Price to Sales Education Series
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. You should be familiar with its current and past levels. You should be able to make an educated guess on its future levels.
The magic word is revenue.
If it were not for revenue, a company would not sustain the ability to pay employees, suppliers, dividends to owners and taxes to our government. Thus, understanding you are buying 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. It is similar to understanding when a movie theatre 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.
You can do the same.
If you can identify the historical price these institutions have paid for the company’s sales, you 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 analyst. Play with the charts. Learn the numbers and become familiar with a company you want to buy. Make it fun.
Let’s begin by studying a company that is ranked high in GuruFocus' Predictability measure, Family Dollar Stores Inc (FDO). This chart depicts FDO's price in green and revenue in blue.
Price is what we pay to buy one share in a company. Similar to when going to the movies, a matinee show is less expensive because the show time is less popular, stock prices have bargain and premium times too.
Revenue is the value of FDO's sales per share for the past year. The blue sales line is less volatile, however it does change over economic cycles. This is the golden ticket for stock investors.
Notice how FDO's price in 1995 was below the blue line but in 2004 was far above. Fast forward to 2009 and notice how price decreased way below the blue revenue line.
What might explain why the investing public bid so little for sales in 1995 but so much in 2003?
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.
Below is a chart of FDO's price-to-sales ratio starting in 1995. 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 .4 in 2008 to a high of 1.58 in 2003. Next, examine what happened to price after it reached near these P/S ratio extremes.
What happened to the price of FDO after institutions bid .5 times the level of sales in 1996?
Below is a chart depicting FDO's price percent increase. 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 percent decrease after 2003 when FDO was above the 1.5x sales level. Those buying near historical P/S highs experienced major price declines.
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 profit.
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. Contrarily, during bad times, the market will offer a discount on each $1.00 of revenue.
In 2003, when the P/S was 1.58, the market was charging $1.58 for every $1.00 in sales. If we predict Family Dollar can maintain a profit margin of 4% (see chart below), as a part owner, we estimate we will receive $0.04 on every $1.00 of sales.
Putting these numbers together, we calculate an estimated owner's yield. This "Owner's Yield" is the return, after all expenses, divided by the price we pay for sales. For Family Dollar, in 2003, that yield was 2.5%. This return was calculated by dividing the $0.04 earned on every $1.00 of sales and dividing it by the price we paid for sales, $1.58 ($.04/$1.58).
However, if we purchased Family Dollar sales at a lower price, as the market offered in 2008, then our “owner’s earning yield” would be more. Had we purchased those same sales for only $0.4, as was offered in 2008, then our return was about 10% ($0.04/$0.40).
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 .9x sales for Family Dollar revenue. This is higher than many of the readings after 1996. If we estimate 4% profit margins into the future and we are currently paying .9x sales, then our “owner’s earnings” yield is about 4.4% ($0.04/$0.90).
Perhaps 4.4% sounds comparable to 30-year risk-free interest rates, but the important thing is to compare this yield to its own historical levels. In addition, ask yourself these questions: What were past growth rates? What are the estimated future growth rates? Why are profit margins contracting? Will profit margins expand?
Do your homework. Study the company. 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.
Remember, 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.
