Why Do Different Stocks Have Different Price-to-sales Multiples?

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In an environment of rising inflation and interest rates, most new-age stocks are struggling. In recent times, backed by expectations of a bright future, these stocks were being priced aggressively, especially when seen on traditional valuation metrics. Most of these companies are loss-making even at the operating level. Not surprisingly, price-to-sales (P/S) is the most commonly used valuation metric to evaluate them. 

The P/S multiple shrinkage has been conspicuous but new-age companies are still enjoying a meaningful premium. For example, today, Zomato is trading at P/S of about 22.6x versus 34x in September 2021. To provide some context, Mindtree and ABB (comparable market capitalization) have P/S of 5.1x and 6.8x. Stocks with high P/S multiples are found mostly in sectors like technology and allied sectors, clean energy, new-age retail, etc. 

So, what are the fundamental drivers of P/S? Further, why are stock with high P/S ratio falling more than other stocks? Here are some key factors that drive differentiation on P/S multiples amongst stocks. 

Growth– As per the bedrock of corporate valuation, DCF, or discounted cash flow methodology, the higher a company’s revenue growth, the higher the value of its future cashflows. In turn, this implies a higher P/S multiple. Many new-age companies like Paytm, Nykaa, Zomato, etc. fall in the high growth category. 

Long and predictable runway– A company whose revenues can be forecasted with reasonable confidence far into the future understandably attracts healthy valuations. Tata Steel has registered a revenue compound annual growth rate (CAGR) of 16%, versus 10% for TCS, in the last five years but is still getting a paltry P/S of 0.6x vs 6.6x for TCS. This, to an extent, can be explained by the cyclicality and hence the lower predictability of Tata Steel’s revenues. 

Quality of revenues and growth – This can be gauged from the following.

Competitive advantages: A company must have an edge somewhere in order to consistently offer its products and services at a price at which it makes healthy return ratios. This edge can be in the form of a strong and difficult-to-replicate distribution channel, cost advantage, or brand strength.

Network effect: This effect kicks in beautifully as a network of consumers grows. These products or services do not require much incremental cost once research, development, and initial marketing costs have been incurred. Network effect ensures that competing products/services, even though more superior, are not able to mount a challenge. Microsoft’s operating system in the 1980s and Facebook in the 2010s are famous examples. None of the two firms were original innovators nor were they providing the best-in-class user experience. However, nudged by the network effect even critics, dissatisfied users, and fans of competitive services were increasingly channelled into using Microsoft’s operating systems and Facebook’s social media platform. 

Stickiness of customers: Revenue with quasi-annuity characteristics does attract better P/S multiples. If customers for some reason — technical, logistics, cost — do not switch to competition easily, the intrinsic value of the company can be high even with a relatively flattish growth.

 On the other hand, high customer churn bumps up the cost of revenues (since subscriber acquisition cost has to be incurred again), thus hurting the company’s intrinsic value. 

Entry barriers: If others can start the same business and offer the same products and services at the same price point as the incumbent, then that firm will witness a dent in its growth, profitability, and return ratios. That’s why entry barriers play an important role in the evaluation of a company. 

Asset turnover:  A company that is efficient at generating revenues out of its assets, commands high P/S. This is a measure of the company’s capital intensity and is one of the fundamental reasons why Bharti Airtel is getting a P/S multiple of 3.8x while HUL enjoys a P/S of 9.7x. Bharti Airtel has an asset turnover ratio of 0.3x versus HUL’s 1.2x.

EBITDA Margin: This factor, apart from asset turnover, is a basic indicator of a company’s return ratios. EBITDA margin indicates the part of the revenue that goes into free cashflows, the building blocks of a company’s intrinsic value. 

As can be seen, typically high P/S companies get a large chunk of their intrinsic value from cashflows predicted far out into the future. Now, the cost of capital at which these cashflows are discounted are mounting with rising policy interest rates. As a result, these companies are witnessing a sharper erosion in their intrinsic values versus companies with lower P/S in general.

Vipul Prasad, founder & CEO at Magadh Capital LLP.

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