A fiscal valuation metric, the enterprise value-to-sales (EV/sales) ratio compares an organisation’s enterprise value (EV) to its yearly revenue. It enables investors to assess a company’s worth by taking into account its sales along with factors like equity and debt. This tangible measure can help you determine if a particular business is overvalued or undervalued. Likewise, the EV/sales ratio assists in comparing the financial status of companies in the same domain.
How to calculate EV/sales ratio?
To determine the company’s EV/sales ratio, you first have to ascertain its enterprise value.
Enterprise Value = MC + D + PS + MI - CC
Here’s what the above-mentioned components mean:
MC - Market capitalisation (number of outstanding shares and its share price)
D - Total debt
PS - Preferred shares
MI - Minority interest
C - Cash and cash equivalents
Once you have worked out the enterprise value, use the following EV/sales formula.
EV/Sales = Enterprise Value/Sales Revenue
Example of an EV/sales ratio calculation
Let’s assume a firm made an annual revenue of Rs. 80 lakh. It owes a total debt of Rs. 30 lakh, including short-term and long-term liabilities. Plus, it possesses Rs. 20 lakh worth of cash assets. Finally, the company has 5 lakh shares which are currently priced at Rs. 20 apiece.
EV = Market Capitalisation (5 lakh shares x Rs. 20) + Total Debt (Rs. 30,00,000) - Cash (Rs. 20,00,000)
EV = Rs. 1,00,00,000 + Rs. 30,00,000 - Rs. 20,00,000
EV = Rs. 1,10,00,000
To find the EV/Sales Ratio, you simply divide the enterprise value by the sales revenue made by the company.
EV/Sales = Enterprise Value (Rs.1,10,00,000)/Sales (Rs.80,00,000)
= 1.375
What’s an EV/sales ratio interpretation and what does it tell you
An enterprise value-to-sales (EV/sales) ratio could assist you in gauging whether or not you should invest in a business. For example, when the EV/sales ratio is higher, the company is deemed to be costlier. This is because, for every rupee of the generated sales, there is a bigger sum of enterprise value. Most investors find high ratios unattractive as they will be unable to make instant profits off of their pledges.
High EV/sales ratios also often indicate that the business is overvalued. However, some investors might not be repelled by higher ratios if they expect an upward trajectory in future sales of the company, increasing their likelihood of enjoying solid returns.
The ideal EV/sales ratio of undervalued companies is lower. Here, for every rupee of generated sales, there is a correspondingly smaller sum of enterprise value. An undervalued business could be appealing to investors as it could provide quick gains.
You can determine the EV/sales ratios of different companies in the same sector to draw comparisons and check how they can benefit you. However, it is important to note that this ratio is a crude marker of the company’s profitability aspect. So, analyse additional qualitative and quantitative factors before making final calls.
Enterprise value-to-sales (EV/sales) or price-to-sales (P/S) — Which is better
When the two metrics are compared, the EV/sales ratio is able to tell a lot more about a company’s suitability for investment than a P/S ratio. This is because the EV/sales ratio considers elements like debt and cash and cash equivalents to reflect the growth potential of a business, whereas a P/S ratio only utilises the market capitalisation figure, giving superficial insights. Since the lenders hold a stake in the generated revenue, the debt amount should ideally be factored in such computations.
If you are specifically interested in learning more about calculating a stock’s profitability, then know about the P/E ratio.
What are the advantages of an EV/sales ratio
- Simplicity: Unlike complex equations that require heavy data and computations, the EV/sales ratio is extremely easy to understand and calculate. This makes it an apt investment tool for new and seasoned investors.
- Comparison tool: The EV/sales formula can help you draw parallels between companies of the same sector. Using the formula can help you weed out businesses that are overvalued and invest in companies that could reinforce your financial vision.
- Financial standing: A high or low EV/sales ratio will assist you in determining and categorising undervalued as well as overvalued firms.
- Growth potential: With the help of the EV/sales ratio, you can pick firms that demonstrate high growth potential and make investments based on your financial goals.
Also read: What is a put-call ratio
What are the disadvantages of an EV/sales ratio
- Limited scope: EV/sales ratios will vary widely across industries due to the contrasting demands and revenue. So, it is an optimal benchmark to rely on only when you are comparing firms in the same sector.
- Lack of certain components: When an EV/sales ratio is computed, it only takes the business’s revenue into consideration and not its profit margins. In the same vein, it misses expenses and taxes in its calculation, which might give off an unrealistic picture of the company’s health.
- Partial insights: EV/sales ratios are designed to assess the most recent data of a company, disregarding its past performance. This is why it is challenging to accurately track a firm’s growth patterns.
- Seasonality: Numerous products and services are impacted by seasonality, changing a company’s revenue numbers, share price, debt, and cash flow. EV/sales ratios overlook this inconsistency, which could result in erroneous financial projections.
Also read: What is price-to-book ratio
Conclusion
An EV/sales ratio is an effective valuation statistic that can be used to draw investment forecasts. Likewise, its data can allow you to easily compare performance and growth across companies. Despite its usefulness, the EV/sales ratio comes with its set of limitations, including the one-dimensional approach and restricted application, implying that it offers an insufficient financial report. It is of utmost importance that you don’t make investment decisions merely based on the information provided by such ratios. Do your research to gain a good understanding of a firm’s history, fiscal performance, and risks before entrusting it with your wealth.
Read more about technical indicators, which can help you trade efficiently in short-term market cycles by predicting future price fluctuations.
