Donville Kent on the uses and abuses of price-to-sales ratios
I am pretty sure the first time I heard of the price-to-sales ratio was sometime in the late 1990s when I joined CSFB in Singapore. This was during the heyday of the 1990s tech cycle when Frank Quattrone was the Eminence Grise of technology banking at CSFB and the world was just beginning to understand the internet and its subsequent bubble. At that time I was a Singapore-based industrial analyst and I had really no idea why anyone would care about a company’s price-to-sales ratio, let alone use it to value a company.
Then somebody at CSFB recommended that I read a book called Super Stocks by Ken Fisher. I had never heard of Ken Fisher, but when it was pointed out that he was the son of Phillip Fisher, the author of Common Stocks and Uncommon Profits, I raced to the book store to buy it. For those not familiar with Phillip Fisher, he was one of the first people to write about investing in growth companies in a systematic and logical way. Warren Buffett has on occasion described himself as “85% Graham and 15% Fisher”.
What I discovered once I had the book in hand was that Ken Fisher, like his father, was both an astute investor and a good teacher and writer. Super Stocks is about investing in technology companies, and a significant part of the book is focused on buying into cyclical technology stocks and how to use price-to-sales ratios to assess the value of a company when profits had temporarily been reduced or disappeared. Fisher was therefore using low price-to-sales ratios to identify bargains. His book had nothing positive to say about buying companies on the extremely high price-to-sales ratios that were being pushed by tech analysts and bankers in the late 1990s (and now).
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Notwithstanding Fisher’s excellent work, we rarely look at the price-to-sales metric from the long side. Indeed, these days we don’t see that many companies with sky-high price-to-sales ratios. What we more commonly see these days are technology stocks with no profits but impressive sales growth. These stocks are often described as being underpriced because they trade at price-to-sales ratios that are lower than their profitable peers or lower than industry price-to-sales averages.
The issues with such companies can best be understood by looking at an example. Imagine that you are looking at two companies, each operating on an equity base of $100MM with 30%+ sales growth. One of the companies is profitable with an ROAE of 30% while the other has been, and continues to operate, at the break-even level. The profitable company trades at 3.0x sales and the break-even company trades at 2.0x sales. On a price-to-sales basis, the break-even company appears to be significantly cheaper. We see at least three significant issues, however, that an investor contemplating investing in the break-even company must first consider.
The first issue is the existence or lack of profits. At the end of year one, the break-even company still has its $100MM, but it has no new capital to support growing sales, expand its product offering, buy back shares, pay a dividend, etc. The second company now has $30MM more than it started with to do all of those wonderful things that the first company could not do without raising equity and therefore issuing more shares. Thus, the profitable company has significantly more options in terms of allocation and deployment of capital than the break-even company.
The second issue is competitive advantage. The break-even company may have many wonderful products, but on average, its products sell for the cost of making them. As such, if an economic moat exists, it’s not apparent, even though the market is buying its product at a rapid pace. The other company, however, is selling its products at an equally rapid pace and, given its 30% ROAE, probably enjoys a very wide profit margin.
See full Donville Kent On The Uses And Abuses Of Price-to-Sales Ratios in PDF format here.