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.
A great starting point is understanding the most basic statistic. This statistic should be ingrained in your memory. Know where it comes from. Become familiar with current and past levels. Be able to make an educated guess on its future levels.
The word is revenue.
If it were not for revenue, a company would not sustain the ability to pay employees, suppliers, taxes to our government, and dividends to its owners. Understanding you are buying revenue is essential to success in 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 a train ticket 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 analysts to study the numbers and determine the best stock at what price.
We can do the same.
If we can identify the historical price these institutions have paid for the company’s sales, we can find areas when revenue was cheap and expensive. This can help in identifying buy and sell ranges.
Finding these past relationships may seem complicated; the good news is GuruFocus.com’s Interactive Chart feature makes it quite easy.
Let GuruFocus be your personal research assistant. Play with the charts. Learn the numbers and become familiar with a company you want to buy. Make it fun.
We begin by studying Caterpillar Inc (CAT) , a company found in Bill Gates's holdings.
In order to master this concept, it is best to start with predictable companies. Caterpillar is ranked 3-Stars in GuruFocus' Predictability measure.
This chart depicts CAT's price in green and revenue in blue.
Price is what we pay to buy one share of Caterpillar. Similar to when purchasing a train ticket, the price may be higher during rush hours and lower during off hours, stock prices have bargain and premium times too.
A train ride is what we buy at the train depot; revenue is what we buy in the stock market. For Caterpillar, we are buying the sales of mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. This blue sales line is less volatile; however, it does change over economic cycles. This is the golden ticket for investors.
Notice how CAT's price in 2000 was below the blue line but by 2006 was above. Fast forward to 2009 and notice how price decreased to below the blue revenue line.
What might explain why the investing public bid so little for sales in 2000 but 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. Ignoring it can cause financial ruin, as happened to many in the 19th Century Rail Mania.
Knowing it can make investors wealthy.
Below is a chart of CAT'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.
To interpret why this chart is important, compare the current level to the past. The range is from a low of .3 in 2009 to a high of 1.58 in 2011. It can be seen as a temperature gauge measuring the investing public's willingness to buy revenue. Next, examine what happened to price after it reached near P/S ratio extremes.
Below is a chart depicting CAT's price increase after the market bid .54 times the level of sales in 2000.
Those Buying near historical P/S lows experienced price gains.
Price gains also occurred after the P/S ratio lows of 2009.
Below is a chart of the price decrease after 2006 when CAT was above the 1.36x sales level. Those buying near historical high P/S levels experienced major price declines.
Understanding how market euphoria or despair affect price is important.
One way we can understand the P/S ratio is by looking at it from a business owner’s perspective. From every $1.00 received in revenue, the company deducts money to pay for employee salaries, materials supplied, interest on loans, and taxes to the government. Only after paying these expenses come earnings and dividends.
In Caterpillar’s case, for every $1.00 in revenue CAT has on average $0.94 of expenses. What's remaining, $.06, is profit, thus an average 6% profit margin.
When we buy a company's stock, we pay a multiple of sales. During good times, the market charges a premium for each $1.00 of sales. In bad times the market will offer a discount on each $1.00 of revenue. Market conditions are often reflected in the PS ratio.
In 2006, when the P/S was 1.34, the market was charging $1.34 for every $1.00 in sales. If we predict Caterpillar can maintain a profit margin of 6%, as a part owner, we estimate we will receive $0.06 on every $1.00 of sales.
Putting these numbers together, we calculate an estimated owner's yield. This "Owner's Yield" is revenue remaining after all expenses, divided by the price we pay for sales. For Caterpillar in 2006, that yield was 4.5%. This return was calculated by dividing the $0.06 earned on every $1.00 of sales and dividing it by the price we paid for sales, $1.34, ($0.06/$1.34).
However, if we purchased Caterpillar sales at a lower price to sales multiple, as the market offered in 2009, then our “owner’s earning yield” would be more. Had we purchased those same sales for only $0.30, as was offered in 2009, our return would have been about 20% ($0.06/$0.30).
Of course, this is a very rough calculation of owner’s earnings. Actual profit margins or revenue change may substantially differ from our estimates.
At today’s level, the market is bidding 1.2x sales for Caterpillar revenue. This is higher than the average reading after 1998. If we estimate 6% profit margins into the future and we are currently paying 1.2x sales, then our “owner’s earnings” yield is about 5% ($0.06/$1.20).
Perhaps 5% sounds comparable to BB-rated corporate bonds. Remember, however, buying common stock provides no guarantee of yield. There is also no guarantee bonds will stay at these levels either. The important thing is to compare this yield to its own historical levels. Within those ranges we mayidentify a margin of safety where institutional investors are comfortable buying.
In addition, ask yourself these questions: What were past growth rates? What are the estimated future growth rates? Where are profit margins in relation to historical levels? Are market conditions creating pressure on profit margins? How will a capital intensive business fair if interest rates rise?
Do your homework. Study the company. Study its history in good times and bad. Become familiar with the numbers backward and forward. Recite the historical bargain levels. Have fun with the numbers. Make it a game and create good-looking charts.
We must put the odds in our favor by being our own investment analyst. And never forget: Revenue is what you buy and price is what you pay.
Thanks to GuruFocusfor providing the Interactive Charts.
