Price and Sales Education Series
To run a successful investment program requires doing your due dilligance. None of the investment greats, the ones with a continuous successful investment record, invest blindly. They familiarize themselves with what they are about to buy.
If you ever attend a Berkshire Hathaway annual shareholder meeting, you will know why Warren Buffett is different than the average Joe. He does his homework. He also does extra credit. You should too.
The first statistic you must study is revenue The lack of revenue means employees, suppliers, taxes and dividends are not going to be paid. Understanding you are buying revenue is essential.
The second task is to study the price the market has historically bid for a company’s sales. This will assist in identifying entry and exit points.
Large institutional investors like pension funds, endowment funds, hedge funds and insurance companies buy at a certain multiple of sales. Their team of securities analysts are hired to identify what that level is.
We should do the same.
GuruFocus.com’s Interactive Chart feature makes finding these past relationships quite easy.
Study the charts, play with the graphics, learn the numbers and most importantly become familiar with a company you want to buy. Let GuruFocus be your personal research assistant, and enjoy the process.
Let’s begin by studying a company that is ranked 5-Stars in GuruFocus' Predictability measure, Deere & Company (DE, Financial).
This chart depicts DE's price in green and revenue in blue.
Price is what we pay to buy one share of Deere & Company. Similar to how the price of corn seed fluctuates before Howard Buffett, son of Warren Buffett, purchases seed for his farm, stock prices change based on market conditions too.
Corn seed is what Howard buys from a grain dealer; revenue is what we buy in the stock market. For Deere & Company, we are buying the sales of, “products and services for agriculture and forestry and a major provider of advanced products and services for construction, lawn and turf care, landscaping and irrigation.” This blue sales line is less volatile; however, it does change over economic cycles. This is the golden ticket for investors.
Notice how DE's price in 1998 was below the blue line but by 2007 was above. Fast forward to 2009 and find price far below the blue revenue line.
What might explain why the investing public bid so little for sales in 1998 but so much in 2007?
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 DE'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 .39 in 2009 to a high of 1.73 in 2007. 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 DE's price increase after the market bid .54 times the level of sales in 1998.
Those buying near historical P/S lows experienced price gains, as witnessed in Brian Rogers’s Deere & Company holdings.
Price gains also occurred after the P/S ratio lows of 2009.
Below is a chart of the price decrease after 2007 when DE reached 1.73x sales. 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 Deere & Company’s case, for every $1.00 in revenue DE has on average $0.94 of expenses. What's remaining, $.06, is profit. Thus, DE has 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 2007, when the P/S was 1.73, the market was charging $1.73 for every $1.00 in sales. If we predict Deere & Company 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 Deere & Company in 2007, that yield was 3.5%. 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, $1.73, ($0.06/$1.73).
However, if we purchased Deere & Company 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 $0.39, as was offered in 2009, our return would have been about 15% ($0.06/$0.39).
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 .8x sales for Deere & Company revenue. This is near the average reading after 1998. If we estimate 6% profit margins into the future and we are currently paying .8x sales, then our “owner’s earnings” yield is about 7.5% ($0.06/$0.80).
A 7.5% yield may sound great compared to government bonds. However, one must remember buying common stock provides no guarantee of yield. The important thing is to compare this yield to its own historical levels. Within those ranges we may identify 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.
1940's John Deere Flash Back from Yvonne Fausak on Vimeo.
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.
Thanks to Howard Buffett for his efforts in fighting global hunger.
