Where do earnings come from? Where do dividends come from? Where do paychecks come from? All these things derive from one source: revenue. If it were not for revenue, a company would not sustain the ability to pay employees, suppliers, and dividends to owners. Thus, understanding revenue is an essential ingredient to successful investing.
In particular, studying the price the market has historically bid for a company’s sales is of utmost importance 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. Finding these past relationships seems complicated, but using GuruFocus.com’s Interactive Chart feature makes it quite easy.
Let’s start with the chart of United States Gypsum Corporation below. This chart depicts USG’s Market Capitalization in blue and trailing 12 months revenue in green.
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 12 months revenue is the value of USG’s sales for the past year. This green sales line is less volatile but does change over economic cycles.
Notice how USG’s Market Cap. (price) in 1998 and 1999 was above the green line (TTM revenue) and by 2002 was below. Fast forward to 2006 and notice how Market Cap again approached the green revenue line.
What might explain why the investing public bid so much for sales in 1999 and 2006 and so little in 2002 and 2008?
Below is a chart of USG’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. Click the “P/S Ratio” tab in Interactive Chart to enable this feature.
To interpret why this chart is important, we take the recent level of 1.0 and compare it to the past. The range is from a low of .04 in 2002 to a high of 1.09 in 2014. We then examine what happened to price after it reached near these P/S ratio extremes.
What happened to the price of USG after institutions bid .86 times the level of sales in 1999?
Below is a chart depicting USG’s price decrease in percent. Those buying when USG was above the .8X sales level experienced a 90% decrease in price.
Below is a chart of the price percent increase after 2002 when USG was below the .15x sales level. Those buying near historical P/S lows experienced major price gains around 750%.
Another feature that helps identify opportunity and risk is the “Price at Med P/S” tab. This concept is the Price USG would be if it traded at the Median P/S ratio. Half the time USG trades above this level and half below. Below is a chart that features this.
The further below the green Median P/S line the Blue Price line goes, the larger a discount you get on USG sales. Way above this line, the investing public is bidding a higher premium on USG sales.
At today’s level, the market is bidding 1.0x sales for USG revenue. This is one of the highest levels the public has bid for USG sales. Substantial revenue growth or margin improvement is possible, but is it probable?
For those who purchase USG above .8x sales today, will this time be similar to the previous two?
Remember, revenue is what you buy and price is what you pay.
Thank you to GuruFocus.com for the Interactive Chart feature that enables these graphics.
