EV/Sales and its Importance

A Ratio (“EV/Sales multiple”) which compares the enterprise value of a company to the company's sales. EV/sales gives investors an idea of how much it costs to buy the company's sales. This measure is an expansion of the price-to-sales valuation (P/E ratio), which uses market capitalization instead of enterprise value. EV/sales is seen as more accurate because market capitalization does not take into account the amount of debt a company has, which needs to be paid back at some point. Generally the lower the EV/sales the more attractive or undervalued the company is believed to be.

EV/Sales = (Market Cap + Debt + Minority Interest + Preferred Shares - Cash and Cash Equivalents)/Annual Sales

The EV/sales measure can be negative when the cash in the company is more than the market capitalization and debt structure, signaling that the company can essentially be bought with its own cash.
The EV/sales measure can be slightly deceiving: a high EV/Sales is not always a bad thing as it can be a sign that investors believe the future sales will greatly increase. A lower EV/sales can signal that the future sales prospects are not very attractive. It is important to compare the measure to that of other companies in the industry (i.e. the peer groups), and to look deeper into the company you are analyzing.

Importance of EV/Sales in Mergers and Acquisitions:

In a M&A deal the seller will always try his best to value the company at as high of a price as possible, while the buyer will try to get the lowest price that he can.  To work a sort of a compromise between the two there are
many legitimate ways to value companies. The most common method is to look at comparable companies in an industry using comparative ratios: 

The following are two examples of the many comparative metrics on which acquiring companies may base their offers:

•  Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be. 
• Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the PIE ratio of other companies in the industry. 

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