Tempted To Buy NetEase Inc (NASDAQ: NTES) At Its Current EV / Sales Ratio?

in VALUATION MULTIPLES by

NetEase Inc (NASDAQ: NTES) trades at a Sales Multiple of 3.7x, which is higher than the Information Technology sector median of 2.2x. While this makes NTES appear like a stock to avoid or sell if you own it, you might change your mind after gaining a better understanding of the assumptions behind the EV / Sales ratio. In this article, I will break down what a Sales Multiple is, how to interpret it and what to watch out for.


Understanding Valuation Multiples and EV / Sales

A multiples valuation, also known as a comparable companies analysis, determines the value of a subject company by benchmarking the subject’s financial performance against similar public companies (peer group). We can infer if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.

An Sales Multiple, also known as Enterprise Value-to-Sales Multiple (EV / Sales), 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. Furthermore, its key benefit over the P/E multiple is that it’s capital structure-neutral, and, therefore, better at comparing companies with different levels of debt. The general formula behind a Sales Multiples valuation model is the following:

Enterprise Value = Revenue x Selected Multiple

A sales multiple is not meant to be viewed in isolation and is only useful when comparing it to other similar companies. Since it is expected that similar companies have similar EV / Sales ratios, we can come to some conclusions about the stock if the ratios are different. I compare NetEase’s sales multiple to those of Tencent Holding Ltd. (NYSE: TCEHY), Alibaba Group Holding Limited (NYSE: BABA), 58.com Inc. (NYSE: WUBA) and Autohome Inc. (NYSE: ATHM) in the chart below.

NTES Sales Multiple vs Peers Chartsource: finbox.io Benchmarks: Sales Multiples

Since NetEase’s sales multiple of 3.7x is lower than the median of its peers (11.6x), it means that investors are paying less than they should for each dollar of NTES’s revenue. As such, our analysis shows that NTES represents an undervalued stock. In fact, finbox.io’s Sales Multiples Model calculates a fair value of approximately $375.00 per share which implies roughly 45.0% upside.

NTES EV / Sales Valuation Calculation

Note that the selected multiple of 5.9x in the analysis above was determined by averaging NetEase’s current sales multiple with its peer group.


Understanding the EV / Sales Ratio’s Limitations

Before jumping to the conclusion that NetEase 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 NetEase, 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 NetEase 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. In addition, revenue multiples are highly correlated with profit margins so differences in EBITDA margin often explain differences in valuation.

NTES revenue Growth and Margins vs Peers Tablesource: sales multiples model

Now if the second assumption does not hold true, NetEase’s lower multiple may be because firms in our peer group are being overvalued by the market.


What This Means For Investors

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 NTES. 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 NetEase by taking a look at the following:

Valuation Metrics: what is NetEase’s free cash flow yield and how does it compare to its publicly traded peers? This metric measures the amount of free cash flow for each dollar of equity (market capitalization). Analyze the free cash flow yield here.

Risk Metrics: what is NetEase’s cash ratio which is used to assess a company’s short-term liquidity. View the company’s cash ratio here.

Efficiency Metrics: return on equity is used to measure the return that a firm generates on the book value of common equity. View NetEase’s return on equity 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.

Expertise: financial technology, analyzing market trends. Brian is a founder at finbox.io, where he’s focused on building tools that make it faster and easier for investors to research stock fundamentals. Brian’s background is in physics & computer science and previously worked as a software engineer at GE Healthcare. He enjoys applying his expertise in technology to help find market trends that impact investors. Brian can be reached at brian@finbox.io or at +1 (516) 778-6257.

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