Company valuation is an important recurring process in every business. It is in many ways a projection as well as a milestone in a company’s growth cycle. Analysts can select from a wide array of valuation tools to suit industry needs. While it is easier to arrive at a valuation for companies with an established cash flow, what happens to early stage startups with no revenue to show? How is the potential of these companies evaluated? How do investors know which startup is worth investing in?
The credibility of an early stage startup rides mostly on the merit of its idea. If it is led by a team of founders who have been serial entrepreneurs, that’s a huge plus. But this is not enough for investors. Experienced investors will look for a reliable metric that justifies their funding plans. Over the years, revenue multiples by industry has emerged as a popular option. Despite some drawbacks, this is the best valuation tool available for early stage startups across diverse industries. Let’s see how.
What is a revenue multiple?
A revenue multiple by industry is simply an industry specific ‘ratio’ or a ‘factor’ that provides a generic idea about how a startup will fare in a particular industry. Since early stage startups do not have a robust cash flow and stable earnings, financial analysts and investors use revenue multiples as a blanket metric to gauge the startup’s profitability. A revenue multiple, as the term suggests, considers only the gross revenue of a startup.
A reliable revenue multiple is derived by considering the selling price and annual revenues of comparable public companies in the industry. The wider the batch of reference companies, the better the credibility. Here is a standard revenue multiple formula:
Let’s explore this with a simple example. Here are five public companies from a particular industry and their revenue multiples derived from the above formula.
|Company||Selling price||Annual Revenue||Revenue Multiple|
The average revenue multiple from these five companies is 3.67x. Thus 3.67x is now a reference point to evaluate the profit potential of any early-stage startup in this industry. For example, if a startup is showing an annual revenue of $1,000,000, the estimated valuation of this company using revenue multiple valuations by industry will be:
Startups vary in profit margins. But the principle driving revenue multiples is that startups of a particular industry operate in similar circumstances such as gross margins, target markets, competitors, and other characteristics that define business models for a particular industry. Hence revenue multiple valuations by industry can be an equalizer. It can help investors arrive at a consensus regarding the future growth potential of startups in an industry.
However, to arrive at a holistic picture, investors should apply their internal metrics or customized revenue multiples in combination with their understanding of the startup’s profit margins. If investors or finance analysts do not have a deeper understanding of the metrics that drive the industry, a stand-alone reference to revenue multiple valuations by industry will lead to wrong estimations. For example:
High profit margins and low revenue multiple = Undervalued firms
Why is a revenue multiple used?
The gross revenue of a startup is usually a combination of various sources of revenue. This is broadly classified as one-time and recurring. To derive a credible revenue multiple, a blend of all types of revenue (transactional and recurring) generated by the startup must be considered. Such a revenue multiple by industry is useful because:
- Every startup takes at least 2 – 3 years to generate revenue. But this does not clarify their actual earnings. A startup normally starts posting an overall revenue well within a year, even if earnings are not visible. Thus unlike earnings or book value ratios, revenue multiple valuations by industry is possible for early-stage startups even with negative earnings.
- The usual sought-after earning multiples vary with factors such as management decisions, finance strategies, depreciation, investor preferences, acquisition costs, and many more. Thus an earning multiple is volatile in the case of early startups. Comparatively, gross revenue calculations are much simpler. Hence, revenue multiples are more stable as a valuation tool.
- Revenue multiples might look like a straightforward metric, but they account for the overall profitability and growth possibilities of a startup. Investors focused on business growth can very well visualize the risk profile of a startup using revenue multiple valuations by industry.
Two Basic Revenue Multiples
By now we know that revenue multiples by industry is derived from an average of values from a batch of public companies in that sector. Though based on gross revenues, there are two basic approaches to this. Let’s explore them one by one:
Price to Sales Ratio
The price to sales ratio considers only the startup’s market value of equity. In this case, the revenue multiple formulae look like this:
One drawback with this ratio is that it varies with the degree of leverage in a startup. As expected, the amount of debt varies with every company even if they all belong to the same sector. Thus a promising startup with high growth potential but operating on heavy debts will show lower valuations if analyzed using this revenue multiple by industry.
Enterprise Value to Sales Ratio
This is a more wholesome ratio when compared to the price-to-sales ratio. This considers the value of a firm to be a combination of debt and equity. The revenue multiple formula, in this case, looks like:
Thus the enterprise value to sales ratio gives a more accurate value because it considers the entire capital structure of a startup. Unlike the price to sales ratio, enterprise value is not limited to equity alone. This is a huge advantage because, in the initial stages, a startup’s cap structure is a combination of various funding sources. A narrow focus on one type of financial instrument will skew the entire valuation.
Advantages and Disadvantages of Revenue Multiples
Early-stage or seed-stage investors can use revenue multiples for a quick peek into a startup’s future potential. But owing to their limited data considerations, a revenue multiple valuations by industry can be misleading too. Here are some of their advantages and disadvantages:
Advantages of revenue multiples:
- Useful to evaluate early-stage companies even with negative earnings.
- Revenue calculations are less affected by varying accounting principles in a startup.
- Helps startups get a company valuation even when not generating profit.
- Revenue multiple based company valuations are much needed to attract early investors.
Disadvantages of revenue multiples:
- Earnings and cash flows are true indicators of profitability. Since revenue multiple valuation by industry skips these, it leaves a wide opening for miscalculations.
- Revenue multiples can be high for companies losing a lot of money.
Revenue Multiples by Industry
One must remember that revenue multiple valuations by industry are only a baseline. It is not an actual value. Since there is no other reliable way to assess the value of a startup in the initial stages of the business cycle, revenue multiples provide a guideline. Here are some reference points:
- 1x – Indicates that the startup is dealing with low-margin products, with low growth potential.
- Less than 3x – This category of startups usually shows recurring revenues. Investors looking for a stable cash flow may choose to backup startups in this category.
- 3x to 5x – Startups in this category are middle of the pack. Investors consider these companies as a fair shot to success.
- More than 10x – This category is the ‘A-list’ as per investors. Startups displaying a 10x or more valuation have the highest chances of growth, profits, and expansion.
Based on these references, we have collated revenue multiples for over a hundred different industries. These revenue multiples by industry is a quick reference guide for anyone trying to evaluate a startup in these industries.
|Row Labels||Annual Volatility||EV to Revenue|
|Accident & Health Insurance||44.03%||0.98|
|Air Freight/Delivery Services||43.54%||2.79|
|Assisted Living Services||53.87%||4.41|
|Auto Parts: O.E.M.||41.07%||1.76|
|Biotechnology: Biological Products (No Diagnostic Substances)||111.05%||17.75|
|Biotechnology: Commercial Physical & Biological Research||110.13%||10.33|
|Biotechnology: Electromedical & Electrotherapeutic Apparatus||62.78%||16.85|
|Biotechnology: In Vitro & In Vivo Diagnostic Substances||110.61%||6.68|
|Biotechnology: Laboratory Analytical Instruments||89.65%||5.03|
|Computer peripheral equipment||83.97%||3.23|
|Computer Software: Prepackaged Software||112.17%||17.81|
|Computer Software: Programming Data Processing||0.00%||2.68|
|Consumer Electronics/Video Chains||155.48%||2.24|
|Department/Specialty Retail Stores||83.54%||1.49|
|Diversified Commercial Services||50.40%||6.08|
|Diversified Financial Services||72.81%||5.15|
|Electric Utilities: Central||47.28%||5.72|
|Engineering & Construction||69.18%||1.09|
|Finance: Consumer Services||56.96%||14.29|
|Integrated oil Companies||61.53%||1.73|
|Internet and Information Services||59.87%||5.19|
|Managed Health Care||47.05%||14.97|
|Misc Health and Biotechnology Services||0.00%||6.78|
|Natural Gas Distribution||50.47%||3.55|
|Oil & Gas Production||62.40%||8.51|
|Ordnance And Accessories||77.24%||3.82|
|Other Consumer Services||42.07%||7.38|
|Other Metals and Minerals||89.21%||2.56|
|Other Specialty Stores||127.77%||2.30|
|Pollution Control Equipment||54.28%||1.65|
|Property or Casualty Insurers||46.69%||1.01|
|Radio And Television Broadcasting And Communications Equipment||123.14%||5.59|
|Real Estate Investment Trusts||75.58%||17.62|
|RETAIL: Building Materials||66.18%||1.15|
|Retail: Computer Software & Peripheral Equipment||73.85%||17.18|
|Service to the Health Industry||78.43%||2.00|
|Services or Misc. Amusement & Recreation||29.34%||5.50|
|Trucking Freight/Courier Services||68.96%||2.00|
|Trusts Except Educational Religious and Charitable||21.76%||0.79|
This data was compiled from the major public companies in each industry from NASDAQ, NSYE & AMEX.
Need Any Assistance in Valuing Your Company?
As we see, company valuations can be tricky. All formulas and guidelines have to be supported by industry expertise and automation to minimize manual errors. Eqvista is a robust equity management software equipped to handle revenue multiple calculations and company valuations.