Where do earnings come from? Where do dividends come from? Where do paychecks come from? All these things derive from one source: revenue. If it were not for revenue, a company would not sustain the ability to pay employees, suppliers, and dividends to owners. Thus, understanding 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.
Often times, large institutions like insurance companies, pension funds, endowment 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. Finding these past relationships seems complicated, but using GuruFocus.com’s Interactive Chart feature makes it quite easy.
Let’s start with the chart of Goldman Sachs Group below. This chart depicts GS’s Market Capitalization in orange and annual revenue in blue.
Market capitalization is the price to buy all the stock of a company. It fluctuates up and down substantially as the investing public becomes greedy and fearful.
Annual revenue is the value of GS’s sales for the past year. This blue sales line is less volatile but does change over economic cycles.
Notice how GS’s Market Cap. (price) in 2000 was much higher than the blue line (annual revenue) and by 2009 nearly matched.
What might explain why the investing public bid so much for sales in 2000 and so little in 2009?
Below is a chart of GS’s price-to-sales ratio starting in 1999. 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. Click the “P/S Ratio” tab in Interactive Chart to enable this feature.
To interpret why this chart is important, we take the recent level of 2.785 and compare it to the past. The range is from a low of .62 in 2009 to a high of 4.68 in 2000. We then examine what happened to price after it reached near these P/S ratio extremes.
What happened to the price of GS after institutions bid 4.68 times the level of sales in 2000 and 4x sales in 2006?
Below is a chart depicting GS’s price percent decrease from the previous high. Those buying when GS was above the 3.8x sales level experienced a 47.5% decrease in price after 2000 and a 75% decrease after 2006.
Those buying at historical P/S highs experienced price declines.
What happened to the price of GS after the investing public bid .62x sales in 2008?
Below is a chart of the price percent increase after 2009 when GS was below the .62x sales level.
Those buying near historical P/S lows experienced price gains.
One way we can understand the P/S ratio is by looking at it from a business owner’s perspective. If we can predict GS will maintain profit margins around 20% (see chart below), as a part owner, we should receive 20% of whatever sales are. However, if we are able to buy sales at a discount, as the market offered in 2008/2009, then our “owner’s earning” would actually be more than 20%. If we only paid $0.62 for every $1.00 of sales and our average return on every dollar is $0.20, then our return is actually about 32% ($0.2/$.62).
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 2.78x sales for GS revenue. This is higher than many of the last five year readings, but compared to the long term historical trend is average. If we estimate 20% profit margins into the future and we are paying $2.78x sales, then our “owner’s earnings” yield is about 7.1% ($0.20/$2.78). Sure, 7.1% sounds great when comparing to treasury rates, but the important thing is to compare this yield to its own historical levels. Otherwise, how will you be able to estimate a margin of safety?
Remember, revenue is what you buy and price is what you pay.
