EV to Sales

EV to Sales Ratio is the valuation metric used to understand the company's total valuation compared to its sale. It is calculated by dividing the enterprise value (Current Market Cap + Debt + Minority Interest + preferred shares – cash) by its annual sales.

Have a look at the above Box IPO Financial model with forecasts. We note that BOX is making losses at the Operating and net income levels. 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 -

EV / Sales is an interesting ratio. It considers the enterprise value, and then the enterprise value is compared with the company's sales. We estimate how much it costs to investors relative to per-unit sales with this ratio. Now, why should we calculate this ratio?

From the investor's point of view, two interpretations are most important –

• If this ratio is higher, then it is considered that the company is costlier, and it’s not a good bet for investors to invest in because they won't be getting any immediate benefit from this investment.
• If this ratio is lower, it is considered a great investment opportunity for investors; when EV / Sales is lower, it is perceived as undervalued. If the investors invest, they will benefit from it.

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

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 they should be considered.

Market Capitalization is the value we get when we multiply the company's outstanding shares 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 shares 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.

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

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

What would we consider "sales" in this ratio?

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

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

Example # 1

We have the following information –

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

It is a simple example, and we will follow along, as we have explained before.

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

Now, as we have market capitalization, we can calculate the enterprise value (EV).

We know the enterprise value and sales are already mentioned. So now, we can ascertain the multiple

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 in a company or not.

Example # 2

Let's look at the following information –

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

In this example, the computation is a bit complex. 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.

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

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

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

We now have enterprise value and net sales as well. So we can ascertain this ratio.

Enterprise value to Sales is 5x, which is higher or lower depending on the firm's industry. So if the EV / Sales of the industry are usually higher, then the investors can invest in the company. And if it is not the case, the investors need to think twice before investing in 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.

• EV to Revenue is very difficult to game from an accounting point of view. Though it is a crude measure, it does provide us with great insights into how much we are paying for the company per-unit sales.
• It can be very helpful when there are significant differences in the accounting policies of companies. On the other hand, the PE ratio can vary dramatically with changes in accounting policies.
• It can be used for companies with negative free cash flows or unprofitable companies. Most 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. 
  In his discussion on restructuring, Andrew Griffin noted that Alcatel-Lucent was reporting losses each year and was valued at 0.1x Ev/Sales. 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 the EBIT margin was expected to be 10%, it should trade at 1x multiple; if it was expected to be 5%, then 0.5xEV/Sales. Andrew expected that the company would reach at least 3% EBIT margins, and hence, it looked undervalued

First thing first, the 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, it is a pre-debt item when we consider the denominator – Sales. It means that we haven’t paid off interest, and hence, it belongs to both the debt holder and the equity holder. The numerator belongs to the equity holder, and the denominator belongs to both the debt and equity holders. It makes apples to oranges comparison and is, therefore, incorrect.

EV / Sales is a better ratio than the P/S Ratio. However, you will still find many analysts using this ratio. In the 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, the valuation inferences drawn from the Price to Sales ratio will be incorrect.

Let us take the example of Godaddy.

If you observe the EV to Sales and Price To Sales trend of Godaddy, you will note a marked difference in both 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 enterprise value will be very different from Market Capitalization. It can happen when (Debt – Cash) is a significant number.

source: Godaddy SEC Filings

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

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

source: ycharts

Amazon's 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 to the Enterprise Value of Amazon meaningfully. Therefore, we note that Price to Sales and EV to Sales of Amazon are similar.

source: Amazon SEC Filings

#1 - Comparable Comps Method using EV / Sales

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

For 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 negative at the EBITDA level. The only option to value such a 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 are an outlier that trades at 44x EV/Sales multiple (expected 2014 growth rate of 94%).
• Cloud companies trade at an EV/EBITDA multiple of 32x.

Box Valuation

• Box Inc valuation range from $11.02 (pessimistic case) to $24.74 (optimistic case)
• The 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. We note all the transactions in a 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 –

• The mean Multiple of 7.4x implies a valuation of closer to $1.8 billion (implying a share price of $18.4/share)
• The highest Multiple of 9.7x implies a valuation of $2.4 billion (implying a share price of $24.7/share)
• The lowest Multiple of 4.1x implies a valuation of $1.1 billion (implying a share price of $9.3/share)

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

EV / Sales is a good metric to determine whether to invest in a company or not. However, it’s based on many variables that may change in days. And it's not recommended that the investors depend on a single ratio to decide on an investment. Investors should look at different ratios to develop factual information before investing their money into any investment.

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.