Price & 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 success in 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 train 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 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 a perfect 5-Stars in GuruFocus' Predictability measure, Union Pacific (UNP, Financial).
This chart depicts UNP's price in green and revenue in blue.
Price is what we pay to buy one share in a company. Similar to when buying a train ticket the price may be expensive during rush hours and cheaper during off hours, stock prices have bargain and premium times too.
A train ride is what we buy at the train depot; revenue is what we buy in the stock market. Revenue is the value of UNP'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 UNP's price in 2000 was below the blue line but by mid 2008 was far above. Fast forward to 2009 and notice how price decreased to near the blue revenue line.
What might explain why the investing public bid so little for sales in 2000 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. Ignoring this can cause financial ruin, as happened to many in the 19th Century Rail Mania.
Exploiting it can make investors wealthy.
Below is a chart of UNP'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 .8 in 2000 to a high of 4.1 in 2014. It can be seen as a temperature gauge measuring the investing public's willingness to buy revenue. Next, examine what happened to price after it reached near these P/S ratio extremes.
What happened to the price of UNP after institutions bid .8 times the level of sales in 2000?
Below is a chart depicting UNP'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 1997 when UNP was above the 2.41x sales level. Those buying at the 2.41x P/S level experienced major price declines.
However, within just a few years, the P/S multiple expanded. Although revenue increased, the price the investing public paid for those sales increased more so. Understanding how market euphoria or despair can at times be stronger than investment fundamentals is important. This is the danger in shorting stock.
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 earnings. In Union Pacific's case, for every $1.00 in revenue UNP has on average $0.89 of expenses. What's remaining, $.11, is profit, thus an average 11% profit margin. Notice below, the current 22.2% profit margin is the highest in almost two decades.
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. In bad times, the market will offer a discount on each $1.00 of revenue. With record high margins, rail-business conditions are currently very good. This is reflected in the PS ratio.
In 2008, when the P/S was 2.41, the market was charging $2.41 for every $1.00 in sales. If we predict Union Pacific can maintain a profit margin of 11% (see chart below), as a part owner, we estimate we will receive $0.11 on every $1.00 of sales.
Putting these numbers together, we calculate an estimated owner's yield. This "Owner's Yield" is revenue after all expenses, divided by the price we pay for sales. For Union Pacific, in 2008, that yield was 4.5%. This return was calculated by dividing the $0.11 earned on every $1.00 of sales and dividing it by the price we paid for sales, $2.41, ($0.11/$2.41).
However, if we purchased Union Pacific sales at a lower price to sales multiple, as the market offered in 2000, then our “owner’s earning yield” would be more. Had we purchased those same sales for only $0.88, as was offered in 2000, our return would have been about 12.5% ($0.11/$0.88).
Of course, this is a very rough calculation of owner’s earnings. Actual profit margins or revenue change may substantially differ from our estimates.
At today’s level, the market is bidding 4.1x sales for Union Pacific revenue. This is higher than every reading in two decades. If we estimate 11% profit margins into the future and we are currently paying 4.1x sales, then our “owner’s earnings” yield is about 2.7% ($0.11/$4.10). This is what investment guru David Winters might expect with his recent Union Pacific purchases.
Perhaps 2.7% sounds comparable to 30-year risk-free interest rates. Remember, however, buying common stock provides no guarantee of yield as would a government bond. There is also no guarantee government bonds will stay at these levels forever too. The important thing is to compare this yield to its own historical levels. Within those ranges you may identify a margin of safety where institutional investors are comfortable buying.
In addition, ask yourself these questions: What were past growth rates? What are the estimated future growth rates? Where are profit margins in relation to historical levels? Who wanted to buy railroads in the 1980s when government bond rates were at record highs? Will current record profit margins encourage competition? What happens if the price of crude oil drops and makes trucking more competative? If profits are seen as unfairly high, will government institute an excess profits tax?
Do your homework. Study the company. Study the history of railroad bubbles. 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.
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.
