Definition

Enterprise Value to Sales is a measure that helps value a company, taking into consideration both the equity and the debt. 

EV/Sales= (Current Market Cap + Debt + Minority Interest + preferred shares – cash)/Annual Net Sales

The ratio can be negative if the Cash portion is greater than the rest of the items in the numerator. 

How to interpret it?

A lower multiple indicates that the company may be undervalued (and vice-versa). Similarly, the higher the ratio the more ‘expensive’ the company is to purchase. Cautionary note here is that a higher multiple may not always signal overvaluation. It may sometimes reflect investor optimism for higher future sales. 

Some major industry multiples include:

• Media: 1.6x 
• Chemicals: 1.9x
• Healthcare: 3.5x

(Source)

It can be used for:

• Financial analysis for an investment opportunity
• Valuation of a company
• When there are significant accounting differences between two companies 
• For negative cash-flow or unprofitable companies
• To identify restructuring potential

Limitations:

EV/Sales is a good metric for analysis. However, it should be used in conjunction with other ratios to get the complete picture of a company’s financial health. 

So why does the choice of multiples differ across industries?

Companies in different industries have fundamentally different business models (both operationally and financially). A manufacturing firm may have a lean operating margin while a software/tech firm might be the complete opposite. Hence using a single multiple say focused on using top-line revenue may not paint an accurate picture for both sectors. 

Another factor here is the difference in growth rate across sectors. Given the boom in the IT sector, it is hardly fair for a company there to be valued like a company in the say real estate sector whose prospects look bleak. 

There can be differences even within a sector. In the retail/apparels department, the difference in the performance of the traditional brick and mortar stores vis-a-vis an e-commerce store is evidence of the same. 

When to use which multiple?

There are a plethora of multiples available – some use earnings while some use revenue, some use past data while others are more forward-looking. It thus becomes imperative to use the correct multiple as it can have a huge effect on the final action. 

Reputed finance professor Aswath Damodaran gave us three possible ways one can go about identifying the correct multiple: 

1. The Cynical View

This is the method that uses the most convenient multiple – one that helps us best sell our story and can be thought of as borderline manipulation. For example, if you’re looking to sell a company you choose the multiple that gives the highest value (and vice versa) 

2. The Bludgeon View 

Here you can use as many multiples as you like and then come up with a value based on your findings. The final value can be a range (maximum and minimum), an average or a weighted average. 

3. The Best Multiple 

This method requires one to analyze each multiple before choosing the best one. Here we can  take the help of a multiple most associated with the industry in question. The table below summarizes the most used multiples for some key sectors.

(Source)

The multiple you use also depends a lot on the purpose of doing the valuation in the first place.

If you are an investor looking to hold a minor stake in a company, equity multiples are preferred like P/E ratio, Price to Book ratio, Price/Sales and dividend yield. 

For M&A purposes Enterprise multiples are preferred like EV/Sales and EV/EBITDA.

Conclusion:

The idea behind the multiples approach is that the value of one firm can be used to determine the relative value of another firm, given that the two are comparable. A multiple aims to capture various aspects of a firm’s operating and financial performance and thus becomes an indicator of whether or not the firm is investable. 

An important point to note here is that these ratios do not tell much in isolation. For the analysis to hold some value, they need to be compared to other ratios for similar firms (usually using a statistical measure like the mean or median). This element of comparison is why this method of valuation is also often known as the Comparable Company Analysis. 

Check out this article on EV/EBITDA to know about the valuation ratios.