Price to Sales: A Concept Every Investor Must Know

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Nov 05, 2014

Studying the price the market has historically bid for a company’s sales could help in identifying when to buy or sell a stock.

Often times, large institutions like insurance companies, pension 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.

The chart below depicts American Express’ (AXP, Financial) Market Capitalization in blue and revenue in green.

Market Cap. is the price to buy all the stock of a company. It fluctuates up and down substantially as large institutions become greedy and fearful.

Revenue is the value of American Express’ sales for the year. This green sales line is less volatile, but still had a couple dips.

Notice how AXP Market Cap. (price) started at the green line (revenue) and by 2000 was way above. Fast forward to 2009 and notice how Market Cap. went below the green line. This was when many institutions were fearful and desperate to sell.

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Below is a chart of American Express AXP’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.

To interpret why this chart is important, we take the recent level of 3.0 and compare it to the past. There were a couple times this P/S Ratio reached above 3.0: around 2000 and 2007.

What happened to the price of American Express after the last two times institutions were bidding three times the level of sales?

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Below is a chart AXP Price decline in percent from the year 2000 to 2002. A 50% decline in price occurred for those buying above the 3X sales level.

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Below is a chart of the price decline in percent for those buying in 2007. Once again, those buying above 3X sales had a major loss, this time 80%.

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For those who purchased AXP in June 2014, when the P/S ratio was 3.06, will this time be different?

Remember, sales is what you buy and price is what you pay.

Thank you to GuruFocus.com for providing the graphics.