Summit Midstream Partners (NYSE: SMLP) trades at a Sales Multiple of 3.6x, which is higher than the Energy sector median of 3.2x. While this makes SMLP 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 Summit Midstream’s sales multiple to those of Valero Energy Partners LP (NYSE: VLP), Tallgrass Energy Partners, LP (NYSE: TEP), Rice Midstream Partners LP (NYSE: RMP) and Antero Midstream Partners LP (NYSE: AM) in the chart below.
Since Summit Midstream’s sales multiple of 3.6x is lower than the median of its peers (7.3x), it means that investors are paying less than they should for each dollar of SMLP’s revenue. As such, our analysis shows that SMLP represents an undervalued stock. In fact, finbox.io’s Sales Multiples Model calculates a fair value of approximately $22.40 per share which implies roughly 48.9% upside.
Note that the selected multiple of 4.7x in the analysis above was determined by averaging Summit Midstream’s current sales multiple with its peer group.
Understanding the EV / Sales Ratio’s Limitations
Before jumping to the conclusion that Summit Midstream 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 Summit Midstream, 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 Summit Midstream 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.
source: sales multiples model
Now if the second assumption does not hold true, Summit Midstream’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 SMLP. 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 Summit Midstream by taking a look at the following:
Valuation Metrics: what is Summit Midstream’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 Summit Midstream’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.