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. Know where it comes from. Become familiar with its current and past levels. Be able to make an educated guess on its future levels.
The 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 essential 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 tulip bulbs are 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 assistant. 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 4.5-Stars in GuruFocus' Predictability measure, Chipotle Mexican Grill (CMG, Financial).
This chart depicts CMG's price in green and revenue in blue.
Price is what we pay to buy one share in a company. Similar to how tulip bulbs can be expensive or cheap depending on what time of the growing season it is, stock prices have bargain and premium times too.
Bulbs are what we buy at a garden store; revenue is what we buy in the stock market. Revenue is the value of CMG's sales per share for the past year. The blue sales line is less volatile, however it does change over economic cycles. Investors expect revenue to grow much like a gardener expects tulips to multiply through propagation.
Understanding investors are paying for revenue and revenue growth is the golden ticket for stock investors. Knowing this can help prevent catastrophic losses that occur when overpaying, as occured to serfs and noblemen during the Tulip Mania of the 17th Century.
Notice how CMG's price in 2008 was way above the blue line but in 2009 was nearly touching. Fast forward to 2012 and notice how price retraced towards the blue revenue line.
What might explain why the investing public bid so little for sales in 2009 but so much in 2008?
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 CMG'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 1.1 in 2009 to a high of 4.9 in 2012. Next, examine what happened to price after it reached near these P/S ratio extremes.
What happened to the price of CMG after institutions bid 1.1 times the level of sales in 2009?
Below is a chart depicting CMG's price percent increase. Those buying near historical P/S lows experienced price gains.
Price gains also occured after the P/S ratio lows of 2009.
Below is a chart of the price percent decrease after 2007 when CMG was priced near 5x sales. 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. In Chipotle's case, for every $1.00 in revenue CMG has on average $0.92 of expenses. What's remaining, $.08, is profit, thus an 8% profit margin.
When we buy a company's stock, we pay a multiple of sales because we expect revenue to grow. During good times, when investors expect continuous rapid growth, 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.
In 2007, when the P/S was 5, the market was charging $5.00 for every $1.00 in sales. If we predict Chipotle can maintain a profit margin of 8% (see chart below), as a part owner, we estimate we will receive $0.08 on every $1.00 of sales.
Putting these numbers together, we calculate anestimated owner's yield. This "Owner's Yield" is revenue after all expenses, divided by the price we pay for sales. For Chipotle, in 2007, that yield was 1.6%. This return was calculated by dividing the $0.08 earned on every $1.00 of sales and dividing it by the price we paid for sales, $5.00 ($.08/$5.00).
However, if we purchased Chipotle sales at a lower price, as the market offered in 2009, then our “owner’s earning yield” would be more. Had we purchased those same sales for nearly $1.00, as was offered in 2009, then our return was about 8% ($0.08/$1.00).
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 5.4x sales for Chipotle revenue. This is higher than the average since 2006. If we estimate 8% profit margins into the future and we are currently paying 5.4x sales, then our “owner’s earnings”yield is about 1.5% ($0.08/$5.40). Could this be why John Hussman sold out of his position by Q3 2011?
Perhaps 1.5% sounds reasonable if one is expecting quick and large growth rates. For that 1.5% could be 3% in just five years if revenue grew at 16% per year for five years. However remember, buying common stock provides no guarentee of receiving that 1.5% yield. It also provides no guarentee of that yield growing to 3%.
The important thing is to compare this yield to its own historical levels. Within those historical ranges you may identify a margin of safety where institutional investors are comfortable buying.
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.
In addition, ask yourself these questions: What were past growth rates? What are the estimated future growth rates? Are profit margins contracting? Will profit margins expand?
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.
