Sprouts Farmers Market, Inc. (NASDAQ: SFM), a consumer staples business with a market capitalization of $2.8 billion, currently trades at a Sales Multiple of 0.7x which is below the sector’s median multiple of 1.6x. Although this makes SFM look attractive, investors may change their mind after reviewing the assumptions behind the EV / Sales ratio. In the post below, I calculate Sprouts Farmers Market’s fair value using a Sales Multiples valuation.
How To Interpret Sprouts Farmers Market’s Sales Multiple
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 companies deemed to be similar. We can then determine if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.
EV / Sales, also known as Enterprise Value-to-Sales Multiple or a Sales Multiple, measures the dollars in Enterprise Value for each dollar of revenue. 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
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 Sprouts Farmers Market’s EV / Sales ratio to its peer group that includes Smart & Final Stores, Inc. (NYSE: SFS), Kroger Company (The) (NYSE: KR), SuperValu Inc. (NYSE: SVU) and Weis Markets, Inc. (NYSE: WMK).
Since Sprouts Farmers Market’s EV / Sales ratio of 0.7x is higher than the median of its peers (0.3x), it means that investors are paying more than they should for each dollar of SFM’s revenue. As such, our analysis shows that SFM represents an overvalued stock. Furthermore, finbox.io’s EV / Sales Ratio Model calculates a fair value of $8.97 per share which implies -58.1% downside.
I selected a fair multiple of 0.3x in my analysis by averaging Sprouts Farmers Market’s current EV / Sales ratio with its peer group.
Sales Multiple Flaws
While this approach typically provides a reasonable valuation range, it is important to understand that our conclusion rests on some important assumptions. The first being that the selected peer group actually contains companies that truly are similar to Sprouts Farmers Market. The second important assumption is that the selected peer group stocks are being fairly valued by the market.
If the assumptions above do not hold to be true, then the difference in EV / Sales ratios could be due to a variety of factors. For example, if you accidentally compare Sprouts Farmers Market with lower growth companies, then its sales multiple would naturally be higher than its peers since investors reward high growth stocks with a higher price. Furthermore, sales multiples are highly correlated with EBITDA margins so differences in profit margin often explain differences in valuation.
source: sales multiples model
Now if the second assumption does not hold true, Sprouts Farmers Market’s higher multiple may be because firms in our peer group are being undervalued by the market.
What To Do Next
As a current investor, you may have already conducted fundamental analysis on the company and its stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to SFM. But keep in mind the EV / Sales ratio’s potential flaws when applying this valuation approach. It is important to note that there are a variety of other fundamental factors that I have not taken into consideration in this article. I highly recommend that you continue your research on Sprouts Farmers Market by taking a look at the following:
Valuation Metrics: what is Sprouts Farmers Market’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 Sprouts Farmers Market’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 Sprouts Farmers Market’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.