A company's size can be measured in different ways. It can be the amount of assets it owns, number of employees, number of factories or amount of income it is generating. The equity market determines a company's size as its market capitalization, its share price multiplied by the number of shares issued. Generally there is a reasonable connection between a company’s physical size and its market capitalization (its assessed value), but not always.

Perhaps the best measure of a company's physical size is how much revenue it generates. Revenue is a relatively blunt tool for assessing a company's value. Profit margins, cash conversion, debt levels and growth rates can differ between two companies. However, comparing market capitalization to revenue can sometimes be revealing. We find it particularly useful for identifying companies at the extreme ends of market optimism and pessimism. This is because profit margins are often volatile and future growth rates are subjective.

For example, a company with $1 billion of revenue, might have a $10 million market capitalisation if it is currently making losses and the market determines that will be the case for the foreseeable future. Alternatively, a company with no revenues and ten boffins sitting behind computers in a shabby office in Silicon Valley might have a market capitalization of $1 billion if the market believes the company will grow quickly and generate large profits and revenues in the future.

Take Tesla versus Toyota for example. Tesla manufactures cars from four manufacturing plants with a capacity of around 2 million units per year, employing around 99,000 people. Tesla’s most recent quarterly vehicle production volume came to 305,407 units. Last year it generated revenue of US$53 billion, forecast to grow to $83 billion in this year. Toyota operates around 40 car plants around the world. The consolidated entity employs around 360,000 people. Toyota has capacity to produce around 9 million units per year. Its revenue last year was $257 billion, forecast to be US$270 million in a more normal post-COVID year. Despite falling nearly 50% from its price highs in 2021, Tesla is still considered to be a larger company than Toyota by the market. Its current market capitalisation is US$670 billion, versus $217 billion for Toyota.

The difference in market capitalisations is primarily due to market expectations of earnings growth. Obviously, Tesla’s revenue growth is higher than Toyota’s. The market is obviously assuming that this growth will continue and is probably right. But small changes in expectations of growth will have a dramatic impact on the assessed value of Tesla. Toyota’s market capitalization is anchored more by its current revenue.  

Considering the connection between market capitalisation and revenues is particularly relevant today. Recently, market capitalisations have been pushed higher above revenues than historic averages. This has been due to several reasons. Lower interest rates increase the value of future cashflows, profit margins have been high, and expectations of growth have been high, particularly in new, large tech companies.

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Since 1994 the Price to Sales ratio for the New Zealand equity market has averaged 1.5x. At its current 2x revenues it remains elevated compared to this recent history. Below is the list of companies in the S&P/NZX50 index, ranked by Price to Sales Ratio.

The numbers above are a disaggregation of the current market average Price to Sales multiple of 2x. As you would expect some companies are above the average and some are below, but what is surprising is the huge range from highest to lowest, from Pacific Edge at 48x to Fonterra at 0.2x.

In volatile markets, expectations about the future can change dramatically as the market seesaws between optimism and fear. And where a company trades on an elevated Price to Sales ratio, there is likely to still be levels of optimism in the share price. In our opinion, companies that have market values anchored by substance and significant revenues for the price paid, are on average likely to recover more quickly once the share market calms.