Today I want to take an in-depth look at what James O'Shaughnessy, author of "What Works on Wall Street," found to be the best historical value metric – the price to sales ratio. I'll discuss how to calculate it, what it tells us and how you can incorporate the metric in your investing approach.
What is price to sales?
The price-to-sales ratio, or P/S, is one of the most basic ratios out there. It's also considered a relative valuation metric since you need to compare one company's with another's, or to its own historical ratio, to find out whether the firm is undervalued or overvalued.
This metric is exactly what is sounds like, price divided by sales – or more precisely price divided by sales per share. In other words, what you're paying for every $1 of sales the company makes. A P/S ratio of 2 means you're paying $2 for every $1 of sales while a P/S of 0.5 means you're paying 50 cents for every $1 of sales.
Calculation – Let's use Apple (AAPL, Financial) as an example. Apple's current share price is right at $100. And we see its TTM revenue is 227,535 while its TTM shares outstanding equals 5,648.
- To obtain Apple's P/S ratio divide share price by sales per share.
- 100 / (227,535 / 5,648) = 2.48.
What did the P/S ratio reveal?
One of the great things about the P/S ratio is that it looks at sales rather than earnings. This is beneficial in two ways. One is you don't have to deal with the accounting tricks and manipulation that come with earnings, one of the shortcomings of the P/E ratio. And two, you can value companies that aren't currently profitable rather efficiently. There are three primary instances where the P/S ratio comes in handy:
- Cyclical companies – In cyclical industries, there are often years when only a few companies are able to turn a profit. In these instances the P/S ratio is useful in determining value. An increased P/S can warn the investor of overvaluation while a decreasing number may point to a recovery.
- Growth companies experiencing temporary setbacks – Growth stocks are notoriously tough to value since earnings are often spotty at best. Just look at Amazon (AMZN, Financial) as an example. It seems it can turn a profit at the flip of a switch but is often reinvesting so much that it makes it hard to be consistent. In this instance you can use the P/S figure as a valuation tool.
- Turnarounds – With turnarounds earnings are almost never present, hence the name. However, as is the case with cyclical companies, a decreasing P/S ratio may indicate a rally is near.
While there is probably no screener out there the P/S ratio wouldn't make better, there are a few drawbacks of which the investor should be wary. For starters, sales don't always translate to earnings. While you can certainly use P/S instead of P/E in certain instances, all things being equal you should definitely choose the company with higher margins, which is why gross and net margins should always be viewed with P/S. For instance, if company A and company B each have similar P/S ratios, but company A has 40% and 15% gross and net margins while company B has 10% and 5%, company A should be the obvious choice. I only bring this up because companies with increasing profitability margins will tend to have higher P/S ratios.
Second, low P/S ratios often accompany firms with increasing debt. This is due to sales being converted into paying off debt rather than the bottom line. This ultimately hurts the shareholder because sales and share price are not decreasing while the company may be inching closer and closer to bankruptcy. In instances where debt is a factor you would be better off using enterprise value to sales, or EV/S, since this metric incorporates long-term debt into the numerator.
How to use the P/S ratio
Ten-year price to sales study
- Average annual return.
Even with its limitations, the P/S ratio has proven to be a formidable valuation tool in the long run. O'Shaughnessey performed a study stretching from 1951 to 2003 and found the P/S ratio to be the most consistent and best valuation metric available. His low P/S stock basket ended up beating the market in 88% of the rolling 10-year periods. The next closest – P/B ratio, which beat the market in 72% of rolling periods.
Another study (performed between 2000 and 2010) found that companies with a P/S of less than 4 significantly outperformed those greater than 4, as the chart illustrates. As you can see, a P/S of less than 2 increases your odds of success even greater while a P/S of less than 1 produced the best returns at 17.8%.
In my opinion, the best way to use the P/S ratio is in a stock screener that includes gross and net margins as well as current and debt to equity ratios. We've seen that P/S is a fairly reliable and consistent predictor of value, but since it tends to lean toward less profitable, debt-holding companies, we need to include metrics that warn us of these potential traps. Any P/S under 3 is generally acceptable to me. Depending on the type of company, I may go over 4, but it has to be a great firm with great management.
Another great way to incorporate the P/S ratio is by utilizing it in as an intrinsic valuation method with the Median P/S technique. Simply take the company's five-year P/S average and multiply it by its current sales per share. In Apple's case it would look like this:
- (227,535 / 5,648) * 3.3 = $132.94
While I wouldn't use this as the only number, it certainly tells you a decent amount about the company's current valuation. According to Apple's five-year average price to sales ratio, the share price should be trading somewhere around $132 rather than the current $100.
Disclosure: I am long Apple.
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