Session 18: Revenue Multiples

Introduction to Revenue Multiples

In this session, the focus is on revenue multiples and how they are used in valuation. The speaker explains that revenues are relatively immune from accounting judgments and discretionary calls, making them a useful item to consider when valuing companies.

Revenue Multiples

• There are two variants of revenue multiples: price-to-sales ratio (market value of equity divided by total revenues) and enterprise value multiple (enterprise value divided by total revenues).

• Companies with high margins will trade at high multiples of revenues, while those with low margins will not.

• Price-to-sales ratio is the most widely used revenue multiple, but it violates consistency principles since the numerator is market value of equity while revenues belong to the entire firm.

• A more consistent version of a revenue multiple can be created by replacing market value of equity with enterprise value (market value of equity plus debt minus cash).

• Revenue multiples vary widely across sectors, making any rule-of-thumb based on them unreliable.

• The price-to-sales ratio is a quasi-equity multiple. A stable growth dividend discount model can be used to derive an equation for the price-to-sales ratio. This equation shows that net profit margin is a key driver of price-to-sales ratios.

• Companies with high net profit margins tend to trade at high price-to-sales ratios, while those with no net profit margins will trade at low ratios.

Distribution of Revenue Multiples

• The distribution of revenue multiples is much less peaked than that of earnings or book value multiples.

• Any rule-of-thumb based on revenue multiples should take into account their wide variation across sectors.

Drivers of Price-to-Sales Ratios

• Net profit margin is a key driver of price-to-sales ratios. Companies with high margins will trade at higher multiples than those with low margins.

• A drop in net profit margin will lead to an immediate drop in the price-to-sales ratio, as well as a longer-term impact on return on equity and growth rate.

Understanding Enterprise Value to Sales Ratio

In this section, the speaker explains the four variables that drive enterprise value to sales ratio and how it differs from price to sales ratio.

Four Variables that Drive Enterprise Value to Sales Ratio

• The four variables that drive enterprise value to sales ratio are cost of capital, expected growth rate, reinvestment rate, and operating margin effect.

• The companion variable for enterprise value to sales ratio is pre-tax or after-tax operating margin.

• Companies with high after-tax operating margins like Coca-Cola tend to have high enterprise value to sales ratios.

Importance of Margins in Valuation

• High margins can lead to a high return on capital and growth rate, resulting in a higher enterprise value to sales ratio.

• However, if margins come under assault, the enterprise value to sales ratio can melt down disproportionately.

Brand Name Valuation

• A brand name allows companies to charge a higher price for the same product and gives them pricing power.

• To estimate brand name value, one can compare a company's existing margin with its estimated margin without the brand name. The difference between these two values is the brand name premium.

• It's easier to apply this method for companies like Coca-Cola where brand names are the primary reason for higher prices compared to generic products.

Importance of Accounting Earnings

In this section, the speaker emphasizes the importance of accounting earnings in determining margins and multiples.

Accounting Earnings are Essential

• Trust accountants to provide accurate accounting numbers.

• Margins and multiples depend on accounting earnings.

• There is no way around the fact that accountants must do their job fairly.