The price to sales ratio is one of the important criteria for selecting value stocks. Famous long term stock investors such as Warren Buffett have the difficult task of trying to place a relative value on a publicly traded company. How can the price to sales ratio help value investors achieve this goal?
Price to Sales Ratio is a Revenue Based Valuation
Investors use numerous methods to valuate stocks. Some of the more common metrics are earnings based such as the price to earnings ratio, or the PEG ratio which is price to earnings divided by growth. Other valuations are based on free cash flow or the net worth of all assets minus liabilities also called book value.
The price to sales ratio is derived this way: all of the shares multiplied by the current market price equal the market capitalization. This number is the total value of all shares. Next, divide this number by the previous 12 months of revenue.
Imagine that a company issues 100 shares at the price of $100 each. The market capitalization is 100 x 100 or $10,000. If the annual revenue was also $10,000 dollars then the price to sales ratio would be 1. The mathematical formula for the PSR ratio is quite simple. What can an investor derive from it?
PSR Ratio Applications
Both Ken Fisher, author of the 1984 book Super Stocks, and James P. O’Shaughnessy, who wrote the book What Works on Wall Street, feel that the price to sales ratio is a key to identifying potentially undervalued stocks. While these two well known investors may use slightly different approaches than each other when selecting companies, they both agree that low PSR ratios can indentify cheap stocks.
Ken Fisher asserts that a PSR ratio under 1 is important. This means that the 12 months of trailing revenue is equal to the market capitalization of the stock. How can this improve an investor stock picks over the sole use of earnings based ratios?
Earnings may Fluctuate Based on Numerous Factors
The reported earnings could have all sorts of one-time oddities driving prices up or holding them down. Assets could be sold off to boost the bottom line as could a non-reoccurring tax break. Investors following earnings based ratios might be lured into the seemingly cheap stock. Revenue based investors will be able to ascertain that no fundamental change has occurred in sales; the erratic earnings report needs to be taken with a measure of skepticism.
Or the earnings could be taking a beating for a host of short term reasons. Focusing on the price to sales ratio will enable one to look past the current earnings report to discern if the company has strong fundamental reasons to go up in the future. If the PSR ratio remained at 0.5 while the earnings dropped, the company would still have a strong sales base to create future earning opportunities from.
Be Wary of Problems
Companies with low price to sales ratios might truly be undervalued or they might be in serious financial distress. A company with heavy debt might appear to be undervalued, but a quick look at the book value, debt to equity ratio or the enterprise to sales value might give a clue as to latent issues.
- Market to book value will show how close the current market price is to the net asset value of the company.
- The debt to equity ratio divides the debt by the equity. means the debt is equal to the equity. A low ratio such as 0.5 or less is desirable.
- EV or enterprise value factors debt into the market value. Enterprise value divided by 12 months of sales will help eliminate low PSR stocks with high debt from the screening process.
Value investing involves much more than merely calculating one revenue based formula. The article linked to here provides the other criteria needed for selecting a value stock with growth potential. Still, a very important investment metric to comprehend is the price to sales ratio.