Understanding the Enterprise Value-to-Sales Ratio

Understanding the Enterprise Value-to-Sales Ratio

Let me explain to you what a company's enterprise value-to-sales (EV/Sales) ratio really means—it's a straightforward way to check if its stock is overpriced or underpriced by pitting its potential takeover value against its recent sales figures.

What Is Enterprise Value-to-Sales (EV/Sales)?

You should know that enterprise value-to-sales (EV/Sales) is simply a ratio comparing a company's enterprise value (EV) to its annual sales. In essence, it measures the company's potential takeover price against its total sales for the year.

This EV/Sales multiple is one tool I use to figure out if a company's stock is overvalued or undervalued. If the multiple is low, it suggests the stock might be cheaper than the company's financial performance warrants.

Key Takeaways

Enterprise value represents what a company might be worth if bought outright, factoring in its equity and debt. The EV/Sales ratio directly compares this potential value to the company's actual annual sales total. Typically, this ratio falls between 1x and 3x, and a lower number points to the possibility that the market is undervaluing the company's stock.

The Formula for Enterprise Value-to-Sales

Here's the basic formula you need: EV/Sales = (MC + D - CC) / Annual Sales, where MC is market capitalization, D is debt, and CC is cash and cash equivalents.

How to Calculate Enterprise Value-to-Sales

To calculate it, start by adding the company's total debt to its market cap, then subtract cash and cash equivalents, and finally divide that result by the annual sales.

Sometimes I use a more detailed version of enterprise value that includes a few extra variables: EV = MC + D + PS + MI - CC, where PS is preferred shares and MI is minority interest.

What Does Enterprise Value-to-Sales Tell You?

This metric builds on the price-to-sales (P/S) valuation, which just uses market capitalization, but EV/Sales is more accurate because it factors in debt—something market cap alone ignores.

You'll usually see EV-to-sales multiples between 1x and 3x. A lower multiple suggests the company might be undervalued and more attractive. It can even go negative if the company's cash exceeds its market cap and debt, meaning you could theoretically buy it with its own money.

But don't be fooled—a high multiple isn't always bad; it could mean investors expect big sales growth ahead. A low one might indicate poor future prospects. To get the full picture, compare it to other companies in the same industry and dig deeper into the specifics of the company you're looking at.

Example of How to Use Enterprise Value-to-Sales

Take a company with $70 million in annual sales, $10 million in short-term liabilities, $25 million in long-term liabilities, $90 million in assets (20% of which is cash), and 5 million shares outstanding at $25 each. First, calculate EV: Market Cap is 5 million shares times $25, which is $125 million; add total debt of $35 million; subtract cash of $18 million (20% of $90 million); that gives EV of $142 million.

Then, EV/Sales is $142 million divided by $70 million, equaling 2.03.

For a real-world case, consider Coca-Cola as of December 31, 2019: market cap $237 billion, total debt $42.8 billion, cash $6.5 billion, and trailing 12-month sales $37.2 billion. EV is $237 billion + $42.8 billion - $6.5 billion = $273.3 billion, so EV/Sales is $273.3 billion / $37.2 billion = 7.3x.

Enterprise Value-to-Sales vs. Price-to-Sales

The key difference is that EV-to-sales includes a company's debt and cash in the equation, while price-to-sales only uses market cap as the numerator and ignores those. Price-to-sales is faster to compute, but since debtholders have claims on sales, they should be part of the valuation.

Limitations of Using Enterprise Value-to-Sales

One downside is that calculating EV requires more effort, as you have to pull data from financial statements. It's mainly for acquisition scenarios where the buyer takes on debt but gets the cash. Also, remember that sales figures don't account for expenses or taxes, so this ratio has its blind spots.