# Is there a relation between market capitalization and revenues?

The company 3M has at this moment an anual revenue of \$33 billion and a market capitalization of \$102 billion. Therefore market cap is 3 times higher than revenues. For Chevron the rate si 2.3. For Tesla it is a whooping 33

Is there any study about the average such relation of the companies included in say Dow Jones Industrial Average or in other such indexes or of any relevant group of companies?

Is there a name for this index (market cap divided by annual revenue) by the way?

The market cap divided by annual revenue is called the price/sales ratio (P/S). In general it is not very useful or precise metric of fair value of a company. If a company has massive revenue, it may still have low profits and no dividends and no expectations of growth.

However, P/S may be somewhat useful when you compare companies in the same sector as they usually have similar profit margin and growth rates, especially when you may believe that the price/earning ratio (P/E) is misleading, e.g. if earnings fluctuate a lot or when a company has faced a temporary decrease of earnings that doesn’t affect its long-term profitability. Earnings also could be manipulated or calculated in different ways across companies, in such case relying on sales can help to asses a company.

A noticeable problem of P/S is that it doesn’t take leverage into account. The assets that are used by a company are financed by both equity and debt. That’s why one can consider using enterprise value divided by revenue to asses the performance of a company.

As Dow Jones consists of companies from very different sectors, P/S is probably of little value.

To understand the precise relation between the market capitalization and the revenue we can use basics of the theory of finance.

Brushing aside some complexities of our reality, we can say that the value of a company is determined by the sum of its discounted free cash flow,

$$\sum_{t=0}^\infty \frac{\text{Cash flow}_t}{1+\text{Discount rate}_t}.$$

I.e. how much you would pay for a company today equals to how much money you could receive in the future taking into account the fact that money received sooner are more valuable than money received later.

A common assumption in economics and finance is that the relative change in value of money is constant over time, i.e.

$$1+\text{Discount rate}_t = (1+ \text{Discount rate})^t.$$

A common assumption about mature companies is that the growth of their dividends (the cash flow you get if you own a company) is stable, i.e.

$$\text{Cash flow}_t = \text{Cash flow}_0 \times (1+\text{Growth rate})^t.$$

Taking that into account and using some math we arrive to the Gordon growth model (GGM) which allows us to rewrite the value as

$$\text{Last dividend} \times \frac{1+\text{Growth rate}}{\text{Discount rate} - \text{Growth rate}}.$$

As dividends are equal to revenue multiplied by profit margin and payout ratio (the part of profit that isn’t paid is reinvested to sustain the growth), we can arrive to the justified P/S using GGM. In such case it is equal to $$\text{Profit Margin} \times \text{Payout ratio} \times \frac{1+\text{Rate of growth}}{\text{Discount rate} - \text{Rate of growth}}.$$

As we can see, the fair P/S ratio consists of many moving parts that vary across companies and sectors. If we simplify it even further and assume that a company pays out all its profits and has no growth, the fair P/S value will still crucially depend on the profit margin. If we move away from the GGM model and assume, for example, that a company is in the stage of growth then the precise fair P/S value will depend on the path of that growth and the characteristics of the company at the moment when it becomes mature.

• Thanks. But maybe successful startups have a high P/S ratio? If I would invest at stock exchange I wouldn't look for profits and dividends. I would try to save in the shares that have increasing prices, and P/S looks like a very interesting index. A high ratio can not exist without a reason. Buying cheap and selling 10 times more expensive looks a lot better than 2% in annual profits and dividends Commented Dec 30, 2021 at 8:17
• High P/S and P/E ratio for startups may mean that investors expect above-average growth in future. Commented Dec 30, 2021 at 23:12