Studying the price the market has historically bid for a company’s sales could help in identifying when to buy or sell a stock.
Often times, large institutions like insurance companies, pension funds, endowment funds, and hedge funds buy at a certain multiple of sales.
If you can identify the historical range these institutions have paid for the company in the past, it could help indicate levels to buy or sell. However, there is one drawback every investor must know to this investment concept.
The chart below depicts Procter & Gamble's (PG, Financial) Market Capitalization in green and trailing twelve months revenue in blue.
Market capitalization is the price to buy all the stock of a company. It fluctuates up and down substantially as the investing public becomes greedy and fearful.
Trailing twelve months revenue is the value of Procter & Gamble's sales for the past year. This blue sales line is much less volatile, but still has fluctuation.
Notice how PG's Market Cap. (price) in 1995 started very close to the blue line (annual revenue) and by 2000 was way above. Fast forward to the middle of 2000 and notice how Market Cap retraced towards the blue line. This was when many institutions were fearful and desperate to sell.
Below is a chart of Procter & Gamble's price-to-sales ratio starting in 1998. This chart is created by taking the Market Cap and dividing it by Revenue. It includes the same numbers as the chart above, but depicts it in an easy to understand chart.
To interpret why this chart is important, we take the recent level of 3.1 and compare it to the past. There were a few times when the P/S Ratio reached above 3.1: around 1998-2000, December 2006 and December 2007.
What happened to the price of Proctor & Gamble after institutions bid 3.1 times the level of sales?
Below is a chart depicting PG's price decline in 2000. A near 35% decline in price occurred for those buying above the 3.1x sales level.
Below is a chart of the price decline in percent for those buying in 2006-2007. Once again, those buying above 3.1X sales had a major loss of 30%.
For those who purchased PG in November 2014, when the P/S ratio once again hit 3.1, will this time be different?
If you predict revenue to grow at the rates PG saw from 2002 to 2008, then perhaps this time is different.
In 2002, the P/S ratio was above 3.1, and fast-forward to March 2009, the P/S Ratio was 1.86. What explains this substantial drop in the P/S multiple without an accompanying major price decline? As seen in the chart below, one can identify a major drawback in the P/S ratio concept: not accounting for revenue growth.
Remember, revenue is what you buy and price is what you pay. If you predict revenue to grow at a substantial rate, perhaps the current high multiple will justify itself in a short period of time. If you don’t estimate another quick and large revenue increase, perhaps this time is not different.
Thank you to GuruFocus.com for providing the graphics.
