33 Finance, Accounting and Business Analysis Volume 1 Issue 1, 2019 Bulgarian SOFIX Levels in 2017 According to The “Price-to-Sales” and “Enterprise Value-to-Sales” Ratios Dimiter Nenkov University of National and World Economy, Sofia Info Articles Abstract History Article: Received 2 June 2018 Accepted 8 December 2018 Published 29 January 2019 This paper is focused on the “price-to-sales ratio” (P/S) and the “enterprise value-to-sales ratio” (EV/S), which can be used in relative valuation, in the analysis of companies’ performance, as well as in the analysis of different sectors and of the market as a whole. The advantages and drawbacks of the market ratios are analyzed in brief. The derivation of the fundamental “price-to-sales” (P/S) and the “enterprise value-to-sales”(EV/S) ratios is discussed in detail. The two fundamental P/S and EV/S ratios for the Bulgarian stock market are calculated and compared with the corresponding actual P/S and EV/S. The results of the study indicate that the current levels of the actual P/S and EV/S are much higher than the levels suggested by fundamentals, which is an indicator for an overpriced Bulgarian stock market in 2017. Keywords : stock markets, relative valuation, market ratios, P/S ratio, EV/S ratio, fundamentals . Address Correspondence: E-mail : dnenkov@unwe.eu Dimitir Nenkov / Finance, Accounting, and Business Analisys 34 Introduction Market ratios, also called ratios of market performance, are one important group out of the several groups of ratios for financial analysis of public companies.1 The feature which distinguishes this group of ratios is that the numerator of each of them is the market price per share (P0), or, alternatively the enterprise value of the company (EV). This is why they are called market ratios. This specific feature of market ratios provides the opportunity to use them in several aspects: - for the analysis of the performance of companies, whose shares are publicly traded; - for the analysis of the market as a whole and of different sectors, including for comparing among different markets and sectors; - in the relative valuation of other companies, which is also popular as multiples valuation, etc. Another specific feature of market ratios makes them especially useful in the above three aspects. This is the fact that they are a kind of “standardized prices” of stocks, which make different companies, sectors and markets comparable with each other.2 According to A. Damodaran, there are a few reasons for the popularity of relative valuation methods: that they are quick, easy to implement, easy to explain, they normally yield results, which are close to current market prices. The truth, however, is that the above advantages also contain the prerequisites for the disadvantages of relative valuation methods. Quite often, applying relative valuation, analysts and appraisers arrive at totally wrong price, because of ignoring key variables. The stocks are normally overpriced when the market overprices the comparable companies and vice versa. The lack of transparency with regard to key variables makes relative valuation very sensitive to manipulation.3 These are a part of the reasons why relative valuation methods are very convenient and very much wanted during bull markets. In such conditions most stock market players, such as investment bankers, consultants, and others, are interested in valuation results, which are close to market prices, thus justifying the respective transactions. Commissions are earned only if deals are finalized. Given the expectations for continuously rising stock prices, most players seem satisfied with such results (until the moment when the bubble bursts out). This copes perfectly with multiples valuation, which yields overpriced stocks in the conditions of an overpriced market. The relatively neutral DCF valuation models are often neglected in such situations. In this way the stock bubble is kind of “legalized” in the eyes of the public. 4 In this connection some valuation experts say that the most important question when reviewing a valuation is not which methods are used, but who paid for the valuation5. Many analysts contend that the multiples valuation methods are easy to implement, but according to Koller, Goedhart and Wessels, in reality it is just the opposite.6 A well elaborated multiples analysis requires a lot of the same efforts and adjustments as with the traditional DCF analysis. The disadvantages of the market ratios, which were discussed in terms of relative valuation, need to be accounted for when used in the other two directions as well – for company analysis and for the analysis of the sectors and of the stock market as a whole. 1 Brigham, Eugene F., Louis Gapenski – “Financial Management – Theory and Practice”, The Dryden Press, 1994 2 Damodaran, A. – “Investment Valuation – Tools and Techniques for Determining the Value of Any Asset”, John Wiley & Sons, New York, 2002, p. 453 3 Damodaran, A. – “Investment Valuation – Tools and Techniques for Determining the Value of Any Asset”, John Wiley & Sons, New York, 2002, p. 454 4 Ненков, Д. – “Финансовият мениджмънт и уроците от финансовата криза”, доклад, Международна научна конференция “Световната финансова криза и поуките за финансовия сектор на България”, Равда, 24-26 септември 2010 г., стр. 19-26 5 Damodaran, A. – „September 12 to October 16 – Five Weeks from Hell and the Lessons We Have Learned”, http://pages.stern.nyu.edu/~adamodar/ 6 Koller, T., Goedhart, M., Wessels, D. – “Valuation – Measuring and Managing the Value of Companies”, (McKinsey & Company ), published by John Weley & Sons, New York, 2015, p. 371 http://pages.stern.nyu.edu/~adamodar/ Dimitir Nenkov / Finance, Accounting, and Business Analisys 35 “Price-to-Sales” (P/S) and “Enterprise Value-to-Sales” (EV/S) Ratios James O’Shaughnessy qualifies the price-to-sales (P/S) ratio as the best of all market ratios.7 Ken Fisher calls it “almost perfect measure of popularity”.8 The P/S is a measure of the value of company’s equity, relative to its sales. As there are many investors who like high P/S ratios, there are also investors, who buy at low P/S ratios, since they believe they have a bargain.9 The price-earnings (P/E) and the price-to-book (P/BV) ratios continue to be very popular as they used to be in the past, but during the latest two or three decades the analysts extended the circle of ratios used, including the P/S ratios. It is very attractive to investors and analysts for several reasons: In the first place, while P/E ratios are often negative, the P/S ratio is available even for the worst-performing companies, as well as for the start-up companies. There is virtually no bias of average P/S, resulting from the exclusion of loss making companies. In the second place, P/S is quite independent of the alternative accounting practices, unlike P/E and P/BV. 10 In the third place, P/S ratios are normally more sustainable in time than P/Es.11 The latter are very volatile because of the effects of the operating and financial leverage, and the resulting serious volatility of earnings per share by year.12 The main disadvantage of the P/S and EV/S ratios is that they may lead to determining high value of a company with growing revenues, even if this company works at loss. In order to have high intrinsic value, the company should generate high profits and cash flows. In this connection, it is extremely important to ensure that the comparable companies have similar profitability ratios and cash flows with the valued company. The P/S is the ratio between the market price per share and the sales per share: 𝑷 𝑺 = 𝑷𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 𝑺𝒂𝒍𝒆𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 Alternatively, the P/S can also be presented as the ratio between market value of equity (market capitalization) and sales: 𝑷 𝑺 = 𝑴𝒂𝒓𝒌𝒆𝒕 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 (𝒎𝒂𝒓𝒌𝒆𝒕 𝒄𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒛𝒂𝒕𝒊𝒐𝒏) 𝑺𝒂𝒍𝒆𝒔 Another drawback of the P/S is that it is incorrectly defined – there is no compliance between numerator and denominator. The denominator is an enterprise indicator, which depends only on company’s operations and is not influenced by financial leverage. The numerator is an equity indicator, which is a function of both of operations and capital structure. This way, when comparing companies with different capital structure, the P/S can lead to the wrong conclusions. In order to overcome this drawback of P/S, an alternative sales-based market ratio is recommended – the enterprise value-to sales ratio (EV/S). It is the ratio between enterprise value and sales: 𝑬𝑽/𝑺 = 𝑬𝒏𝒕𝒆𝒓𝒑𝒓𝒊𝒔𝒆 𝒗𝒂𝒍𝒖𝒆 𝑺𝒂𝒍𝒆𝒔 7 O’Shaughnessy, J. P. – “What Works on Wall Street”, McGraw-Hill, 2005, p. 127 8 Fisher, Kenneth L., 2008, Super Stocks, McGraw-Hill, Reissued Ed., 2008, p…… 9 O’Shaughnessy, J. P. – “What Works on Wall Street”, McGraw-Hill, 2005, p. 127 10 Damodaran, A. – “Investment Valuation – Tools and Techniques for Determining the Value of Any Asset”, John Wiley & Sons, New York, 2002, p. 543 11 Reed, J.P. – “Five Fisher Super Stocks”, March 2011, https://www.forbes.com/sites/investor/2011/03/07/five- fisher-super-stocks/#33070f3752fb (Accessed 1 Aug, 2017) 12 Molodovsky, Nickolas – “A Theory of Price-Earnings Ratios”, Financial Analysts Journal, January/February 1995 (Reprinted from “The Analyst Journal”, November 1953), p. 33 https://www.forbes.com/sites/investor/2011/03/07/five-fisher-super-stocks/#33070f3752fb https://www.forbes.com/sites/investor/2011/03/07/five-fisher-super-stocks/#33070f3752fb Dimitir Nenkov / Finance, Accounting, and Business Analisys 36 According to Aswath Damodaran (Damodaran, A. 2002), the enterprise value (EV) is equal to:13 𝐄𝐕 = 𝐌𝐚𝐫𝐤𝐞𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 + 𝐌𝐚𝐫𝐤𝐞𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐝𝐞𝐛𝐭 − 𝐂𝐚𝐬𝐡 This should correspond to the market value of the operating assets of the company. By definition, it does not include financial and other non-operating assets. The above formula reflects the earlier definition provided by Damodaran.14 In more recent publications15 the same author gives a little bit different definition, as follows: 𝐄𝐕 = 𝐌𝐚𝐫𝐤𝐞𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 + 𝐁𝐨𝐨𝐤 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐝𝐞𝐛𝐭 − 𝐂𝐚𝐬𝐡 This second definition should be accepted as more sustained. The main argument for this is that when calculating equity market value, it is normal to deduct the book value of debt from enterprise value. This is the amount due to creditors. For example, when the company has high default risk, the market value of bonds goes down significantly below their face value. If we deduct this low market value of debt, we arrive at equity value, which is overpriced. The market value of debt is connected with bond holders and potential buyers of debt on the secondary bond markets. This is the value at which bondholders could sell their bonds. But the principle due by a company to its bondholders should equal their book value, regardless of the current market value of bonds. Finally, it makes sense to use book value of debt in the formula for EV. Another important issue related to the above definition of EV concerns the scope of “cash”. In our view this should not be limited to cash in banks, but should also include investments in different financial and other non-operating assets. The EV, defined in this way, is indeed the equivalent of the operating value of the company. The interpretation of EV is not unanimous by different authors. Koller, Goedhart and Wessels16 have a little bit different understanding about enterprise value. They define it in an alternative way, as the function of certain positions in the asset side of the balance sheet, as follows: Operating value (value of operations) + Value of financial assets + Value of non consolidated interest in other companies + Excess cash = Enterprise value (EV) Obviously, these authors have in mind the value of the company as a whole, including both operating and non operating assets. For this value Damodaran uses the term Firm Value.17 Identifying EV with operating value is more justified in terms of ensuring comparability between the numerator and denominator of the EV/S. The sales (S) in the denominator are the function predominantly of the operating assets of the company. They do not include revenue from financial and other non operating assets. In this connection, it is sustained that the numerator is equal to the value of operating assets only, which corresponds to the definition of enterprise value, given by A. Damodaran. Further in this study we stick to this interpretation of enterprise value (EV). 13 Damodaran, A. – “Investment Valuation – Tools and Techniques for Determining the Value of Any Asset”, John Wiley & Sons, New York, 2002, p. 544 14 Same source 15 http://pages.stern.nyu.edu/~adamodar/ 16 Koller, T., Goedhart, M., Wessels, D. – “Valuation – Measuring and Managing the Value of Companies”, (McKinsey & Company ), published by John Weley & Sons, New York, 2015, p. 107 17 http://pages.stern.nyu.edu/~adamodar/ http://pages.stern.nyu.edu/~adamodar/ http://pages.stern.nyu.edu/~adamodar/ Dimitir Nenkov / Finance, Accounting, and Business Analisys 37 Actual P/S and EV/S Ratios on the Bulgarian Capital Market Table 1 presents the market ratios P/S and EV/S of the companies included in the leading index on the Bulgarian Stock Exchange SOFIX. The net margin and the operating margin, influencing the levels of the two market ratios, are also shown in the table. There are two things which make impression: - in the first place, there is no data about these indicators for four of the companies in the index in the Infostock database: Eurohold Bulgaria, CCB, Advance Terafond ADSIC, and Real Estate Fund BG ADSIC; - in the second place, for four other companies in the index, the indicators are obviously abnormally high and have no economic sense. These are: Chimimport, Holding Varna AD, Stara Planina Hold AD and Industrial Capital Holding AD. The holdings most likely have a problem with some incorrect interpretation of input data, which does not allow for compatibility between numerator and denominator of the ratios. It is quite possible that the denominators of each of the indicators of the four companies expresses only the sales, respectively the profits, of the mother companies, rather than of the whole holding. Table 1: P/S and EV/S Ratios of Companies in the SOFIX as of July 2017 Company PS EVS Net Margin Operating Margin /pre- tax / Sopharma AD 3.60 4.20 20.88% 23.11% FIBank 0.75 3.66% 4.08% Monbat AD 1.34 1.62 4.38% 4.88% Chimimport 29.51 47.89 278.30% 257.54% M+S Hidravlik AD 3.76 3.75 12.31% 13.67% Alkomet AD 0.97 1.27 7.23% 8.03% Albena 3.28 4.34 32.17% 33.98% Eurohold Bulgaria CCBank Advance Terra Fund ADSIC Holding Varna AD 172.85 240.02 150.43% 150.43% Stara Planina Hold AD 2288.46 2226.88 6594.87% 6594.87% Neohim AD 0.70 0.82 11.01% 11.89% Industrial Capital Holding AD 12354.48 15233.88 28860.00% 28860.00% Real Estate Fund BG ADSIC Mean (average) 1350.88 1776.47 3270.48% 3269.32% Median 3.60 4.27 20.88% 23.11% Minimum 0.7 0.82 3.66% 4.08% Maximum 12354.48 15233.88 28860.00% 28860.00% Source: Infostock: http://www.infostock.bg/infostock/control/trading/index/quotes/SOFIX (28 July, 2017) This is a typical example about the commented in previous items of this study bias of average (mean) ratios, as a result of individual extremely high ratios of some companies. This shouldn’t be allowed or left as it is. It is more than clear that average market ratios of more than 1000 and average profit margins above 3000% are not normal, especially for mature companies. The positions of these four holdings are marked in yellow, in order to indicate that their indicators will be excluded from the database in the next table (Table 2). In this way much more realistic average P/S and EV/S ratios and profit margins for the SOFIX are calculated. http://www.infostock.bg/infostock/control/trading/index/quotes/SOFIX Dimitir Nenkov / Finance, Accounting, and Business Analisys 38 Table 2: Corrected P/S and EV/S Ratios of Companies in the SOFIX as of July 2017 Company PS EVS Net Margin Operating Margin /pre- tax / Sopharma AD 3.60 4.20 20.88% 23.11% FIBank 0.75 3.66% 4.08% Monbat AD 1.34 1.62 4.38% 4.88% Chimimport M+S Hidravlik AD 3.76 3.75 12.31% 13.67% Alkomet AD 0.97 1.27 7.23% 8.03% Albena 3.28 4.34 32.17% 33.98% Eurohold Bulgaria CCBank Advance Terra Fund ADSIC Holding Varna AD Stara Planina Hold AD Neohim AD 0.70 0.82 11.01% 11.89% Industrial Capital Holding AD Real Estate Fund BG ADSIC Mean (average) 2.06 2.67 13.09% 14.23% Median 1.34 2.69 11.01% 11.89% Minimum 0.7 0.82 3.66% 4.08% Maximum 3.76 4.34 32.17% 33.98% Source: Infostock: http://www.infostock.bg/infostock/control/trading/index/quotes/SOFIX (28 July, 2017) In this way, the average SOFIX indicators in Table 2 are calculated on the basis of 7 companies (and for the EV/S on the basis of only 6 companies) out of 15 included in the index. This is a much better variant, since the average indicators for the index are calculated only on the basis of individual indicators that are within a reasonable range of values. And still, the representativeness of the above averages is not good enough, given the fact that 4 holding companies, the ADSIC companies and one bank are out of the database. Unfortunately, this happens quite often with most databases. The calculated mean for the P/S is 2.06, and the median is 1.34. When the difference between the mean and the median is significant, as it is in this case, the recommendation is to use the median. The mean is very susceptible to upward distortion when there are individual very high ratios in the database, especially for small databases. The mean for the EV/S of 2.67 is almost equal to the median of 2.69 and this problem does not exist here. The net margin is with a mean of 3.09% and a median of 14.23%. The operating margin respectively is with a mean of 14.23% and a median of 11.89%. It is logical to ask the question what is the purpose of the above review of the P/S and EV/S ratios. This is done with a reason. An important prerequisite for the correct use of market ratios is to find out which values are low or high, and which are normal for the market. The analysts should know the typical levels of market ratios on different stock markets both at present and from historical perspective. This requires that analysts are familiar to what extent the average values themselves might be distorted by individual extremely high or low ratios of certain companies in the samples. 18 This can cause significant distortion of the average, when the samples contains a small number of companies, as is the case with the Bulgarian capital market, 18 Stickney, Clyde P. – “Financial Reporting and Statement Analysis”, The Dryden Press, 1996, p. 614 http://www.infostock.bg/infostock/control/trading/index/quotes/SOFIX Dimitir Nenkov / Finance, Accounting, and Business Analisys 39 for example. There are too many such cases in reality.19 It is also curious to ask why net margin and operating margin are included as important data in the table. Both indicators measure the profitability of sales. The net margin is the so called companion variable for the P/S ratio, which pretty much explains the changes in its values. Respectively, the operating margin is the companion variable for the EV/S ratio has the most serious impact on its values. 20 This will be explained further in the course of the study. Fundamental Model of the P/S Ratio The correct use of the P/S ratio goes through serious analysis of the average ratios from a sample, before they are applied as multiples for valuation or as indicators for assessment of the performance of companies, sectors and markets. This analysis includes, among other things, comparing current average P/S of a sample with the average P/S in other sectors or markets for the same period, as well as comparing them with historic average P/S. Another perspective of the analysis of the actual market ratios, including P/S, is the comparison with their corresponding fundamental ratios, which are derived directly from fundamentals. While actual market ratios indicate the price at which a company’s stocks are traded, fundamental ratios indicate the price at which a company’s stocks should be traded. Unfortunately, this perspective of the analysis is preformed quite rarely in reality, which is a serious prerequisite for the distortion of many valuations and analyses. Only after the above aspects of the analysis we could know whether the respective market ratios of the comparable companies (peer companies), or of any sample, are normal, representative, and have economic sense, in order to be used in a specific valuation or analysis. In order to find out which variables drive the fundamental P/S, we have to get familiar with its theoretical or fundamental model. It is derived as follows: 𝑷𝟎 = 𝑫𝑰𝑽𝟏 𝒓 − 𝒈 = 𝑬𝑷𝑺𝟏 × (𝟏 − 𝒃) 𝒓 − 𝒈 = 𝑬𝑷𝑺𝟎 × (𝟏 − 𝒃) × (𝟏 + 𝒈) 𝒓 − 𝒈 (𝟏) Where: P0 = current price per share of stock, DIV1 = expected dividend per share for next year (year 1), EPS1 = expected earnings per share for next year (year 1), EPS0 = earnings per share for the current year, b = foreseen plowback ratio, (1–b) = foreseen payout ratio, r = cost of equity, g = expected growth rate of dividends per share. The net margin is equal to the net profit divided by sales (NI/Sales). It can also be presented as the ratio of earnings per share to sales per share (EPS/Sales per share). This makes possible to express EPS as a function of the net margin and sales per share, as follows: 19 Nenkov, D., Bathala, C. – “Price-Earnings Ratios on the Bulgarian Capital Market: An Analytical Approach to Comparing Actual Vs. Fundamental P/E Ratios”, in “Globalization: Opportunities & Challenges”, Wisdom Publications, Delhi, 2008, p. 351 20 Damodaran, A. – “Investment Valuation – Tools and Techniques for Determining the Value of Any Asset”, John Wiley & Sons, New York, 2002, p. 462 Dimitir Nenkov / Finance, Accounting, and Business Analisys 40 𝑬𝑷𝑺𝟎 = 𝑵𝒆𝒕 𝒎𝒂𝒓𝒈𝒊𝒏 × 𝑺𝟎 Where: S0 = current sales per share Given the above, equation (1) becomes:21 𝑷𝟎 = 𝑺𝟎 × 𝑵𝒆𝒕 𝒎𝒂𝒓𝒈𝒊𝒏 × (𝟏 − 𝒃) × (𝟏 + 𝒈) 𝒓 − 𝒈 (𝟐) Dividing both sides by the sales per share (S0) we come at the fundamental model of the P/S – equation (3): 𝑷 𝑺 = 𝑵𝒆𝒕 𝒎𝒂𝒓𝒈𝒊𝒏 × (𝟏 − 𝒃) × (𝟏 + 𝒈) 𝒓 − 𝒈 (𝟑) As seen from the equation, the price-to-sales ratio is a function of: - the net margin, - the plowback ratio (or alternatively the payout ratio), - the cost of equity, and - the growth rate of EPS - g. If we express the plowback ratio b as a function of the return on equity (ROE) and the expected growth rate (g), the model becomes as follows – equation (4): 𝑷 𝑺 = Net margin × (𝟏 − 𝒈/𝑹𝑶𝑬) × (𝟏 + 𝒈) 𝒓 − 𝒈 (𝟒) One of the advantages of this variant of the model is that it can be used to determine the P/S of non public (closed) companies, which do not pay dividends. It also becomes clear from the model that the price- to-sales ratio of a company with a very low or zero growth rate is actually determined by the differential between net margin and cost of capital. If the net margin is higher than the cost of equity, the price per share should be higher than the sales per share. And vice versa, if the net margin is lower than the cost of equity, the price per share should be lower than the sales per share. The fundamental P/S ratio of a company with temporarily high growth can be derived from the two- stage dividend discount model. Under this model future dividends are grouped in two sub-periods: high growth period and stable (sustainable) growth period. One way to present the two-stage dividend discount model is as follows:22 𝑷𝟎 = 𝑬𝑷𝑺𝟎 × (𝟏 − 𝒃𝟏) × (𝟏 + 𝒈𝟏) × [𝟏 − (𝟏 + 𝒈𝟏)𝒏 (𝟏 + 𝒓𝟏)𝒏 ] 𝒓𝟏 − 𝒈𝟏 + + 𝑬𝑷𝑺𝟎 × (𝟏 − 𝒃𝟐) × (𝟏 + 𝒈𝟏)𝒏 × (𝟏 + 𝒈𝟐) (𝒓𝟐 − 𝒈𝟐) × (𝟏 + 𝒓𝟏)𝒏 (𝟏) 21 Damodaran, A. – “Investment Valuation – Tools and Techniques for Determining the Value of Any Asset”, John Wiley & Sons, New York, 2012, p. 546 22 Same source Dimitir Nenkov / Finance, Accounting, and Business Analisys 41 Where: P0 = price per share of stock, EPS0 = net income (profit) per share for current year, (1–b1) = payout dividend during high-growth period, (1–b2) = payout dividend during stable-growth period, g1 = expected growth rate of EPS during high-growth period, g2 = expected growth rate of EPS during stable-growth period, r1 = cost of capital during high-growth period, r2 = cost of capital during stable-growth period, n = number of years of high-growth period. The first collectible at the right side of the equation is the present value of a growing perpetuity, in which the annual cash flows are the dividends for the respective years of the high-growth period. The second collectible presents the present value of the future price Pn, which is the equivalent of the future dividends during the stable-growth period. The EPS0 can be expressed as the function of sales per share (S0) and net margin, after which both sides of the equation are divided by the sales per share, as a result of which we arrive at the two-stage fundamental model of P/S: 𝑷 𝑺 = Net margin × (𝟏 − 𝒃𝟏) × (𝟏 + 𝒈𝟏) × [𝟏 − (𝟏 + 𝒈𝟏)𝒏 (𝟏 + 𝒓𝟏)𝒏 ] 𝒓𝟏 − 𝒈𝟏 + + Net margin × (𝟏 − 𝒃𝟐) × (𝟏 + 𝒈𝟏)𝒏 × (𝟏 + 𝒈𝟐) (𝒓𝟐 − 𝒈𝟐) × (𝟏 + 𝒓𝟏)𝒏 (𝟐) Fundamental Model of the EV/S Ratio Taking into account that the numerator of the EV/S is the operating value of the company, the DCF enterprise valuation model is the most appropriate for deriving the fundamental model of this ratio. If the case is about a mature company, with assumed stable growth rate until infinity, its enterprise value can be determined as follows: 𝑬𝑽 = 𝑵𝑶𝑷𝑳𝑨𝑻𝟏 × (𝟏 − 𝒃) 𝑾𝑨𝑪𝑪 − 𝒈 = 𝑵𝑶𝑷𝑳𝑨𝑻𝟎 × (𝟏 + 𝒈) × (𝟏 − 𝒃) 𝑾𝑨𝑪𝑪 − 𝒈 (𝟏) Where: NOPLAT = net operating profit after tax, b = retention (reinvestment) ratio, WACC = weighted average cost of capital, g = expected growth rate of NOPLAT. Dimitir Nenkov / Finance, Accounting, and Business Analisys 42 Dividing both sides by the sales from current year (S0), we arrive at: 𝑬𝑽 𝑺 = 𝑵𝑶𝑷𝑳𝑨𝑻𝟎/𝑺𝟎 × (𝟏 + 𝒈) × (𝟏 − 𝒃) 𝑾𝑨𝑪𝑪 − 𝒈 (𝟐) The net operating margin is equal to the ratio between net operating profit after tax (NOPLAT) and sales (NOPLAT0/S0). After substituting, the above equation transforms into the one-stage fundamental model of EV/S: 𝑬𝑽 𝑺 = Net operating margin × (𝟏 + 𝒈) × (𝟏 − 𝒃) 𝑾𝑨𝑪𝑪 − 𝒈 (𝟑) In this case the net operating margin is calculated as the ratio of current NOPLAT to current sales. From equation (3) we see that the enterprise value-to-sales ratio is a growing function of the net operating margin and the growth rate (g) and a decreasing function of the reinvestment rate (b) and the weighted average cost of capital (WACC). After expressing the reinvestment rate (b) as a function of the return on invested capital (ROIC) and the growth rate (g), the fundamental model acquires the following shape: 𝑬𝑽 𝑺 = Net operating margin × (𝟏 + 𝒈) × (𝟏 − 𝒈/𝑹𝑶𝑰𝑪) 𝑾𝑨𝑪𝑪 − 𝒈 (𝟒) It becomes clear from the model that for a company with a growth rate close to or equal to zero, the EV/S should be determined by the differential between net operating margin and WACC. The model also shows that for a given level of the growth rate (g), the higher the ROIC, the higher is the EV/S. The two-stage fundamental model of EV/S can be derived from the two-stage DCF enterprise valuation model, where the future is divided into two sub-periods - an explicit forecast period and after it. From the DCF model we know that, other things being equal, the free cash flow to investors (FCFI) for each year is equal to that part of NOPLAT, which is not retained and reinvested, and can be expressed as follows: FCFI = NOPLAT × (1-b) If we assume that there is one and the same growth rate for the years of the explicit growth period - g1, and another constant growth rate after the explicit forecast period - g2, then the model can be presented in the following way: 𝑬𝑽 = 𝑵𝑶𝑷𝑳𝑨𝑻𝟎 × (𝟏 − 𝒃𝟏) × (𝟏 + 𝒈𝟏) × [𝟏 − (𝟏 + 𝒈𝟏)𝒏 (𝟏 + 𝑾𝑨𝑪𝑪𝟏)𝒏] 𝑾𝑨𝑪𝑪𝟏 − 𝒈𝟏 + + 𝑵𝑶𝑷𝑳𝑨𝑻𝟎 × (𝟏 − 𝒃𝟐) × (𝟏 + 𝒈𝟏)𝒏 × (𝟏 + 𝒈𝟐) (𝑾𝑨𝑪𝑪𝟐 − 𝒈𝟐) × (𝟏 + 𝑾𝑨𝑪𝑪𝟏)𝒏 (𝟏) Where: NOPLAT0 = net operating profit for current year, b1 = reinvestment rate for NOPLAT during the explicit forecast period, b2 = reinvestment rate for NOPLAT after the explicit forecast period, g1 = expected growth rate of NOPLAT during the explicit forecast period, g2 = expected growth rate of NOPLAT after the explicit forecast period, WACC1 = weighted average cost of capital during the explicit forecast period, WACC2 = weighted average cost of capital after the explicit forecast period, n = number of years of the explicit forecast period. The first collectible at the right side of the equation is the sum of the present values of annual free cash Dimitir Nenkov / Finance, Accounting, and Business Analisys 43 flows to the firm (FCFI) during the explicit forecast period. The second collectible is the present value of the continuing or terminal value (CV, TV). CV is the equivalent of future FCFI after the end of the explicit forecast period. After expressing NOPLAT0 as a function of sales and the net operating margin and dividing both sides of the equation by (S0), we arrive at the two-stage fundamental model of the EV/S: 𝑬𝑽 𝑺 = Net operating margin × (𝟏 − 𝒃𝟏) × (𝟏 + 𝒈𝟏) × [𝟏 − (𝟏 + 𝒈𝟏)𝒏 (𝟏 + 𝑾𝑨𝑪𝑪𝟏)𝒏] 𝑾𝑨𝑪𝑪𝟏 − 𝒈𝟏 + + Net operating margin × (𝟏 − 𝒃𝟐) × (𝟏 + 𝒈𝟏)𝒏 × (𝟏 + 𝒈𝟐) (𝑾𝑨𝑪𝑪𝟐 − 𝒈𝟐) × (𝟏 + 𝑾𝑨𝑪𝑪𝟏)𝒏 (𝟐) The sales-based market ratios, even though a function of several variables, are mostly influenced by the profit margins – the net margin for P/S and the net operating margin for EV/S. Different sectors and businesses have different profit margins, which suggests different P/S and EV/S for these businesses. Companies in businesses with high margin should have high sales-based ratios and vice versa. A low profit margin directly leads to lower P/S and EV/S, but it has also indirect effect in the same direction, because it reduces the growth rate (g). However, this does not necessarily mean that all companies with low net margin or net operating margin would be with poor financial results and not creating value. Many companies rely on high turnover, which very often is at the expense of low operating margin. They bet on being the leaders in the market by volume of sales. Others bet on high margin, trying to be the price leaders. Not always the latter are better off than the first. This depends on the effect which the selected strategy has over the value creation process. Value creation itself depends on the spread between the return on invested capital (ROIC) and the cost of capital (WACC), at the enterprise level, and respectively on the spread between the return on equity (ROE) and the cost of equity (r), at the equity level. This is the moment to note that each of the two sales-based market ratios is influenced also by another variable, which does not show up in the above fundamental models of P/S and EV/S. In this connection it is useful to express ROIC and ROE in the following way: 𝑹𝑶𝑰𝑪 = 𝑵𝑶𝑷𝑳𝑨𝑻 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 = 𝑵𝑶𝑷𝑳𝑨𝑻 𝑺𝒂𝒍𝒆𝒔 × 𝑺𝒂𝒍𝒆𝒔 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 = = 𝑵𝒆𝒕 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑴𝒂𝒓𝒈𝒊𝒏 × 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝑶𝑬 = 𝑵𝑰 𝑬𝒒𝒖𝒊𝒕𝒚 = 𝑵𝑰 𝑺𝒂𝒍𝒆𝒔 × 𝑺𝒂𝒍𝒆𝒔 𝑬𝒒𝒖𝒊𝒕𝒚 = = 𝑵𝒆𝒕 𝑴𝒂𝒓𝒈𝒊𝒏 × 𝑬𝒒𝒖𝒊𝒕𝒚 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 The two equations indicate that the variable in question at the enterprise level is capital turnover ratio and at the equity level it is equity turnover ratio. Normally businesses with low margin have higher turnover of both invested capital and equity. This compensates the low profit margin, leading to ROIC and ROE which are high enough. This explains how companies with low profit margins can also create economic value added. The fact that the net margin is the leading (companion) variable, which has significant impact on the values of the P/S ratio is confirmed by different studies. For example, one very simplified regression of P/S against net margin for companies in sector “production of machines and equipment” on the Bulgarian Stock Exchange in 2006 establishes strong positive correlation and a relatively high determination ratio (R2) of 0.68. The same strong positive correlation is established between EV/S and the operating margin, with Dimitir Nenkov / Finance, Accounting, and Business Analisys 44 coefficient of determination (R2) of 0.78 23. In other words, in this case both margins explain the changes in the two market ratios to a very high extent. Damodaran makes annual regressions for each of the main market ratios against a group of independent variables. They also confirm the high weight of the profit margins in explaining the changes of P/S and EV/S.24 Fundamental P/S and EV/S for the Bulgarian Capital Market for 2017 Fundamental Р/S ratio for SOFIX For the calculation of the average fundamental P/S for the SOFIX we can use average values of the key variables which determine it. We can start with the one-stage model, as a more simple one. Besides the average net margin (Table 2), some other input variables for the USA are also needed, such as: cost of equity (r), return on equity (ROE) and retention rate (b). The last two variables are necessary for determining forecasted growth rate (g). These indicators are shown in Table 3. Table 3: Average ROE, ROA, ROCE, payout ratios and retention ratios for SOFIX as of July 2017 SOFIX Payout Ratio Retention Ratio ROE ROA ROCE Mean 0.41 0.59 9.98% 7.31% 8.70% Median 0.34 0.66 8.49% 6.06% 7.06% Minimum 0.07 0.19 1.02% 0.69% 0.47% Maximum 0.81 0.93 22.81% 15.04% 19.57% Source: Infostock: http://www.infostock.bg/infostock/control/trading/index/quotes/SOFIX (28 July, 2017) The difference between the mean and the median very significant and we can use each of them or the average between them. In this case, for determining the growth rate (g) we use the mean for the ROE of 9.98, which is slightly more optimistic, as well as the retention ratio of 0.59. Another important input variable is the average cost of equity for the companies on the Bulgarian market. We can take it from other studies. According to the prevailing opinion, there should be a country risk premium for emerging markets, such as the Bulgarian stock market.25,26 The arguments in favor of this vision can be seen in many publications,27, 28 but they are not the subject of this research. In this case we use a cost of equity, determined on the basis of the geometric average risk-free rate and the geometric average risk premium for the US stock market, plus a risk premium for Bulgaria. The latter is determined using the combined approach: the default spread of Bulgarian government bonds, multiplied by an adjustment coefficient. Thus, the cost of equity is: 23 Nenkov. D. – “Opredelyane na stoynostta na kompaniite”, Sofia, 2015, p. 286 24 Source: http://pages.stern.nyu.edu/~adamodar/ 25 Reilly, Frank K., Keith C. Brown – “Investment Analysis – Portfolio Management”, Thomson Learning, USA, 2003 26 Fishman, Pratt, Wislon, Griffith, Meltzer – “Guide to Business Valuations” 27 Damodaran, Aswath – “Investment Valuation – Tools and Techniques for Determining the Value of Any Asset”, John Wiley & Sons, New York, 2002 28 Copeland, Tom, Tim Koller, Jack Murrin –“Valuation – Measuring and Managing the Value of Companies”, John Wiley & Sons, New York, 2000 http://www.infostock.bg/infostock/control/trading/index/quotes/SOFIX Dimitir Nenkov / Finance, Accounting, and Business Analisys 45 RЕ (RRRЕ) = Risk-free Rate (USA) + Beta × Risk Premium (САЩ) + + Country risk premium (default spread on BG bonds × 1.23) = 4.91% + 1.0 × 4.62% + 2.20% × 1.23 = = 9.53% + 2.71% = = 12.24% Source: http://pages.stern.nyu.edu/~adamodar/ (Value Line, Bloomberg и Capital IQ) It is usually recommended to add also a specific risk premium, because of the smaller average size of Bulgarian companies, but in this case we ignore it, in order to avoid accumulating too many different risk premiums. This gives us the opportunity to find out what the results will be when we are not that conservative. Finally, the input variables for applying the one-stage model are: Net margin = 13.09% Plowback (retention) ratio b = 0.59 Cost of equity r (RRRE) = 12.24% Growth rate g = 5.89% (ROE × b = 9.98% × 0.59 = 5.89%) Table 4 shows the calculated by the model average fundamental P/S ratio. It is equal to 0.89 and is considerably lower than the actual arithmetic average P/S for SOFIX of 2.06, and the median of 1.34, as shown in Table 2. The low value of the fundamental (theoretical) P/S should be explained with the fact that regardless of the good net margin of 13.09%, ROE is much lower than the cost of equity (r). This fundamental P/S, which is much lower than the actual average P/S, indicates that the current SOFIX level is unjustifiably high. Table 4: Average fundamental P/S for SOFIX for 2017 (one-stage model) Pace of change of Net Margin (in %): 10% Pace of change of "r" (in %): 10% Values Values of Net Margin Of 6.5% 7.9% 9.2% 10.5% 11.8% 13.1% 14.4% 15.7% 17.0% 18.3% 19.6% "r" Р/S Р/S Р/S Р/S Р/S Р/S Р/S Р/S Р/S Р/S Р/S 6.1% 12.26 14.71 17.16 19.61 22.06 24.52 26.97 29.42 31.87 34.32 36.77 7.3% 1.95 2.34 2.73 3.12 3.51 3.90 4.29 4.68 5.07 5.47 5.86 8.6% 1.06 1.27 1.48 1.70 1.91 2.12 2.33 2.54 2.76 2.97 3.18 9.8% 0.73 0.87 1.02 1.16 1.31 1.46 1.60 1.75 1.89 2.04 2.18 11.0% 0.55 0.66 0.78 0.89 1.00 1.11 1.22 1.33 1.44 1.55 1.66 12.2% 0.45 0.54 0.63 0.72 0.81 0.89 0.98 1.07 1.16 1.25 1.34 13.5% 0.38 0.45 0.53 0.60 0.68 0.75 0.83 0.90 0.98 1.05 1.13 14.7% 0.32 0.39 0.45 0.52 0.58 0.65 0.71 0.77 0.84 0.90 0.97 15.9% 0.28 0.34 0.40 0.45 0.51 0.57 0.62 0.68 0.74 0.79 0.85 17.1% 0.25 0.30 0.35 0.40 0.45 0.51 0.56 0.61 0.66 0.71 0.76 18.4% 0.23 0.27 0.32 0.36 0.41 0.46 0.50 0.55 0.59 0.64 0.68 Source: Calculations of the author The values in the table also illustrate the high sensitivity of the fundamental P/S to the combination between net margin and r. They vary within a broad range from 0.23 at the bottom left corner of the table to 36.77 at the upper right corner of the table (under a combination of 6.1% cost of equity and a net margin of 19.6%). This is mainly due to the application of the one-stage model. The extreme values received under this model usually do not have economic sense and are not recommended for use. http://pages.stern.nyu.edu/~adamodar/ Dimitir Nenkov / Finance, Accounting, and Business Analisys 46 The one-stage models for determining the fundamental ratios reproduce the drawbacks of the capitalization models, from which they were derived, such as the Gordon dividend model and its analogues. Because of this, one-stage models easily yield illogical and misleading results for the fundamental ratios. This is why, it is recommended in most cases to apply the two-stage fundamental models. From the models above it became clear that the two-stage model divides the future into two sub-periods: high growth period and stable growth period. More conservative values for the growth rate g2 should normally be used for the stable growth period. The retention ratio b2 should be with some moderate value, such as 0.50. Other things being equal, the average ROE in the long run would most likely be equal to the average cost of equity r. This is why, in this case we assume that ROE during the stable growth period will be equal to the cost of capital of 12.24%. We also use the calculated average net margin for SOFIX of 13.09%, assuming that it will stay the same during the stable-growth period. Thus, the input variables for the two-stage model are as follows: Net margin for the first sub-period (first 5 years) = 13.09% Retention ratio for the first sub-period b1 = 0.59 Cost of equity for the first sub-period r1 = 12.24% Growth rate for the first sub-period g1 = 5.89% (ROE × b = 9.98% × 0.59 = 5.89%) Continuance of the first sub-period n = 5 years Net margin for the stable growth period = 13.09% (remains the same) Retention ratio during the stable growth period b2 = 0.5 Cost of equity during the stable growth period r2 = 12.24% Growth rate during the stable growth period g2 = 6.12% (ROE × b = 12.24% × 0.5 = 6.12%) The specifics in this case is that it is not correct to talk about a high growth period at the beginning. The input assumptions and variables are such, that forecasted growth rate during the first sub-period is actually somewhat lower than growth rate during the stable growth period. Table 5: Average fundamental P/S for SOFIX for 2017 (two-stage model) Pace of change of Net Margin (in %): 10% Pace of change of "r" (in %): 10% Values Values of Net Margin Of 6.5% 7.9% 9.2% 10.5% 11.8% 13.1% 14.4% 15.7% 17.0% 18.3% 19.6% "r" Р/S Р/S Р/S Р/S Р/S Р/S Р/S Р/S Р/S Р/S Р/S 6.1% 1.26 1.28 1.31 1.34 1.36 1.39 1.42 1.44 1.47 1.50 1.52 7.3% 1.19 1.21 1.24 1.27 1.29 1.32 1.34 1.37 1.39 1.42 1.45 8.6% 1.13 1.15 1.18 1.20 1.23 1.25 1.28 1.30 1.33 1.35 1.38 9.8% 1.07 1.09 1.12 1.14 1.16 1.19 1.21 1.24 1.26 1.28 1.31 11.0% 1.01 1.04 1.06 1.08 1.11 1.13 1.15 1.18 1.20 1.22 1.25 12.2% 0.96 0.98 1.01 1.03 1.05 1.07 1.10 1.12 1.14 1.16 1.19 13.5% 0.91 0.93 0.96 0.98 1.00 1.02 1.04 1.07 1.09 1.11 1.13 14.7% 0.87 0.89 0.91 0.93 0.95 0.97 1.00 1.02 1.04 1.06 1.08 15.9% 0.83 0.85 0.87 0.89 0.91 0.93 0.95 0.97 0.99 1.01 1.03 17.1% 0.79 0.81 0.83 0.85 0.87 0.89 0.91 0.93 0.95 0.97 0.99 18.4% 0.75 0.77 0.79 0.81 0.83 0.84 0.86 0.88 0.90 0.92 0.94 Source: Calculations of the author The calculated average P/S ratios is only 1.07 (Table 5). The P/S ratios, which are determined by using the two-stage model are much more precise. and is not sufficiently different from the fundamental P/S calculated through the one-stage model. As a rule, the results received under the two-stage model are much Dimitir Nenkov / Finance, Accounting, and Business Analisys 47 more precise. By forecasting the return on equity (ROE) for the stable growth period to be equal to the cost of equity on average, we come up with a combination, suggesting moderate levels of the fundamental P/S. Under the two-stage model, given a duration of the first period of 5 years, the weight of the cash flows from the stable growth period (the so called “continuing value”) is decisive for the present value of stocks. In the applied here two-stage model the net margin and the cost of equity (r) change only during the first sub- period, and remain constant during the stable growth period. This is why the values in Table 5 are not very sensitive to the different combinations between net margin and cost of equity. They vary within a narrow range between 0.75 and 1.52. This fundamental average P/S of 1.07 is higher than the one calculated under the one-stage model (0.89), but again…. it is almost two times lower than the average actual P/S for SOFIX of 2.06. It is quite lower than the median actual P/S of 1.34, too. We should bear in mind that we have made somewhat optimistic assumptions about net margin and ROE during the stable-growth period. In other words, the fundamental P/S of 1.07 could be regarded to as relatively optimistic. If we assume that the mean and the median of the actual average P/S are representative, we should conclude that the SOFIX index is overpriced against its fundamental value. Fundamental EV/S ratio for SOFIX The input variables for the fundamental EV/S are indicators at the enterprise level (or invested capital level), including: net operating margin, weighted average cost of capital (WACC), return on invested capital (ROIC), growth rate of net operating profit (g). In order to calculate WACC, we need the debt-to-capital ratio (D/C). For this purpose we use the closest to it indicator, available in the Infostock database for SOFIX companies – total debt-to-total assets. On 28 of July, 2017, its mean is 0.2555 and its median is 0.2400. 29 We use the mean of 0.2555 in this case. The cost of debt is determined on the basis of debt on a mature capital market (US market in this case), plus a premium, equal to the average default spread on Bulgarian government bonds, plus spread for companies with “AA” ratings, according to Standard & Poors Ratings Services: RD = Risk-free rate (USA) + Default spread on BG government bonds + Spread for companies with rating „АА“ according to S&P = 4.91% + 2.20% + 0.80% = = 7.91% Source: http://pages.stern.nyu.edu/~adamodar/ The corporate-tax rate (T) is 10%. Thus, the weighted average cost of capital is: WACC = E/C × RE + D/C × RD × (1-T) = = 0.7445 × 12.24% + 0.2555 × 7.81% × (1-0.10) = = 10.93% The rest of the input variables are taken from the mean (average) values in Table 1 and Table 2. In the place of ROIC (return on invested capital) we use the closest to it, available in Infostock – Return on capital employed (ROCE). 29 Infostock: http://www.infostock.bg/infostock/control/trading/index/quotes/SOFIX (28 July, 2017) http://pages.stern.nyu.edu/~adamodar/ http://www.infostock.bg/infostock/control/trading/index/quotes/SOFIX Dimitir Nenkov / Finance, Accounting, and Business Analisys 48 Thus, the input variables for the one-stage model for calculating the fundamental EV/S are as follows: Net operating margin = 14.23% Reinvestment rate b = 0.59 Weighted average cost of capital WACC = 10.93% Growth rate g = 5.13% (ROCE × b = 8.70% × 0.59 = 5.13%) The results of the application of the one-stage model are in Table 6. The calculated fundamental EV/S ratio for SOFIX is 1.06, about two and a half times lower than the mean of the actual EV/S of 2.67 and the median of 2.69. The conclusion is that this actual ratio for SOFIX also looks unjustifiably elevated. The values in the table show very high sensitivity to the combination between the operating margin and WACC. This has to be explained again with the usage of the one-stage model. Table 6: Average fundamental EV/S for SOFIX for 2017 (one-stage model) Pace of change of Net Operating Margin (in %): 10% Pace of change of "WACC" (in %): 10% Values Values of Net Operating Margin Of 7.1% 8.5% 10.0% 11.4% 12.8% 14.2% 15.7% 17.1% 18.5% 19.9% 21.3% WACC EV/S EV/S EV/S EV/S EV/S EV/S EV/S EV/S EV/S EV/S EV/S 5.5% 9.24 11.09 12.93 14.78 16.63 18.48 20.32 22.17 24.02 25.87 27.71 6.6% 2.15 2.58 3.01 3.44 3.87 4.30 4.73 5.17 5.60 6.03 6.46 7.7% 1.22 1.46 1.71 1.95 2.19 2.44 2.68 2.92 3.17 3.41 3.65 8.7% 0.85 1.02 1.19 1.36 1.53 1.70 1.87 2.04 2.21 2.38 2.55 9.8% 0.65 0.78 0.91 1.04 1.17 1.30 1.43 1.56 1.70 1.83 1.96 10.9% 0.53 0.63 0.74 0.85 0.95 1.06 1.16 1.27 1.38 1.48 1.59 12.0% 0.45 0.53 0.62 0.71 0.80 0.89 0.98 1.07 1.16 1.25 1.34 13.1% 0.38 0.46 0.54 0.61 0.69 0.77 0.85 0.92 1.00 1.08 1.15 14.2% 0.34 0.41 0.47 0.54 0.61 0.68 0.74 0.81 0.88 0.95 1.01 15.3% 0.30 0.36 0.42 0.48 0.54 0.60 0.66 0.72 0.78 0.84 0.90 16.4% 0.27 0.33 0.38 0.44 0.49 0.54 0.60 0.65 0.71 0.76 0.82 Source: Calculations of the author The input variables for the two-stage model are determined, following the same logic as for the two- stage fundamental P/S model. We assume that the net operating margin during the stable growth period will remain the same as for the explicit forecast period. For determining the expected growth rate g2 we assume that the return on capital (ROC) in the long term will be about the same as the weighted average cost of capital (WACC), and the reinvestment rate of the net operating profit (NOPLAT) is with a moderate value of 0.5. Dimitir Nenkov / Finance, Accounting, and Business Analisys 49 Thus, the input variable for the model are as follows: Net operating margin during the explicit forecast period = 14.23% Retention (reinvestment) rate during the explicit forecast period b1 = 0.59 Weighted average cost of capital during the explicit forecast period WACC1 = 10.93% Growth rate during the explicit forecast period g1 = 5.13% (ROCE × b = 8.70% × 0.59 = 5.13%) Continuance of the explicit forecast period n = 5 years Net operating margin after the explicit forecast period = 14.23% (remains the same) Retention (reinvestment) rate after the explicit forecast period b2 = 0.5 Weighted average cost of capital after the explicit forecast period WACC2 = 10.93% Growth rate after the explicit forecast period g2 = 5.46% (ROCE × b = 10.93% × 0.5 = 5.46%) Table 7: Average fundamental EV/S for SOFIX for 2017 (two-stage model) Pace of change of Net Operating Margin (in %): 10% Pace of change of "WACC" (in %): 10% Values Values of Net Operating Margin Of 7.1% 8.5% 10.0% 11.4% 12.8% 14.2% 15.7% 17.1% 18.5% 19.9% 21.3% WACC EV/S EV/S EV/S EV/S EV/S EV/S EV/S EV/S EV/S EV/S EV/S 5.5% 1.50 1.52 1.55 1.58 1.61 1.64 1.67 1.70 1.73 1.76 1.79 6.6% 1.42 1.45 1.48 1.51 1.54 1.56 1.59 1.62 1.65 1.68 1.70 7.7% 1.36 1.38 1.41 1.44 1.46 1.49 1.52 1.55 1.57 1.60 1.63 8.7% 1.29 1.32 1.34 1.37 1.40 1.42 1.45 1.48 1.50 1.53 1.56 9.8% 1.23 1.26 1.28 1.31 1.33 1.36 1.39 1.41 1.44 1.46 1.49 10.9% 1.17 1.20 1.22 1.25 1.27 1.30 1.32 1.35 1.37 1.40 1.42 12.0% 1.12 1.14 1.17 1.19 1.22 1.24 1.27 1.29 1.31 1.34 1.36 13.1% 1.07 1.09 1.12 1.14 1.16 1.19 1.21 1.23 1.26 1.28 1.31 14.2% 1.02 1.05 1.07 1.09 1.11 1.14 1.16 1.18 1.21 1.23 1.25 15.3% 0.98 1.00 1.02 1.04 1.07 1.09 1.11 1.13 1.16 1.18 1.20 16.4% 0.93 0.96 0.98 1.00 1.02 1.04 1.06 1.09 1.11 1.13 1.15 Source: Calculations of the author Table 7 shows that the received average EV/S ratio under the two-stage model is 1.30. The table also shows that as a result of the change of the net operating margin and the weighted average cost of capital during the explicit forecast period, the fundamental EV/S ratios vary within a narrow range – between 0.93 and 1.79. This is mainly due to the moderate average input variables during the stable growth period. The calculated average EV/S of 1.30, even though somewhat higher than the one under the one-stage model, is two times lower than the actual average EV/S for SOFIX of 2.67. This is again an indicator that the SOFIX is probably significantly overpriced. Dimitir Nenkov / Finance, Accounting, and Business Analisys 50 Conclusion The P/S and EV/S ratios provide excellent opportunity for analysis of stock prices and indexes on the different capital markets, including the Bulgarian market. Besides through the comparison among different markets, and with historic averages, actual P/S and EV/S can be even better analyzed by comparing them with the respective fundamental P/S and EV/S for each capital market. The derived fundamental P/S and EV/S ratios for SOFIX are much lower than the actual average ratios. This means that judging from these two market ratios, the SOFIX is probably highly overpriced. This conclusion, of course, is valid only if the average actual P/S and EV/S are representative for SOFIX, and if the input variables for calculating the fundamental P/S and EV/S for SOFIX are representative as well. Dimitir Nenkov / Finance, Accounting, and Business Analisys 51 REFERENCES Alford, A. W., 1992. The Effect of the Set of Comparable Firms on the Accuracy of the Price-Earnings Valuation Method, Journal of Accounting Research (Spring 1992), pp. 94-108 Block, E. F., 1995. A Study of the Price to Book Relationship, Financial Analysts Journal, January/February, 1995 Blodget, H., 2011, Is there a New Tech Bubble? No., Business Insider, Available at: