In previous blog post, we learnt what is Enterprise Value (EV), EV-to-EBITDA ratio and how it is used by investors who want to compare two companies in same sector.
Today, we’ll learn what is a comparative ratio, various comparative ratios using EV and their purpose.
What is a comparative ratio?
Value investors study the financial statements of competing companies before making any decision as to whether and to what extent they would want to invest in any of them. Apart from assessing reasonability of stock-value, they also check the company’s relevant sector updates, corporate communications issued by the company, minutes of Board meetings, and financial data in order to determine the stock value compared to its peers.
A comparative ratio is a metric that companies’ top management, technical analysts and investors use to compare the company’s performance in terms of sale, equity, etc. With ratios one can examine in-depth efficiency of various aspects of the company’s performance such as revenue earning, profitability, productivity, financial standing, and so on.
EV to Revenue ratio:
EV to Revenue ratio = Enterprise Value ÷ Total Annual Revenue
The EV to Revenue ratio is the valuation metric used to value a company by dividing its Enterprise Value by company’s Total Annual Revenue. This ratio is used either for early-stage businesses or for “high revenue – high growth” businesses that haven’t yet accounted for any positive earnings.
Why Use the EV to Revenue ratio?
If a company doesn’t have positive Earnings Before Interest Taxes Depreciation & Amortization (EBITDA) or positive Net Income, then we cannot use EV-to-EBITDA ratio or P/E ratio to value the business. In such cases, we have to use a ratio involving revenue from the income statement.
If EBITDA in the denominator is negative, then having a negative EV-to-EBITDA multiple is not useful. Similarly, a company with a barely positive EBITDA (almost zero) will result in a large amount multiple, which isn’t very useful or realistic either.
For such reasons, early-stage companies (often operating at loss) and high-growth companies (often operating at breakeven) require an EV-to-Revenue ratio for valuation.
EV to Sales ratio:
EV to Sales ratio = Enterprise Value ÷ Annual Net Sales
In certain scenarios, we are unable to apply valuation multiples like PE ratio due to negative earnings, or we cannot apply EV-to-EBITDA if EBITDA is negative. In such cases, EV divided by Annual Net Sales is the valuation metric used to find out the company’s total value (EV) compared to its Annual Net Sales. Even though this value is below 10, the investors have to decide whether that value is higher or lower depending on the industry or sector that the company belongs to.
EV to Equity ratio:
EV to Equity ratio = Enterprise Value ÷ Equity Share Capital at market value
This valuation metric is used to determine the total value (EV) of the company compared to its Equity Share Capital. EV gives an accurate current value of the enterprise; whereas Equity Value offers both current and estimated future value of the company.
The market value of Equity Share Capital is not same as book-value of Equity Share Capital. Book-value of equity is all about owned assets and owed liabilities whereas market value of equity considers the company’s growth potential beyond its current Balance Sheet.
Equity value is calculated by multiplying a company’s share price by outstanding shares and that’s the value we need to apply in this ratio; and not the book-value which is the difference between company’s assets and liabilities.
For healthy companies, equity value far exceeds its book-value as the market value of the company’s shares appreciates in the long term. Equity value can never be negative. Book-value can be positive, negative, or zero.
EV to Capital Employed ratio:
EV to Capital Employed ratio = EV ÷ Capital Employed
This metric determines the total value (EV) of the company compared to Capital Employed.
Capital Employed is the total amount of capital invested. When we subtract Current Liabilities from Total Assets, or add Fixed Assets to Working Capital, we get total Capital invested (Employed).
EV to Free Cash Flow ratio:
EV to Free Cash Flow ratio = EV ÷ Free Cash Flow
The total value (EV) of the company compared to its ability to generate Free Cash Flow. The lower the output of this ratio, faster the company can generate cash for reinvestment and repay its cost of acquisition.
Being a theoretical figure, Free Cash Flow is the cash flow available to all equity holders and debtholders, after making payments for all Operating expenses, Capital expenditures, and Investments in Working Capital, etc.
Thus, in today’s blog post, we have learnt how various ratios using Enterprise Value help investors examine the company’s financial standing.
Do let us know in the comments section your queries, if any, or any new relevant topic(s) that you would like to have better understanding about.