What it means
Enterprise value is the price of the whole business rather than just its shares. It is calculated as the market value of the equity plus total debt minus cash, on the logic that a buyer would inherit the debt and get to keep the cash.
Using enterprise value instead of market capitalisation is what makes the ratio comparable across companies with different funding. Two businesses with identical revenue and identical operations will show very different price-to-sales ratios if one is debt-funded and the other is not, but their EV/Sales figures will be close.
The ratio is most useful where profits are absent, distorted or temporarily depressed. Early-stage software companies, biotechnology firms and businesses in the middle of a heavy investment cycle are all commonly valued this way.
Its weakness is that revenue says nothing about quality. A dollar of subscription revenue at an 80% gross margin is worth far more than a dollar of low-margin distribution revenue, so comparing EV/Sales across different business models is close to meaningless.
In practice the ratio is used relatively rather than absolutely. An analyst finds the multiples paid for comparable companies, applies a suitable one to the target's revenue and works back to an implied equity value.
In practice
Real-world examples.
Example
A venture capital firm assessing a loss-making software business cannot use earnings multiples, so it benchmarks the company at 6 times revenue against recent transactions in the same sector. The valuation debate then shifts to growth rate and gross margin rather than to profit.
Example
A supermarket group trades at 0.4 times sales while a luxury goods company trades at 4 times sales. The difference reflects margin and pricing power rather than any judgement that one management team is better than the other.
Example
An acquirer compares two distribution targets with identical revenue of $90,000,000. One has $40,000,000 of debt and the other none, and using EV/Sales rather than price-to-sales shows immediately that the apparently cheaper company is not cheaper at all.
Formula
Calculation
Enterprise value = Market capitalisation + Total debt - Cash
Enterprise value-to-sales = Enterprise value / Annual revenue
A listed software company has a market capitalisation of $480,000,000, total debt of $120,000,000 and cash of $60,000,000. Its enterprise value is $480,000,000 + $120,000,000 - $60,000,000 = $540,000,000.
Annual revenue is $180,000,000, so the ratio is $540,000,000 / $180,000,000 = 3.0 times.
Now suppose comparable companies trade at 4.5 times sales. Applying that multiple gives an implied enterprise value of $180,000,000 x 4.5 = $810,000,000.
Working back to the shares, implied equity value is $810,000,000 - $120,000,000 + $60,000,000 = $750,000,000. That is $750,000,000 - $480,000,000 = $270,000,000 above the current market capitalisation, an uplift of about 56%, which is the gap an analyst would then have to explain or challenge.Case study
Seen in the real world.
Vantorra Analytics is an illustrative, fictional data business used here to show the ratio in use. It had revenue of $180,000,000, debt of $120,000,000, cash of $60,000,000 and a market capitalisation of $480,000,000, giving an enterprise value of $540,000,000 and an EV/Sales ratio of 3.0 times.
A prospective acquirer noted that three comparable listed businesses traded at an average of 4.5 times sales and argued that Vantorra should be worth $810,000,000 at enterprise level, implying equity of $750,000,000. The board was understandably keen on that argument.
The acquirer's own analysts then pointed out that Vantorra's gross margin was 55% against the comparable group's 78%, and that most of its revenue was project work rather than recurring subscriptions. In this illustrative case the multiple was eventually agreed at 3.6 times, which shows that the ratio starts a valuation conversation rather than settling one.
Watch out
Common mistakes.
- Using market capitalisation instead of enterprise value in the numerator. That produces a price-to-sales ratio, which ignores debt and makes highly geared companies look artificially cheap.
- Comparing the ratio across different business models. A 1.2 times multiple for a wholesaler and a 1.2 times multiple for a subscription software firm carry entirely different meanings.
- Forgetting to subtract cash when calculating enterprise value. A company holding a large cash balance will otherwise look more expensive than it really is.
Questions
People also ask.
Why use revenue instead of profit as the denominator?
Because revenue is available and comparatively hard to distort even when a company is loss-making or its profits are temporarily depressed by investment.
What is considered a high EV/Sales ratio?
Anything above roughly 4 times is high in most sectors, but fast-growing software businesses have traded well into double figures, so the sector benchmark is what matters.
Should the revenue figure be historical or forecast?
Both are used, but the basis must be stated clearly, because a forward multiple on next year's revenue will always look lower than a trailing one.
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