Most new-age stocks are struggling in an environment of rising inflation and interest rates. In recent times, backed by bright future expectations, these stocks were being priced aggressively, especially when viewed on traditional valuation metrics. Most of these companies are making losses even at the operating level. Not surprisingly, price-to-sales (P/S) is the most commonly used valuation metric to evaluate them.
P/S multiple shrinkage is evident but new age companies are still enjoying meaningful premiums. For example, today, Zomato is trading at a P/S of around 22.6x versus 34x in September 2021. To provide some context, the P/S of Mindtree and ABB (comparable market capitalization) is 5.1x and 6.8x. Stocks with high P/S multiplier are mostly found in sectors like technology and allied sectors, clean energy, new age retail, etc.
So, what are the fundamental drivers of P/S? Also, why are stocks with higher P/S ratios falling more than other stocks? Here are some of the key factors that cause the difference in P/S multiples between stocks.
GrowthBased on the Corporate Valuation, DCF, or Discounted Cash Flow method, the higher a company’s revenue growth, the greater the value of its future cashflows. In turn, this means a higher P/S multiplier. 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 forecast with reasonable confidence into the future, clearly attracts healthy valuations. Tata Steel has registered a Revenue Compounded Annual Growth Rate (CAGR) of 16% over the last five years, which is 10% for TCS, but is still achieving a modest P/S of 0.6x versus 6.6x for TCS . This can, to an extent, be explained by the cyclicality and hence the low predictability of Tata Steel’s revenue.
Revenue and quality of growth This can be inferred from the following things.
Competitive Advantage: A company must have somewhere to offer its products and services consistently at a price at which it generates a healthy return ratio. This edge can be in the form of a strong and difficult-to-replicate distribution channel, cost advantage, or brand strength.
network effect: As the network of consumers grows, this effect is beautifully manifested. These products or services do not require much incremental cost once the research, development and initial marketing costs are incurred. The network effect ensures that competing products/services, even if more superior, are not able to meet the challenge. Microsoft’s operating system in the 1980s and Facebook in the 2010s are well-known examples. Neither of the firms was the original innovator nor were they providing best-in-class user experiences. However, critics, disgruntled users, and fans of competing services were also increasingly disseminated to using Microsoft’s operating system and Facebook’s social media platform, influenced by the network effect.
Customers’ Viscosity: Revenue with semi-annual characteristics attracts better P/S multiples. If customers for some reason — technical, logistics, cost — don’t easily pass into competition, a company’s intrinsic value can be high even with relatively flat growth.
On the other hand, high customer churn increases the cost of revenue (since customer acquisition costs have to be reinvested), thus hurting the intrinsic value of the company.
entry barrier: If others can start similar business and offer similar products and services at the same price point, that firm will dent its growth, profitability and return ratio. That’s why barriers to entry play an important role in the valuation of a company.
asset turnover: A company that is efficient at generating revenue from its assets commands a high P/S. It is a measure of a company’s capital intensity and is one of the fundamental reasons why Bharti Airtel is getting a P/S multiplier 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, in addition to asset turnover, is a basic indicator of a company’s return ratio. EBITDA margin indicates that portion of revenue that goes to free cashflow, the building blocks of a company’s intrinsic value.
As can be seen, typically high P/S companies derive a large portion of their intrinsic value from projected cash flows in the future. Now, the cost of capital at which these cash flows are discounted is rising with rising policy interest rates. As a result, the intrinsic values of these companies are generally showing a sharp decline in comparison to companies with lower P/S.
Vipul Prasad, Founder and CEO, Magadh Capital LLP.