What it means
The ratio divides enterprise value, which is the value of the whole business including debt and net of cash, by revenue, which is the total sales for a year. A result of 4 means the business is valued at four times its annual sales.
It is also known as the EV to sales multiple. Revenue multiples are popular because sales are harder to distort than profit and are positive even when a company is making a loss.
Young software and technology firms are often valued this way, since their profit is held down by heavy spending on growth. Investors use the multiple to compare these companies with each other.
The weakness is that revenue says nothing about profitability. A company with high sales but thin or negative margins may deserve a low multiple, while one with strong margins deserves a higher one.
For this reason, analysts often compare multiples only between companies with similar margins and growth. The right multiple depends heavily on the sector and the quality of revenue.
Recurring subscription revenue is usually valued more highly than one-off project revenue, because it is more predictable. A distribution business with low margins might trade at less than one times revenue, while a high-margin software firm might trade at several times revenue.
Analysts use the ratio with growth rates. A company growing revenue at 40% a year may reasonably command a higher multiple than one growing at 5%, and some investors adjust for this by dividing the multiple by the growth rate.
As growth slows, the multiple usually falls, which has caught many investors by surprise. As with other valuation ratios, consistency is vital.
The revenue should be measured over the same period for every company compared, and the enterprise value should be calculated the same way each time.
In practice
Real-world examples
Example 1
An investor compares three subscription software companies. Their multiples are 3 times, 5 times and 9 times revenue, and the 9 times company is growing at 60% a year compared with 15% for the others. The investor decides the premium is explained by growth.
Example 2
A founder of a marketing agency is told that agencies sell for around 1 times revenue. With annual revenue of $4,000,000, she estimates a value of $4,000,000 and then checks this against a profit-based valuation. The two approaches give similar answers, which gives her confidence.
Example 3
A corporate development team is evaluating a loss-making start-up with $10,000,000 of recurring revenue. Because there is no profit to value, the team uses a multiple of 6 times revenue, based on comparable deals, to reach an enterprise value of $60,000,000.
Think of it
EV/Revenue shows what you'd pay for every dollar of sales if you bought the entire company.
Formula
Calculation
Enterprise value to revenue = Enterprise value / Revenue
Suppose a software company has a market capitalisation of $230,000,000, debt of $30,000,000 and cash of $20,000,000, and annual revenue of $60,000,000.
Enterprise value = 230,000,000 + 30,000,000 - 20,000,000 = $240,000,000.
Enterprise value to revenue = 240,000,000 / 60,000,000 = 4.0 times.
If a similar company with the same growth trades at 3 times revenue, the first is priced at a 33% premium, since 4 / 3 = 1.33.Case study
Seen in the real world
Quill Analytics is an illustrative, fictional software company that grew revenue by 50% a year and reported a small loss. Its board saw that rivals traded at 8 times revenue and set an ambition to be valued at $400,000,000 on revenue of $50,000,000.
When a buyer examined the business, it found that growth had slowed to 20% and customers were leaving at a higher rate than expected. The buyer valued it at 4 times revenue, giving an enterprise value of $200,000,000.
The board accepted that the earlier multiples had applied to faster growth, and it focused on lowering customer churn to recover value. The illustrative lesson is that a revenue multiple moves with growth and quality, so a headline multiple should never be borrowed from a different kind of company.
Watch out
Common mistakes
- Ignoring profitability, so that a high-revenue but loss-making business is treated as valuable.
- Comparing multiples for companies with very different growth rates or revenue quality.
- Using market capitalisation rather than enterprise value, which distorts the comparison when debt or cash levels differ.
Questions
People also ask
What is a good enterprise value to revenue multiple?
It depends on growth, margins and sector, with high-margin, fast-growing software often valued at several times revenue and low-margin distribution businesses at less than one times.
Why is the ratio used for loss-making companies?
Revenue is positive even when profit is not, so it allows a valuation comparison when profit-based ratios cannot be calculated.
Is it the same as the price to sales ratio?
They are related, but price to sales uses market capitalisation, while enterprise value to revenue uses enterprise value and so accounts for debt and cash.