Bank balances |
500,000 |

Gross Sales |
1,500,000 |

Sales Return |
400,000 |

Compute enterprise value (EV) and the ratio EV / Sales.

In this example, the computation is bit complex as first we need to find out the number of shares and then we will be able to compute the market capitalization.

So, let’s find out the outstanding shares first.

Details |
In US $ |

Book Value of Shares (A) |
2,500,000 |

Book value per share (B) |
10 / share |

Outstanding Shares (A / B) |
250,000 shares |

We know the market price per share and now we have the exact number of outstanding shares as well. Then we can compute the market capitalization right away –

Details |
In US $ |

Outstanding Shares (C) |
250,000 shares |

Market Price of Share (D) |
12 / share |

Market Capitalization (C * D) |
3,000,000 |

We have now the market capitalization. So it would be easier to calculate enterprise value. Let’s calculate the enterprise value now –

Details |
In US $ |

Market Capitalization |
3,000,000 |

(+) Long term liabilities |
3,000,000 |

(-) Cash & Bank balances |
(500,000) |

Enterprise Value (EV) |
5,500,000 |

We will now calculate the net sales. As we cannot include gross sales in the ratio, we need to deduct sales return from the gross sales and find out the net sales first.

Details |
In US $ |

Gross Sales |
1,500,000 |

(-) Sales Return |
(400,000) |

Net Sales |
1,100,000 |

We now have the enterprise value and the net sales as well. So we can ascertain EV / Sales ratio.

Details |
In US $ |

Enterprise Value (EV) |
5,500,000 |

Sales |
1,100,000 |

EV / Sales |
5.00x |

Enteprsie value to Sales is 5x which is higher or lower depending on the industry that the firm operates in. So if the EV / Sales of the industry is usually higher, then the investors can invest into the company. And if it is not the case, the investors need to think twice before investing into the company. But as an investor, it’s of primary importance that you check with all other ratios to come up with a concrete conclusion.

## When to use EV/Sales?

**EV to Sales is very difficult to game from an accounting point of view.**Though EV/Sales is a crude measure, it does provide us with great insights on how much are we paying for the company per unit sales.- EV/Sales can be very helpful when there are
**significant differences in accounting policies of companies**. PE ratio, on the other hand, can vary dramatically with changes in accounting policies. **EV/Sales can be used for companies with negative free cash flows or unprofitable companies.**Most of the internet e-commerce startups (running unprofitably) like Flipkart, Uber, Godaddy etc can be valued using EV/Sales.

**EV/sales can be useful for identifying restructuring potential.**Andrew Griffin noted in his discussion on restructuring that Alcatel-Lucent was reporting losses with each year and was valued at 0.1x Ev/Sales. According to him, the rule-of-thumb was that a mature company should trade at an EV/sales of its EBIT margin percentage, divided by 10. So if EBIT margin was expected to be 10%, it should trade at 1x EV/Sales, if it was expected to be 5%, then 0.5xEV/Sales. Andrew expected that the company will reach atleast 3% EBIT margins, and hence, it looked undervalued.

## Which is Better – EV to Sales vs Price to Sales?

First thing first, Price to Sales ratio is technically incorrect. Price per share is the price at which one can buy a share i.e. it belongs to the shareholder or the equity holder. However, when we consider the denominator – Sales, it is a pre-debt item. This means that we haven’t paid off interest and hence, it belongs to both the debt holder as well as the equity holder. This means that numerator belongs to the equity holder and denominator belongs to both the debt and equity holders. This makes apples to oranges comparison and is, therefore, incorrect.

However, you will still find many analysts using this ratio. In Price to Sales ratio, an analyst may be using market capitalization to understand how much it costs to purchase the company. However, in P/S, debt is not considered. If a company has huge amounts of debt in its capital structure then the valuation inferences drawn from Price to Sales ratio will be incorrect. That’s why EV / Sales is a better ratio than P/S Ratio.

Let us take an example of Godaddy.

If you observe the trend in EV to Sales and Price To Sales of Godaddy, you will note that there is a marked difference in both the ratios. **Why?**

source: ycharts

To answer this question, we need to understand the following concept.

Enterprise value = Market Cap + Debt – Cash.

Now when do you think will Enterprise Value be very different from Market Capitalization. This can happen when (Debt – Cash) is a significant number.

source: Godaddy SEC Filings

Godaddy’s Balance Sheet reveal the presence of large amounts of debt ($1,039.8 million). Its Debt to Equity Ratio is greater than 2.0x. However, Godaddy has cash & cash equivalent of $352 million. The contribution of (Debt – Cash) is pretty significant in case of Godaddy and hence, both the ratios differ.

Let us now contrast this with Amazon. Amazon Price to Sales ratio and EV to Sales ratio almost mimic each other.

source: ycharts

Amazon Debt to Equity ratio is low (less than 0.75x) and they have a huge pile up of cash. Due to this, (Debt – Cash) does not contribute meaningfully Enterprise value of Amazon. Therefore, we note that Price to Sales and EV to Sales of Amazon are similar.

source: Amazon SEC Filings

## Using EV to Sales for Box IPO Valuation

#### #1 – Comparable Comps Method using EV / Sales

Please note that I did this Box IPO Valuation long time back and I have not updated the numbers since then. However, from understanding EV/Sales point of view, this example is still valid.

For doing a quick comparable comp analysis SaaS companies, I took the SaaS companies data from the BVP Cloud Index.

We note that Box is not profitable and is negative at the EBITDA level too. The only option to value such company with negative free cash flows is to use EV/Sales.

**We make the following observations from the above table**

- Cloud companies are trading at an average of 9.5x EV/Sales Multiple.
- We note companies like Xero is an outlier that trades at 44x EV/Sales multiple (expected 2014 growth rate of 94%).
- Cloud companies trade at EV/EBITDA multiple of 32x.

#### Box Valuation

- Box Inc valuation range from $11.02 (pessimistic case) to $24.74 (optimistic case)
- Most expected valuation for Box Inc using Relative Valuation is $16.77 (expected)

#### #2 – Comparable Acquisition Analysis using EV/Sales

Here we use the comparable acquisition method to find the value of Box IPO. for this we make note of all the transactions in the similar domain and their Enterprise Value to Sales ratio.

Below are some of the large M&A transactions in the recent past.

Based on the above comparable acquisition analysis, we can arrive at the following conclusions for Box Valuation –

- Mean EV/Sales of 7.4x implies a valuation of closer to $1.8 billion (implying a share price of $18.4/share)
- Highest EV/Sales of 9.7x implies a valuation of $2.4 billion (implying a share price of $24.7/share)
- Lowest EV/Sales of 4.1x implies a valuation of $1.1 billion (implying a share price of $9.3/share)

in the above, Sales forecast used for Box is $248,38 million.

## Limitations of Enterprise Value to Sales

EV / Sales is a good metric to find out whether to invest into a company or not. However, it’s based on many variables which may change in matter of days. And it’s not recommended that the investors depend on a single ratio to decide for an investment. The investors should go ahead and look at different ratios to come up with concrete information before investing their money into any investment.

## In the final analysis

If you know how to compute EV, you should never bank upon only market capitalization as the debt should also be considered in the equation.

C Chan says

I think you are missing a zero for you $10mm long-term liabilities and $20mm for your sales in Example 1. Similarly, Example 2 is missing a zero place for values in the millions.

Dheeraj Vaidya says

thanks Chan for pointing this out. There was a mistake in the “,” that i used in numbers.

Rukky says

great write up sir!

By the way I downloaded your material from the free download section… but I have no idea where to start from.

Dheeraj Vaidya says

what do you want to learn Rukky. Best is to start with Ratio Analysis and then move to Financial Modeling. Thereafter, you can look at valuation sections to master IB skills.

Rukky says

thank you so much for the speedy response,

I have gone through the ratios actually, I guess I was just overwhelmed with the numbers and how you arrived a each figure in the forecast. I shall take my time to digest the material.

I shall be in touch again soon.

Many thanks

Dheeraj Vaidya says

sure. good luck!

Jubair-Al-Mahmud says

Great write up, Sir!

Dheeraj Vaidya says

thanks Jubair!

Karan says

Mean EV/Sales of 7.4x implies a valuation of closer to $900 million – can you please explain how you got 900?

Dheeraj Vaidya says

Hi Karan, thanks for your question and highlighting a mistake in the calculation. The actual sales forecast of Box was $248 million and multiplying it by 7.4 will give an enterprise value of $1.8 billion.

thanks,

Dheeraj

p.s. I corrected the mistake in the blog post.

Manu says

Very Helpful. You are doing a great work.

Thanks a ton!!

Dheeraj Vaidya says

thanks Manu!

Ashrit Kasshyap says

I don’t agree with your statement that you can’t value a company who’s fcfe/fcff is negative using DCF. You could project cash flows (even when negative) and still compute the value as long as you have a positive terminal value(with stable mature growth in perpetuity). In fact all young startups more often than not will have negative cash flows upfront.

Dheeraj Vaidya says

Hi Ashrit,

You are right. You can still value a company with negative FCFE/FCFF (for next 5-7). This can happen when terminal value is positive in the future estimates. Generally, in Equity Research, we tend to forecast for 5-7 years at max and hence, we give up on finding the terminal value in the distant future. Also, the confidence level shown to a terminal value number (arrived after 20 years of projection) will always remain doubtful for investors.

Just think of Flipkart etc. Do you think their FCFF will be positive in the next 15-20 years? If not, DCF valuation model will throw a value that will be too theoretical. In such cases, we look at alternate approaches of valuation like Relative Valuation like EV/EBITDA or EV/Sales or some other measure.