Oracle Corporation (NYSE: ORCL) shares currently trade at 4.5x its trailing revenue which is higher than the Information Technology sector median of 2.2x. While this makes ORCL look like a stock to avoid or sell if you own it, equity investors might change their mind after taking a closer look at the assumptions behind the EV / Sales ratio. In this article, I define how to calculate a Sales Multiple and what to keep an eye out for when applying it in a comparable companies analysis.
Oracle Comparable Companies Analysis
A comparable companies analysis, also known as a multiples valuation, determines the value of a subject company by benchmarking its financial performance against similar public companies or peers. We can conclude if a company looks undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation ratios.
Enterprise Value-to-Revenue Multiple, also known as the EV / Sales ratio or a Sales Multiple, measures the dollars in Enterprise Value for each dollar of revenue. To determine if a company is expensive, it’s far more useful to compare EV / Sales multiples than the absolute stock price. The general formula behind a Sales Multiples valuation model is the following:
Enterprise Value = Revenue x Selected Multiple
The EV / Sales ratio by itself is not very helpful at all. It is only useful when comparing it to other companies that are considered similar to the subject company. The basic idea is that companies with similar characteristics should trade at similar multiples, all other things being equal. Therefore, we can come to a conclusion about the stock if the ratios are different. In the chart below, I compare Oracle’s EV / Sales ratio to its peer group that includes Salesforce.com Inc (NYSE: CRM), SAP SE (NYSE: SAP), Vmware, Inc. (NYSE: VMW) and Red Hat, Inc. (NYSE: RHT).
Since Oracle’s sales multiple of 4.5x is lower than the median of its peers (7.2x), it means that investors are paying less than they should for each dollar of ORCL’s revenue. As such, our analysis shows that ORCL represents an undervalued stock. In fact, finbox.io’s Sales Multiples Model calculates a fair value of $66.53 per share which implies 45.7% upside.
I selected a fair multiple of 6.7x in my analysis by averaging Oracle’s current EV / Sales ratio with its peer group.
Are Comps Really Comparable?
Before concluding that Oracle should be added to your portfolio, it is important to understand that our conclusion rests on two important assumptions.
(1) the selected peer group actually contains companies that truly are similar to Oracle, and
(2) the selected peer group stocks are being fairly valued by the market.
If the first assumption is not accurate, the difference in sales multiples could be due to a variety of factors. For example, if you accidentally compare Oracle with higher growth companies, then its sales multiple would naturally be lower than its peers since investors reward high growth stocks with a higher price. It’s also important to note that EV / Sales ratios are highly correlated with profit margins so differences in EBITDA margin often explain differences in valuation.
source: sales multiples model
Now if the second assumption does not hold true, Oracle’s lower multiple may be because firms in our peer group are being overvalued by the market.
How This Impacts Shareholders
As a shareholder, you may have already conducted fundamental analysis on the stock so its current undervaluation could signal a potential buying opportunity to increase your position in ORCL. However, keep in mind the limitations of a sales multiples valuation when making an investment decision. There are a variety of other fundamental factors that I have not taken into consideration in this article. If you have not done so already, I highly recommend that you complete your research on Oracle by taking a look at the following:
Valuation Metrics: what is Oracle’s EBITDA less CapEx multiple and how does it compare to its peers? This is a helpful multiple to analyze when comparing capital intensive businesses. View the company’s EBITDA less CapEx multiple here.
Risk Metrics: what is Oracle’s asset efficiency? This ratio measures the amount of cash flow that a company generates from its assets. View the company’s asset efficiency here.
Efficiency Metrics: is management becoming more or less efficient in creating value for the firm? Find out by analyzing the company’s return on invested capital ratio here.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.