Enterprise Value To Sales (EV/Sales) Ratio

Why should I care about enterprise value to sales (EV/sales) ratios?

For markets: The EV/sales ratio is used by investors to gauge whether a stock is undervalued or overvalued compared to its peers or historical performance. A lower EV/sales ratio may indicate that a company is undervalued, suggesting a potential investment opportunity. Conversely, a higher EV/sales might suggest that the company is overvalued, reflecting high market expectations for future growth or profitability.

Zooming in: The EV/sales ratio combines two fundamental aspects: a company’s valuation and its revenue. For investors to have confidence that an EV/sales ratio is “right”, they need to have confidence in both parts of it. For example, a company with a low EV/sales might be considered undervalued if an investor believes the company’s share price is too low and should rise (perhaps thanks to stronger-than-expected sales growth). Similarly, a high EV/sales company might be seen as overvalued if an investor believes that its sales will fall short (meaning the unchanged share price, relative to lower revenue creates an even higher EV/sales ratio, which might trigger other investors selling).

What is a good enterprise value to sales ratio?

A good enterprise value to sales (EV/sales) ratio depends on the company, industry, wider market conditions, and investors’ growth expectations. Investors should assess EV/sales ratios together with other valuation metrics and fundamental analysis to understand a stock's valuation.

A good EV/sales ratio, then, aligns with the company’s growth prospects and is comparable to, or more attractive than, industry averages. Investors should assess whether a company’s market position, cost structure, and future earnings trajectory justify its current market valuation as reflected by its EV/sales ratio.

Historically, the average EV/sales ratio for S&P 500 companies has ranged between 1 and 3, and currently sits at 3.9. During periods of investor optimism, average EV/sales ratios climb higher as investors are willing to pay more in anticipation of continued sales and profit growth. Conversely, in economic downturns, EV/sales ratios tend to fall as sales slow, earnings drop and market sentiment wanes.

What do high and low EV/sales ratios mean?

• High EV/sales ratio: A high ratio may indicate that the market values the company highly relative to its sales, often due to expected sales growth or high and rising profit margins. However, a very high ratio could also signal an overvalued stock, posing downside risks if the company falls short of investors’ expectations.
• Low EV/sales ratio: A low ratio might suggest that the company is potentially undervalued or that it is facing challenges that could limit sales growth or profit margin expansion. A lower EV/sales multiple could represent a buying opportunity if an investor concludes that others have unfairly discounted the company's potential.

How do you calculate enterprise value to sales ratio?

Step 1: Calculate enterprise value (EV)

Enterprise value is a measure of a company's total value, including its net debt, offering a comprehensive idea of what it would cost to buy the entire business. The formula to calculate enterprise value is:

• EV = Market capitalization + total debt − cash and cash equivalents

Market capitalization: Calculate it by multiplying the current share price by the total number of outstanding shares.

Total debt: Includes both short-term and long-term debt. Historical or current data is shown in a company’s balance sheet under “liabilities”.

Cash and cash equivalents: All liquid assets that can be quickly converted into cash. Historical or current data is shown in a company’s balance sheet under “assets”.

Note: a shorthand for total debt minus cash and cash equivalents is net debt.

Depending on the company, you might need to use a more detailed EV calculation, including the value of preference shares, minority interests, and subtracting the value of associates. That formula is:

• EV = Market capitalization + net debt + preference shares + minority interests − associates

Step 2: Determine sales

Sales (or revenue) refers to the money a company brings through the door from selling its goods or services to customers and is the top line of an income statement.

Step 3: Calculate the EV/sales ratio

• EV/sales ratio = Enterprise value / sales

A word on debt. Simplistically, investors tend to calculate net debt based on the last reported annual or quarterly figures. However, professional analysts, being forward-looking, prefer to calculate EV using their own forecasted net debt figures. Let’s say an analyst forecasts a company will earn much more than investors expect and they believe it’ll use that windfall to pay off a lot of its debt. All else being equal, that’ll lead to a lower EV, which would show the company as being relatively cheaper than other investors – who haven’t updated their debt forecasts – see it.

What’s the difference between trailing, current, and forward EV/sales ratios?

Comparing trailing, forward, and current EV/sales ratios.

When to use each type of EV/sales ratio?

• Trailing EV/sales is more valuable when analyzing companies in stable industries or during stable economic conditions where past performance reliably indicates the future. That’s because trailing EV/sales tells you what investors are willing to pay for shares currently, relative to historical sales – and if things don’t change much, it may indicate what they’re willing to pay in the future, too.
• Forward EV/sales is more valuable for companies or industries in which investors expect rapid changes – whether positive or negative – that drive shifts in financial outcomes. It's also more useful during periods of economic recovery, where future revenues are expected to improve versus recent history, or where a company might rapidly take on or shed debt.
• Current EV/sales provides a snapshot that is more timely than trailing EV/sales and less speculative than EV/sales, making it a helpful starting point for analysis. It can be particularly useful for interim assessments where recent events such as mergers and acquisitions might impact capital structures in the short term.

What’s the difference between enterprise value to sales (EV/sales) and price to sales (P/S)?

Both EV/sales and P/S ratios assess a company's valuation relative to its sales, but they differ in scope and detail. EV/sales, as the name suggests, reflects a company’s enterprise value (comprising its market capitalization and net debt) which shows what the entire company – equity and debt obligations – might cost to buy outright. In contrast, the P/S ratio uses only market capitalization, ignoring debt and cash, which simplifies the calculation but overlooks important financial nuances.

Consequently, while EV/sales offers a more accurate assessment considering a company's actual economic situation, it may be more complex to accurately calculate if the debt and cash levels fluctuate significantly. P/S is more straightforward but less informative about the company’s financial health and potential liabilities, potentially leading to skewed conclusions if debt and cash levels are significant.

When should you use EV/sales ratios?

EV/sales ratios are particularly useful when comparing companies within the same industry but with different capital structures or when assessing firms in sectors where earnings can be volatile or negative. It’s also a valuable metric to use across different industries given it reflects capital structures that will vary between industries.

By incorporating both debt and cash, EV/sales provides a more comprehensive assessment of a company's valuation relative to its current sales, making it an ideal metric to use for industries like technology or biotech, where high growth expectations or a lack of profitability can hamper the effectiveness of earnings-based valuation methodologies.

Investors often use EV/sales ratios during mergers and acquisitions to understand the full valuation of potential targets. It's also utilized in preliminary screens of investment opportunities, especially when looking for high-growth companies that might not yet be profitable but show substantial revenue growth potential.

What are the potential limitations of EV/sales ratios?

The enterprise value to sales ratio, while a valuable metric for stock valuation, has several limitations:

• It ignores operational profitability: EV/sales doesn’t directly reflect how much profit a company actually makes from its sales, and can therefore potentially treat companies with particularly high or low profitability unfairly. This is the exception, however, because investors sense-check EV/sales against profit margins and profit-based valuation metrics to make sure they’re justified. As a shortcut, you can divide a company’s EV/sales ratio by its EBIT or EBITDA margin to get its EV/EBIT or EV/EBITDA multiple, respectively.
• It ignores net profitability –Debt and cash overlooked: While EV itself includes a company’s net debt, the ratio doesn’t directly reflect how these elements might affect the company’s net profitability. That is, a company with high debts might show an attractive EV/sales despite expensive interest payments that limit or lower its profitability.
• It’s one-dimensional: By including market capitalization and net debt in EV, the metric looks to represent what a company’s worth to both shareholders and debt holders. That stands to reason: if a company had no costs, then both groups stand to benefit from revenues. However, this treats shareholders and bondholders equally, and in reality, debt (or bond) holders are more senior than shareholders. In other words, they get paid first from any money a company makes.

Frequently Asked Questions (FAQs)

What is the difference between EV/sales and EV/EBITDA?

The EV/sales ratio compares a company's enterprise value to its total sales, offering a measure of how much investors are willing to pay per dollar of revenue. EV/EBITDA, on the other hand, compares enterprise value to a profit metric investors often use as a proxy for cash earnings in EBITDA (earnings before interest, tax, depreciation, and amortization). EV/EBITDA, then, takes a company’s operational profitability (before financing and accounting decisions impact the bottom line) into account.

What is the difference between EV/sales and P/E?

EV/sales considers a company’s total value relative to its revenue, ignoring profitability – and is often used when earnings are negative or volatile. P/E, meanwhile, measures the share price of a company relative to its per-share earnings, directly linking the stock price to profitability. While EV/sales is more holistic from a company value perspective, P/E is more holistic from a net profitability perspective.

Can a company have a negative EV/sales ratio?

A negative EV/sales ratio is generally not possible since both enterprise value and sales are typically positive figures. If a company’s enterprise value were somehow negative, it could theoretically occur only if a company had a high amount of cash, surpassing its market cap and debt levels. This would suggest an unusual financial structure, indicating that the company could be bought with its own cash balance.