Revenue Multiples And Sectorspecific Multiples

While earnings and book value multiples are intuitively appealing and widely used, analysts in recent years have increasingly turned to alternative multiples to value companies. For new economy firms that have negative earnings, multiples of revenues have replaced multiples of earnings in many valuations. In addition, these firms are being valued on multiples of sector-specific measures such as the number of customers, subscribers or even web-site visitors. In this chapter, the reasons for the increased use of revenue multiples are examined first, followed by an analysis of the determinants of these multiples and how best to use them in valuation. This is followed by a short discussion of the sector specific multiples, the dangers associated with their use and the adjustments that might be needed to make them work.

Revenue Multiples

A revenue multiple measures the value of the equity or a business relative to the revenues that it generates. As with other multiples, other things remaining equal, firms that trade at low multiples of revenues are viewed as cheap relative to firms that trade at high multiples of revenues.

Revenue multiples have proved attractive to analysts for a number of reasons. First, unlike earnings and book value ratios, which can become negative for many firms and thus not meaningful, revenue multiples are available even for the most troubled firms and for very young firms. Thus, the potential for bias created by eliminating firms in the sample is far lower. Second, unlike earnings and book value, which are heavily influenced by accounting decisions on depreciation, inventory, R&D, acquisition accounting and extraordinary charges, revenue is relatively difficult to manipulate. Third, revenue multiples are not as volatile as earnings multiples and hence are less likely to be affected by year-to-year swings in firm's fortune. For instance, the price-earnings ratio of a cyclical firm changes much more than its price-sales ratios, because earnings are much more sensitive to economic changes than revenues.

The biggest disadvantage of focusing on revenues is that it can lull you into assigning high values to firms that are generating high revenue growth while losing significant amounts of money. Ultimately, a firm has to generate earnings and cash flows for it to have value. While it is tempting to use price-sales multiples to value firms with negative earnings and book value, the failure to control for differences across firms in costs and profit margins can lead to misleading valuations.

Definition of Revenue Multiple

As noted in the introduction to this section, there are two basic revenue multiples in use. The first, and more popular one, is the multiple of the market value of equity to the revenues of a firm - this is termed the price to sales ratio. The second, and more robust ratio, is the multiple of the value of the firm (including both debt and equity) to revenues - this is the enterprise value to sales ratio.

. , n , „ Market Value of Equity Price to Sales Ratio =--——


„ x . Tr , x „ , _ . Market Value of Equity + Market Value of Debt-Cash


As with the EBITDA multiple, we net cash out of firm value, because the income from cash is not treated as part of revenue. The enterprise value to sales ratio a more robust multiple than the price to sales ratio because it is internally consistent. It divides the total value of the firm by the revenues generated by that firm. The price to sales ratio divides an equity value by revenues that are generated for the firm. Consequently, it will yield lower values for more highly levered firms and may lead to misleading conclusions when price to sales ratios are compared across firms in a sector with different degrees of leverage.

Accounting standards across different sectors and markets are fairly similar when it comes to how revenues are recorded. There have been firms, in recent years though, that have used questionable accounting practices in recording installment sales and intracompany transactions to make their revenues higher. Notwithstanding these problems, revenue multiples suffer far less than other multiples from differences across firms.

Cross Sectional Distribution

As with the price earning ratio, the place to begin the examination of revenue multiples is with the cross sectional distribution of price to sales and value to sales ratios across firms in the United States. Figure 20.1 summarizes this distribution.

Figure 20.1: Revenue Multiples

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