Explained: EV to sales ratio
EV to sales ratio is one of the simplest multiples for valuation purposes. During the process of mergers and acquisitions, the ratio gives all parties a good idea.
Enterprise value-to-sales (EV/sales) is a financial ratio measuring the company’s total value (in enterprise value terms) to its total sales revenue. To simplify more, it is EV per dollar of sales. This means that the higher the ratio, the more ‘expensive’ or valuable the company is, and vice versa. The ratio is used for financial analysis and valuation strategies while doing research for a potential investment.
The most common way to calculate enterprise value-to-sales is:
EV/sales = (MC + D + PS + MI - CC) /annual sales
where,
MC – market capitalisation
D – debt
PS – preferred shares
MI – minority interest
CC – cash and cash equivalents
It is imperative to get an idea of the cost relative to per-unit sales while choosing a company for investment purposes. This helps to understand whether the company is undervalued or overvalued. When the ratio is high for every dollar of revenue, a large amount of enterprise value is associated. Investors generally don't prefer a high ratio as they will not benefit from the investment immediately. On the other hand, if the ratio is low, the shares can be considered undervalued and there are chances that the investor can have an immediate benefit from the investment made. Some investors can accept a high ratio if they believe that future sales will increase significantly and they can earn greater returns.
When to use EV/sales?
-EV to revenue is rather tough 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 also be used 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.
EV to sales ratio is one of the simplest multiples for valuation purposes. During the process of mergers and acquisitions, the ratio gives all parties a good idea. Better results are obtained by using other multiples alongside the EV/revenue multiple. Rather than using only the EV/revenue metric in isolation, it’s beneficial to use this multiple with other complementary ratios to match within the same industry and size.