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What do revenue based valuation multiples really tell us?

08/12/2015

In the absence of profits, revenue based valuation multiples such as price/sales or EV/sales are widely used in the VC world. Redpoint VC Mahesh Vellanki’s blog post on e-commerce sales-multiple valuations caught the attention of several other start-up bloggers and news sites. We thought we’d cast an equity analyst eye over the data he uses for a basket of listed ecommerce stocks and test his assertion that they aren’t worth very much, given that on an earnings basis, their PE multiples look pretty high. Bottom line for executives looking at your company’s valuation: sales multiples are a very coarse valuation tool. If you can argue a good case for a future level of profitability and capital requirements, that will give you a much better likely valuation of your business.

The EV/Sales rule-of-thumb

Back when I worked at BofA Merrill Lynch, our investor clients frequently used an EV (enterprise value)/sales “rule of thumb” to value loss-making companies coming out of a period of restructuring. This was in 2009 when Alcatel-Lucent, a perennial loss-maker, was restructuring. It was valued at about 0.1x EV/Sales. The rule-of-thumb was that a mature stock should trade at an EV/sales of its EBIT margin percentage, divided by 10. So if EBIT margin was expected to be 5%, it should trade at 0.5x EV/Sales, if it was expected to be 10%, then 1x EV/Sales (there is method in this madness, see footnote for the theory behind this). We thought the company could achieve at least 3% EBIT margins, and so it looked seriously undervalued.
What does this have to do with the fast growth VC funded world where sales multiples frequently exceed 10x? Well, it explains the apparently low multiples in the ecommerce sector.

Listed companies do appear to support the rule

The linear relationship between profitability and EV/sales ratios is born out in the real world. The chart below shows EV/Sales mapped against EBITDA margins for the FinTech payments sector. You can see how well stocks line up. EV/Sales is simply a proxy for profitability, it doesn’t tell you anything about whether the company is expensive or not, unless you adjust for profitability – you could do this using the chart below but a simpler way is to just look at price-earnings multiple.
 FinTech ev-s and profitability Dec 2015
We took Mahesh’s commerce basket, added ASOS and eBay which we thought were worth including, and as with the FinTech sector, plotted sales multiple against forecast profitability. The ecommerce world shows far less correlation between sales-multiple and profitability.
 ecommerce ev-s and profitability Dec 2015The dispersion is driven by the fact that these companies may still be showing much higher levels of growth and their profitability is yet to settle (some still growing, some shrinking post-growth). A business valued at 10x sales that is doubling revenue every year will be on 1x sales within a little over three years. This likely explains those stocks with EV/Sales multiples in the upper left quadrant of the chart. Rising (or falling) profit margins can also explain why stocks would track away from the usual trend line. Or they could simply be wrongly valued by the market.
Stock market investors love these more dispersed sectors as there is more opportunity to spot a mis-priced stock.

Low profit margin can still mean high return on capital

Ecommerce stocks trade at lower EV/sales multiples but we would suggest this does not mean they are cheaply valued. The low multiple is because they are lower margin. This isn’t necessarily a bad thing – if you are buying and selling physical goods, you will have additional costs that aren’t present in pure digital businesses (like marketplaces eBay and Etsy, and coupons companies RetailMeNot and Quotient). But as long as you get high volume, you will still achieve high dollar profits.
German eCommerce business Zalando was one of the fastest companies to reach $1bn of revenue – that is a much more impressive achievement than reaching a $1bn valuation.
Looking at profitability alone also misses an important investment consideration,  what return the business is generating from invested capital. UK ecommerce retailer ASOS has higher accounts payable to suppliers than it has inventory of goods. So it has “negative working capital”. Despite the term “negative”, this is a good thing for cash flow – it means that it uses later payment of suppliers to fund its business. ASOS’s after tax return on capital employed is about 30%.
So, these may be low margin stocks but they are often high return on capital, and not actually lowly valued, and we can see this by looking at the price-earnings (PE) multiples of those companies.
 ecommerce PE ratios Dec 2015As the chart shows, all the stocks are trading at or above the PE multiple of European stock markets.  Amazon’s lack of earnings and focus on growth has long been discussed (see Ben Evan’s blog link below) and explains the eye watering PE multiple.
Relevant Links:
Mahesh VC blog – here’s why ecommerce companies aren’t worth very much
TheEquityKicker – forecasting ecommerce multiples at exit
Ben Evans – Why Amazon has no profits (and why it works)

Appendix – the maths behind the rule-of-thumb

ev-s rule of thumb
Andrew Griffin spent almost two decades as a technology equity analyst before working in investor relations, corporate development and market intelligence for a UK listed software company. In 2015 he set up Oakhall to provide smart financial analysis and articulation for European public and private companies.