The Price-to-Sales ratio (PSR) is a measure used by many of the Guru Strategies I run on Validea.com as a way to find undervalued stocks. The ratio, which is simply the market capitalization of the firm divided by the company’s sales, has become more popular over the years as investors look for additional ways to uncover value among publicly traded stocks.
The individual who popularized the PSR is Ken Fisher. Fisher, a longtime Forbes magazine columnist, is one of the most widely recognized names in the money management business. His firm, Fisher Investments, manages tens of billions of dollars. In his 1984 book Super Stocks, Fisher outlined an investment approach using the PSR – this is the approach I utilize in the computerized Price/Sales Investor strategy on Validea.com.
In the spirit of the PSR and Fisher, I thought it would be worth taking a look at why this variable can be useful in finding stocks with value. The following is excerpted from my new book, The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies, while the stocks in the table are current holdings in the Validea.com P/S Investor portfolio.
– Excerpted from The Guru Investor –
If you’re going to understand why Fisher believed so strongly in using the PSR to identify undervalued stocks, you need to understand what he called “the glitch.” Like some of the other gurus we’ve looked at, Fisher is a student of investor psychology, and one thing he believed investors did was raise expectations to unrealistic levels for companies that have periods of strong early growth. When these darlings of Wall Street have a setback—maybe their earnings drop, or maybe they continue to grow but simply don’t keep pace with investors’ lofty expectations—their stocks can then plummet as investors overreact and sell, thinking they’ve been led astray.
But while investors overreact, Fisher believed that these “glitches” are often simply a part of a firm’s maturation. Good companies with good management identify the problems, solve them, and move forward. As they do, the firms’ earnings and stock prices begin to rise again. If you can buy a stock when it hits a glitch and its earnings and price are down, you can make a bundle by sticking with it until it rights the ship and other investors jump back on board.
The trick is thus trying to evaluate a company during those periods when Wall Street is down on it because its earnings are in flux, or even negative, so that you can find good candidates for a rebound (remember, you can’t use a P/E ratio to evaluate a company that is losing money, because it has no earnings). The answer, Fisher said, was to look at sales, and the PSR.
“Why should one consider price-sales ratios at all?” Fisher asked in Super Stocks. “Because they measure popularity relative to business size. Price/Sales Ratios are of value because the sales portion of the relationship is inherently more stable than most other variables in the corporate world.”
His point is this: Earnings can be highly volatile, including the earnings of good companies, while sales rarely decline for top-flight businesses. They may be flat, but they generally tend to be less volatile than earnings. Earnings, however, can be moved quickly and dramatically by a wide variety of variables that do not necessarily portend how the company will perform, such as changes in accounting procedures or in the amount of research and development the company engages in. Wall Street focuses on earnings and abandons companies with earnings troubles, which is why Fisher liked to look at sales. A company with troubled earnings but strong sales is a company Fisher may well have wanted to own in his Super Stocks days.
Part of Fisher’s thinking was that, if a company has a low PSR, even a slight improvement in its profit margins can produce a big gain in earnings, which will then drive the stock’s price up since most investors react to earnings. Companies with high PSRs don’t have this leverage.
Another part of Fisher’s thinking was that investors should focus on causes, not results, when it came to evaluating a firm’s prospects. “What is the bottom line?” he wrote. “To buy stocks successfully, you need to price them based on causes, not results. The causes are business conditions—products with a cost structure allowing for sales. The results flow from there—profits, profit margins, and finally earnings per share.”
One more general note on Fisher’s take on PSRs: He doesn’t like looking at per-share numbers because he thinks it is important to focus on the overall business, including its size.
In terms of specifics, Fisher listed three rules regarding PSRs in Super Stocks:
Rule 1. Avoid stocks with PSRs greater than 1.5, and never buy those with a PSR in excess of 3. In this case, you are paying $3 for every $1 of sales. He admits stocks with such high PSRs can increase in price but only based on hype, not anything of substance.
Rule 2. Aggressively look for stocks with PSRs of 0.75 or less. Such a PSR means you are paying 75 cents or less for every $1 of sales. These are the stocks you want, and you should hold onto them for a long time, he says.
Rule 3. Once you’ve bought a stock with a desirable PSR (0.75 or less), sell it when the PSR reaches 3.00 (if you don’t want to take much risk) or hold it even longer, to 6.00 or higher, if you are really a risk taker.
-End of excerpt-
The 10 stocks in the table below are taken directly from Validea’s P/S Investor portfolio. As you will see, five stocks were added on the portfolio’s last rebalancing (March 20). Each of these holdings meets the PSR tests developed by Fisher and also a host of other important investment criteria.