A traditional price-to-earnings ratio is not much help when a company earns little or no profit. Yet many of the market’s fastest-growing technology companies spend heavily to capture market share and report small or negative earnings for years. Investors use a different toolkit to value them.
Price-to-sales and EV-to-revenue
The price-to-sales (P/S) ratio divides market capitalization by the last twelve months of revenue. A related measure, enterprise value to revenue (EV/revenue), uses enterprise value, which adds debt and subtracts cash, so companies with different balance sheets can be compared more fairly.
These multiples are useful for comparing similar companies, but they have a major weakness: revenue is not profit. A company with 80% gross margins, typical for software, deserves a much higher revenue multiple than one with 20% gross margins, because far more of each sales dollar can eventually become profit.
Gross margin and revenue quality
Because of that weakness, analysts pair revenue multiples with measures of revenue quality:
- Gross margin: what is left after the direct cost of delivering the product.
- Recurring revenue: subscription revenue is more predictable than one-time sales.
- Net revenue retention: how much revenue from last year’s customers grew this year, including upgrades and losses. Above 100% means existing customers are spending more.
The Rule of 40
A popular benchmark for software companies is the Rule of 40: revenue growth rate plus profit margin should total at least 40%. Companies often use free cash flow margin or adjusted operating margin for the profit part. A company growing 30% with a 10% margin passes; so does one growing 10% with a 30% margin. A company growing 20% while losing 15% of revenue does not.
The rule captures a real trade-off. Early on, it is reasonable to sacrifice profit for growth. As a company matures, investors expect efficiency to improve. It is a rule of thumb, not a law, and different analysts define its components differently.
Forward P/E and PEG
For growth companies that are profitable, analysts often use forward P/E, based on expected earnings, and the PEG ratio, P/E divided by the expected earnings growth rate. A PEG near 1 is sometimes described as fairly valued, but the result depends entirely on the growth estimate, which is uncertain.
Where these metrics break down
- Stock-based compensation: many growth companies pay employees heavily in stock. Adjusted margins that exclude it can overstate profitability, and share counts can rise over time, diluting existing holders.
- Interest rates: growth-stock multiples are highly sensitive to rates because most of their value lies in distant future cash flows. See how interest rates move the stock market.
- Growth decay: high growth rates rarely persist. Paying a high multiple assumes growth stays high for many years.
Putting it together
A sensible approach combines several lenses: revenue multiple relative to peers, gross margin, growth durability, progress on profitability, and dilution. For the basics of earnings-based valuation, read our guide to the P/E ratio.
