Value flows into and out of business designs, according to Adrian Slywotzky in “Value Migration”.  A key measure of that value flow is the price-to-sales ratio, which is the ratio of the market capitalization of a firm divided by its annual (or trailing twelve months) revenue. He asserts that a ratio greater than two indicates value inflow; a ratio less than one indicates value outflow.  In between is a region of stability.

Price-to-sales is a nice measure; it is easy to calculate, and, as a top-line measure, takes into account nearly all aspects of a firm’s business model. Other measures, like price-to-enterprise value, or price-to-earnings, factor out book value, and costs of doing business, respectively, which make comparisons more difficult. From an investor point of view, the price-to-sales ratio reflects relative optimism (or pessimism) about a given business design.

It is interesting to look at a portfolio of companies in various technology-based businesses, and plot their ratios. I chose 35 publicly traded companies, and plotted them on a semi-log scale (so they’d all fit.)

I segmented the companies into seven groups:  Reference companies, Industrial, Integrated, Hardware Technology, Software Technology, Internet, and X-as-a-Service companies.

The trend is striking. As companies become more and more “virtual”, their price to sales ratio generally increases. Whereas a dollar of incremental revenue will increase AT&T’s market capitalization by about $1.30, an incremental dollar of revenue for Workday (a provider of cloud-based HR and financial services) will drive a $40 increase in market capitalization!

One of the more subtle discoveries in the course of this research is that the vast majority of companies in the center and left of this chart pay dividends as a way to reward shareholder in the absence of significant price appreciation for sales growth. On the right hand side, it is all about sales growth.

The model can be applied to private and start-up firms as well, although such data is not readily available. It is reasonable to expect that valuations for venture investment would be higher for XaaS and pure-play Internet companies than for hardware-based companies.

I will continue to track this information on roughly six month intervals, and report back as to any emerging trends.