The EV/Revenue ratio highlights the Enterprise Value of a company in comparison with its revenue. This is a more comprehensive valuation metric than the popular Price/Sales ratio since the former includes market capitalization, debt and cash equivalents as well in the calculation.
What is Enterprise Value?
The total valuation of a company is demonstrated by Enterprise Value, which is deemed as a far better alternative to market capitalization. As the value of market capitalization is computed by adding more components to it that are essential, the value calculated as Enterprise Value is a bit more comprehensive..
The components used in the calculation of Enterprise Value are debt, preferred interest, minority interest, and combined money and cash equivalents. The values of debt, minority interest, and preferred interest are used with market capitalization value. At the same time, to get the enterprise value, the overall cash and cash equivalents are subtracted from the calculated value (EV).
Enterprise Value is calculated as:
Enterprise Value = Market Capitalization + Preference Shares + Total Debt – Cash & Cash Equivalents
If not readily available, the number of outstanding shares is multiplied by the existing stock price to determine the market capitalization. Then, it is necessary to calculate the total debt by incorporating both short and long-term debt from the company’s balance sheet. Finally, the total debt and market capitalization shall be combined with all cash and cash equivalents of the outcome and shall be deducted.
What is Revenue?
Revenue refers to the cash inflows from regular business activities, which includes returned sales discounts and deductions. Net profits are known as the top line as its figure appears on a company’s income statement first and are calculated by subtracting expenses from the gross revenue figure.
Revenue is additionally referred to as sales on the earnings report..
Depending on the accounting system used, there are numerous ways to measure revenue. Revenue made on credit for products or services supplied to the client is included in accrual accounting. To determine how effectively a business collects money owed, it is essential to review the cash flow statement. On the other hand, cash accounting considers only those transactions when cash is received or paid. Cash earned by a company is referred to as a “receipt”. It is possible to earn receipts without generating actual revenue within a certain period. For example, when the consumer pays for a service not yet provided or undelivered products in advance, this action results in a receipt but not revenue.
When revenue surpasses expenses, there is a profit. To assess the health of a corporation, investors also consider the revenue and net income of a company separately. Revenue is calculated as follows:
Revenue = No. of Units Sold * Average Selling Price
Depending on the business, the revenue formula may be simple or complicated. Product sales are calculated by considering the average price at which the goods are sold and multiplying it by the total number of products sold. Service companies calculate the value of all service contracts, or the number of consumers multiplied by the typical price of services.
What is the EV/Revenue Ratio?
The Enterprise Value to Revenue Multiple is a valuation metric used to value a business by dividing its corporate value (equity plus debt minus cash) by its annual revenue. This multiple is commonly used for early-stage or high-growth businesses that do not yet have positive earnings. The Enterprise Value-to-Revenue multiple (EV/R) may measure the worth of a stock that compares a company’s enterprise value to its revenue. EV/R is one among several fundamental indicators that investors use to determine whether a stock is priced fairly. The acquirer shall use the EV/R multiple to determine an appropriate fair value. The value of the enterprise is used because it adds debt and takes out cash that the acquirer would take on and receive. The EV/R Multiple is also often used to determine a company’s valuation within the case of a possible acquisition. It’s also called the enterprise value-to-revenue multiple. It can also be used for companies that don’t generate income or profits.
It is calculated as:
EV/Revenue =Enterprise Value/Revenue, where:
Enterprise Value = Market capitalization + Debt – Cash and cash equivalents
Revenue = Total Annual Revenue
EV/Revenue Calculation example:
To demonstrate, we can use the above formula to measure the enterprise value of Apple (AAPL) against
As of 1 January, 2021, Apple’s enterprise value was $2,248,899 Million.
Apple’s revenue for the trailing twelve months (TTM) ended in Sep. 2020 was $274,515 Million.
Therefore, Apple’s EV-to-Revenue on 1/1/21 is $2,248,899 Million / $274,515 Million. = 8.19.
Why use the EV/Revenue Ratio?
Suppose a company does not have positive Earnings Before Interest Taxes Depreciation & Amortization (EBITDA) or positive Net Income. In that case, it is not possible to use EV/EBITDA or P/E ratios for valuing the business. In this case, the financial analyst will have to move up the income statement either to gross profit or all the way up to revenue. If EBITDA is negative, it is not useful to have a negative EV/EBITDA multiple. Similarly, a company with a barely positive EBITDA (nearly zero) will result in a massive multiple, which is not very useful either. For these reasons, early-stage companies (often operating at a loss) and high-growth companies (often operating at breakeven) require an EV/Revenue multiple for valuation.
Advantages of using EV/Revenue Ratio:
- It is often beneficial when there are significant differences between the accounting policies of companies. PE ratio, on the opposite hand, can vary dramatically with changes in accounting policies.
- It is often used for companies with negative free cash flows or unprofitable companies. Most of the web e-commerce start-ups (running unprofitably) like Flipkart, Uber, Godaddy, etc., are often valued using EV/Revenue.
- EV/Revenue is often useful for identifying the restructuring potential of a company.
- Useful for businesses with an EBITDA negative or near zero
- It is easy to find revenue data for most businesses making it easy to calculate this ratio.
Disadvantages of using the EV/Revenue Ratio
- EV to Revenue is extremely difficult to game from an accounting point of view. Though it’s a valid measure, it does not provide us with great insights on what proportion of the revenue covers the cost of revenue.
- Does not take into account the cost structure of the company (The Cost structure refers to different types of expenses that a company incurs and is typically composed of fixed and variable costs).
- Ignores profitability and generation of cash flow.
- Hard to compare across different industries and different company phases (early vs mature).
- The results may be difficult to interpret.
- It is not recommended that investors depend on a single investment ratio. Investors should look at different ratios to come up with concrete information before investing their money in any investment.
What is considered a good EV/Revenue Ratio?
EV-to-Revenue multiples are typically considered healthy when between 1x and 3x.
- If this ratio is higher, then it’s considered that the stocks are over-valued, and it’s not profitable for investors to invest in the company. Investors are most likely to not get any returns from this investment.
- If this ratio is lower, then it’s considered to be an excellent investment opportunity for investors, as a lower EV / Revenue is perceived as undervalued. If investors invest in such investment options, they might get good benefits out of it. The lower the ratio, the better it is.
Although the EV/Revenue multiple has its drawbacks, it’s still one of the simplest multiples for valuation purposes. It offers some extent of reference and a sign of whether or not the worth set on the block is fair. During the process of Mergers & Acquisition, it 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.