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Common Misuses of the P/S Ratio

March 24, 2014 | About:
Grahamites

Grahamites

114 followers

A few years ago, when I first started my investment journey right after college, I used to subscribe a value investing service. A typical buy recommendation from the service would be as simple as the following:

XYZ is trading with a forward P/E of 11.2 which puts it well underneath the average of the S&P 500 at 16.5x. It has a price-to-sales ratio of just 0.3. A P/S under 1.0 usually indicates value. XYZ also has an attractive price-to-book ratio of 1.3. I look for stocks with P/B ratios under 3.0 to find value.

I thought the above statement was extremely misleading. Most readers on this forum should be fairly familiar with the shortcomings of the P/E and P/B ratios but I think misconception about the P/S ratio is still prevalent, even among non-professional value investors. In this article, I will discuss the shortcomings of the P/Ss ratio and where I see investors stumble when using this ratio.

Let’s start with a review of the P/S ratio. Essentially, the P/S ratio is a simple valuation metric calculated by taking the company's market capitalization and dividing it by the company's total sales over the past 12 months. The popular wisdom says the lower the ratio, the more attractive the security.

Arguments in favor of the P/S ratio include:

  • P/E is meaningless for companies suffering from losses.
  • Sales number is harder to manipulate than earnings.
  • Because sales tend to be more stable than earnings, P/S can be a more reliable indicator for companies with fluctuating earnings patterns.

Arguments against the P/S ratio include:

  • P/S is useless if sales cannot translate into earnings.
  • Sales can still be subject to management manipulation.
  • P/S ratio does not capture the capital structure of a company. For example, heavily leveraged companies with a ton of debt can have very low P/S ratios because their sales have not suffered as big as a drop as that of the equity values.

As the P/S ratio is so simple to use, many professional services have been promoting a screening method based on this ratio alone, such as this one.

In my observation, many investors are able to discern the capital structure factor that can cause a very low P/S ratio. A common misuse of P/S ratio, especially when comparing investment opportunities, is the failure to consider the impact of margin, which varies vastly from industry to industry, on the P/S ratio. Put into other words, the P/S ratio is not a useful metric when viewed separately from operating margins. Very often an investor choose one investment over another based on the lower valuation implied by the P/S ratio.

A dollar of sales at a highly profitable firm is worth more than a dollar of sales for a company with narrow profit margins.

To understand the differences across industries, let's compare Wal-Mart with Priceline.

Wal-Mart, like most other grocery stores, tend to have very small profit margins and very fast inventory turnovers, earning only a few pennies on each dollar of sales. As such, Wal-Mart and other grocery stores deserve a very low P/S ratio. In fact, the latest P/S ratio is just about 0.50. Because it takes a lot of sales to create a dollar of earnings at Wal-Mart, investors should not value those sales dollars very highly.

Meanwhile, Priceline has a much fatter profit margin. Relative to the Wal-Mart, it does not take nearly that much in sales to create a dollar in earnings. As such, Priceline and other online travel agencies deserve a much higher P/S ratio than that of Wal-Mart. The most recent P/S ratio for Priceline is well over 9. Granted this may include the potential overvaluation of the common stocks of Priceline but nevertheless, a P/S ratio of 5 or more should be reasonable for a company with margins like Priceline.

You may be wondering since there are so many industries out there and how do non-professional investors gather the necessary data needed in order to evaluate industry margins and appropriate P/Ss ratio to use for specific industries. Fortunately, renowned NYU Professor Aswath Damodaran built this terrific database of industry margins and related P/S ratios, which he shares with the investing public. I encourage the readers to take a look of this link.

Another common mistake when using a P/S ratio is the failure to take into consideration future sales growth for a profitable company, or sales contraction for a non-profitable company when valuing a company using the P/S ratio. For example, back in 2007, when the iPhone was first launched, Apple’s stock experienced one of the highest P/S ratios in its history. Investors who used TTM P/S ratio may conclude that AAPL looked expensive. But in the next few years, Apple’s revenue has almost sextupled. So a TTM P/S ratio of six during 2007 is misleadingly expensive. Apple’s stock has almost tripled since, while the P/S ratio has dropped. On the other hand, RadioShack had a R/S ratio of below 0.25 during 2011. But if you had bought RadioShack on the basis of a low P/S ratio, you would have lost your shirts as the stock kept plunging along with deterioration of business. As of today, RadioShack’s P/S ratio has dropped below 0.10 and the stock has dropped from more than $9 in 2011, to just above $2 per share.

So to sum up, as with all other valuation techniques, the P/S ratio is just the beginning of the valuation process. Low P/S may indeed indicate great value after taking margins, capital structure and growth into consideration. In other cases, P/S can be a sign of classic value traps.


Rating: 4.7/5 (12 votes)

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Comments

eddysee
Eddysee - 4 months ago

Thank you for sharing and hope to see more of your articles. My personal opinion of using either PE or PS should only be applied after doing the fundamental check on the companies historical financial performance of at least 5-10yrs to give you a gauge of the health of the company. PS or PE can then be applied as a useful measure of their valuation, but the reference should be base on historical or similar industry to check if the price is indeed under value vs peers or historical performance.

Grahamites
Grahamites premium member - 4 months ago

Eddysee, you are welcome for the article and thanks for the nice words. And I agree you should apply the multiples after thorough fundamental check. I wrote this article because I've seen so many so-called "professional" investing services try to beguile unsophisticated investors by providing recommendations based on low p/s, p/e and the like.

johnheiderscheit
Johnheiderscheit - 4 months ago

Good article. I have been a fan of price to gross profit for screening for years, but few screeners offer p/gp as an option. Do you know of any stock screeners where you don't have to back into the p/gp calculation?

Grahamites
Grahamites premium member - 4 months ago

Unfortunately I don't know any stock screeners that satisfy your criteria. I've never used P/GP as

(1) You can have a business with high gross margins but very profit margin.

(2)Even though you can have a business with high gross margins and high profit margins, the business may be turning over its inventory very slowly.

Exone, one of the 3D printing companies is such an example. Very high gross margin, but no profit and low turnover.

If you've used this ratio successfully in the past, I'd like to hear your thoughts on how you apply it.

Thanks

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