Shopping for a Margin of Safety: Bed Bath & Beyond

BBBY

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Nov 11, 2014

Price to Sales Education Series

Understanding a company is essential to a successful investment program. The more familiar we are with a company’s statistics the better chance of putting the odds in our favor. Investing is similar to shopping. There are bargains and there are rip-offs. If you don't know which one you are getting, it is certainly the latter.

Before taking any action, we must develop techniques to prevent receiving the short end of the stick. In order to keep from getting ripped off in the investing world, there is one word “shoppers” must ingrain in their memory, even become obsessed with its historical levels. They must know where it came from, and have the abiltiy to roughly estimate its future levels.

The magic word is revenue.

If it were not for revenue, a company would not sustain the ability to pay employees, suppliers, dividends to owners and taxes to our government. Thus, understanding you are buying 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. It is similar to understanding when shopping for a gallon of milk is a bargain.

Often times, large institutions like insurance companies, pension funds, endowment funds, and hedge funds buy at a certain multiple of sales. They employ investment shoppers to study the numbers and determine the best stock at what price. You can do the same.

If you can identify the historical price these institutions have paid for the company’s sales, you'll know a bargain may be available. Finding these past relationships may seem complicated, but GuruFocus.com’s Interactive Chart feature makes it quite easy.

Let’s begin by studying a company that is ranked high in GuruFocus’ Predictability measure, Bed Bath & Beyond (BBBY, Financial). This chart depicts BBBY’s price in green and revenue in blue.

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Price is what we pay to buy one share in a company. Just like retail, it fluctuates up and down in relation to supply and demand.

Revenue is the value of BBBY’s sales per share for the past year. The blue sales line is less volatile, however it does change over economic cycles. This is the golden ticket for investment shoppers.

Notice how BBBY’s price in 1995 was touching the blue line and in 2004 to 2006 it was far above. Fast forward to 2009 and notice how Market Cap dropped below the blue line.

What might explain why the investing public bid so little for sales in 1995 and so much in 2006?

Much of these trends are due to investor psychology. Understanding why, by how much, and how often it occurs is paramount to an investment shopper's responsibilities.

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Below is a chart of BBBY’s price-to-sales ratio starting in 1998. This chart is created by taking the price 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.

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To interpret why this chart is important, compare level 1.2 to the past. The range is from a low of .67 in 2009 to a high of 3.67 in 2002. Next, examine what happened to price after it reached near these P/S ratio extremes.

What happened to the price of BBBY after institutions bid .67 times the level of sales in 2009?

Below is a chart depicting BBBY’s price percent increase. Those buying near historical P/S lows experienced price gains.

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Below is a chart of the price percent decrease after 2002 when BBBY was above the 3.6x sales level. Those buying near historical P/S highs experienced major price declines.

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One way we can understand the P/S ratio is by looking at it from a business owner’s perspective. If we predict BBBY can maintain profit margins around 7% (see chart below), as a part owner, we estimate we will receive 7% of whatever sales are.

In 2002, when the P/S was 3.6x sales, the estimated owner's yield was 1.9%. This return was calculated by dividing the $0.07 earned on every $1.00 of sales and dividing it by the price we paid for sales $3.6 ($.07/$3.60).

However, if we purchased BBBY sales at a large discount, as the market offered in 2009, then our “owner’s earning yield” would be more. If we only paid $0.67 for every $1.00 of sales and our average return on every dollar of sales is still $0.07, then our return is about 10.4% ($0.07/$0.67).

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Of course, this is a very rough calculation of owner’s profits. Actual profit margins or revenue change may substantially differ from our estimates.

At today’s level, the market is bidding 1.2x sales for BBBY revenue. This is slightly lower than the last few years and compared to the long term historical trend is much lower. If we estimate 7% profit margins into the future and we are currently paying $1.20x sales, then our “owner’s earnings” yield is about 5.8% ($0.07/$1.20).

Perhaps 5.8% sounds fine, but the important thing is to compare this yield to its own historical levels. What were the growth rates back then? What are the estimated growth rates today?

Do your homework. Study the company. Become familiar with the numbers backwards and forwards. Recite the historical bargain levels. As a soccer coach said in his famous training video, to master the game of soccer, "sleep with your soccerball."

Remember, we must put the odds in our favor by being our own investment shopper. And never forget: revenue is what you buy and price is what you pay.

Thanks to GuruFocus for providing the Interactive Charts.