Valuation for a growing or venture firm with a deficit or under capital erosion
Why analysts use PSR?
PSR is the stock price divided by sales. It is a good multiple to apply to a new technology or a venture firm that has grown in sales but are not making profits yet. You can also use it to some specific sectors. In the case of private companies in which the number of subscribers, users, or visitors is important, you can value them by comparing to that number of listed comparable companies.
PSR is attractive as follows.
- First, you can use it to companies that have a loss or have a negative net asset. Those are venture firms, distressed companies, or growth firms that are still in the red.
- Second, profits or net assets are affected by accounting standards such as depreciation, inventory, and R&D expenses. However, sales are relatively less affected. Therefore, PSR is less affected by accounting standards than PER or PBR.
- Third, profits can be volatile, but sales are relatively stable. Thus, PSR can provide relatively flat outcomes while PER can fluctuate every year.
However, PSR could have a big problem in use. Even a company in negative equity or with a steady deficit could show a considerable value when their sales are significant. Therefore, when you use PSR for those companies, you should analyse them thoroughly to see whether those figures could go in the black. If you judge the company to be unable to escape from a deficit or capital impairment, you may need another approach for valuation.
What are the differences between PSR and EVSR?
PSR (Price to Sales Ratio) is the ratio of stock price to sales.
PSR = Market Cap / Sales
You can interpret a PSR multiple in the way of how much investors pay for £1 of sales to buy the one share.
Meanwhile, from the above equation, you can obtain a more robust multiple by using ‘Enterprise value’ in the denominator instead of ‘Equity value’.
EV to Sales Ratio = EVSR = EV / Sales
EV = Market value of equity + Market value of debt – Cash
EVSR refers to total firm value per £1 of sales. In some cases, EVSR multiple could provide a more reliable result that PSR. Suppose there are company A and company B. Their sales are all £100, but A has no debt and £100 of equity in capital, and B has £80 of debt and £20 of equity. Then, A has 1.0 of PSR (£100/£100), and B has 0.2 (£20/£100). When calculating EVSR, both A and B have 1.0. A company with considerable leverage will have a low PSR.
Therefore, when companies within the same sector have a variable level of leverage, comparing PSRs may lead to an incorrect result.
Fundamental factors of PSR and EVSR
Like other relative valuation methods, you can calculate PSR using fundamental factors. Let’s use the dividend discount model to find the factors.
Dividing the last formula above by Sales0, you can get intrinsic or theoretical PSR as shown below.
Intrinsic PSR consists of net margin, dividend rate, growth rate, and risk as fundamental factors. By comparing the intrinsic PSR with the market PSR, you can judge the current stock price undervalued and overvalued.
You can also obtain theoretical EVSR by using fundamental factors.
By dividing both sides by Sales in the above equation, you can get the intrinsic EVSR as follows.
Intrinsic EVSR is determined by the factors of after-tax operating income, reinvestment rate, growth rate, and cost of capital. The primary determinant of PSR and EVSR is margin rate. Net margin is the most important fundamental factor for PSR, and operating margin is for EVSR. The higher the margin, the higher the multiples. In particular, the decrease in margin rate has a double impact on those theoretical values. Not only the margin rate decreases itself, but also the growth rate sequentially diminishes in the long run, which finally lowers the multiple.
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