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Uncover bargain valuations with the price-to-sales strategy

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This week, we cover AAII’s strategy of focusing on firms with low price-to-sales (P/S) ratios compared to their historical averages. Since earnings-based measures such as the price-to-sales ratio are used less often, they can lead you to stocks Their bargain valuations are not disclosed by other investors. our Price-to-sale screening model It has an annualized price gain of 12.9% since inception (1998), compared to 5.7% for the S&P 500 index over the same period. Read on to find out how we put this screen together.

Price-Sales Ratio

Income-based appraisals are considered the “cleanest” of appraisal methods. Revenues or sales are less affected than earnings or book value by accounting decisions made by management and corporate financial structure.

There are two big reasons why income-based valuation methods have the following. First, they are among the least likely of evaluation measures to have a negative or unusable value. A temporary loss makes earnings-based valuation ratios meaningless. Second, income-based valuation measures are less volatile than earnings-based valuation measures.

Although the price-earnings ratio and its variants are the most popular valuation measure, revenue-based valuation methods should not be overlooked as a means of assessing whether a company is cheap, fairly priced, or expensive. Because these measures are less commonly used, they can lead you to stocks that aren’t exposed to bargain valuations by other investors.

Criticisms of the price-sales ratio have some validity because sales do not equal profits. Merely screening for low price-to-sales ratios is likely to turn up companies with poor margins and weak prospects. To use this valuation measure effectively, you need to compare a company’s price-to-sales ratio to its previous level or to companies in the same industry.

Investing using the Price-to-Sales Screening Model

Several studies agree on the desirability of investing in out-of-favour stocks as a strategy for achieving above-average long-term returns. The market often reacts to news—good and bad—by bidding up their prices to overvalue companies, while driving down the prices of distressed companies to the point where they represent attractive value.

Screening for undervalued stocks based on the price-to-sales ratio (current price divided by sales per share for the most recent 12 months) is not a new concept. This strategy was first popularized by Kenneth Fisher in his 1984 book “Super Stocks”. Proponents of the price-to-sales ratio argue that earnings-based methods for selecting stocks are inferior because earnings are influenced by many management assumptions through the accounting books. A basing value related to sales is more reliable than a basing value related to earnings. Temporary developments such as costs incurred in the rollout of a new product or cyclical slowdowns can impact earnings more than sales, often resulting in negative earnings. The price-to-sales ratio provides a meaningful valuation tool when negative earnings render earnings-based models useless.

Sales levels tend to be more comparable across different firms—leading to a more comparable valuation tool from firm to firm within the same industry. Asset-based models, such as lower-cost-book-value screens, are influenced by company factors such as specific depreciation schedules, age of assets, and inventory accounting methods. The market may not be able to properly adjust for these company-specific factors, leading to mispricing of securities.

Ranges for price-sales ratio

Investors often look for stocks with low valuation measures, such as price-to-sales or price-to-earnings ratios, with the belief that the market may have overlooked the company or misjudged its value.

Stocks with low valuation levels can already be beat, so any good news can translate into higher stock prices. However, some industries traditionally sell with low price-to-sales ratios. Companies in these industries typically have low profit margins (revenue divided by sales), such as supermarkets or firms with very poor sales growth prospects. A simple screen for a low price-to-sales ratio turns many of these firms around. That’s why we focus on companies with current price-to-sales ratios below their historical averages and below their industry norm.

Price-to-sales levels relate to future company growth, profitability and risk expectations. The higher the expected growth, the higher the price-to-sales ratio supports the stock. Higher dividends translate to higher price-to-sales ratios. Profit margins measure the level of revenue generated for a given level of sales. Profit indicates a company’s long-term growth and staying power.

Developing a sales filter from primary price

Price-to-sales ratios generally do not work well with banks, real estate investment trusts (REITs) or other firms where ongoing sales are not a major driving force. Therefore, our first criterion excludes financial institutions and REITs.

With the exception of banks and REITs, we have the question of establishing an appropriate cutoff level for the price-to-sales ratio. Firms with low price-to-sales ratios are thought to be better prospects for future share price appreciation. Since stocks have already fallen from low prices, any good news can translate into higher stock prices.

As mentioned, some industries traditionally sell with low price-to-sales ratios. To help take industry factors into account, our filter looks for companies whose price-to-sales ratios are below the average for their industry.

Another way to assess the relative level of a company’s price-to-sales ratio is to compare it against historical levels for the firm. A ratio lower than its historical average is a sign that the stock is potentially undervalued, while a higher ratio compared to its historical average indicates an overvalued firm. This approach assumes that the firm’s underlying growth and profit expectations have not changed drastically. Comparing a firm to its own average eliminates the problem of finding the right fit in terms of an industry group. Another advantage of this type of analysis is that it does not automatically rule out high-growth companies in high-growth industries, as does the absolute price-sales ratio. Companies are ranked by how their current ratios compare to the average ratio over the past five years.

Conditioning standards

Even a stock with a low price-to-sales ratio is not a bargain if it has no sales and earnings growth prospects. If a company has poor prospects, it should trade with a lower ratio. At best, investors are looking for a growth company that has stumbled due to a temporary factor or a neglected company that is yet to catch Wall Street’s attention. The next criterion requires that the company have a growth rate in sales over the past five years above its industry average—identifying companies that have expanded their sales levels faster than other firms in their industry, but that are trading at a discount. Industry norm.

A screening criterion using growth rates alone may mask much of the variability. A close examination of year-over-year figures, recent quarterly trends in sales, and future prospects for sales growth should be part of a detailed analysis conducted on companies passing through the screen. Another consideration is that the investor’s analysis should look forward to the future prospects of the firm.

Financial advantage

A value screen for underperforming stocks reveals firms that may be in some trouble. As a safety hedge, many investors include a screen that establishes a maximum level of financial leverage. While the use of debt helps increase return on equity when the company is performing strongly, it can saddle the company with interest payments that must be made throughout the business cycle, thereby slowing return on equity when business slows and increasing the risk that the company may not be able to meet its interest payments.

Basic leverage screens look at factors such as debt relative to equity or liabilities relative to assets. Companies in more stable industries can safely take on higher levels of debt. Companies are tested for liability-asset ratios below their industry average. Although leverage screens do not tend to make promising investments, they are helpful in highlighting troubled firms, especially if studied over time.

Relative price strength

Value screens often turn firms that require patience from investors who are waiting for the market to change its pessimistic view of the industry. A screen of higher relative price strength can help indicate an improved stock outlook. A screen is specified that requires a 52-week relative strength ratio above the industry average. The relative strength ratio compares a company’s price performance to the S&P 500. Firms with positive relative strength ratios outperform the S&P 500, while negative ratios reflect relative underperformance.

Firm size

As companies get bigger, their price-to-sales ratios usually get smaller. Once a firm reaches large scale, it becomes more difficult to sustain above-average growth rates. Low price-to-sales ratios come with these low expectations. At the other end of the scale, very small, high-growth firms in developing markets are difficult to integrate into the value screen. These micro-cap stocks are illiquid stocks with high transaction costs. To exclude the smallest end of the market, a minimum market capitalization of $50 million is specified as the final screen. As is true for any screen, the list of passing companies represents a crude starting point for further in-depth analysis.

Final Thoughts on the Price-to-Sales Approach

The price-sales ratio holds promise as a screening method. It can identify firms with lower value than the price-earnings method and avoid some of the accounting complications of the price-earnings and price-book screens. But knowledge of the industry is critical in assessing price-to-sales ratios. Cost-to-sales screens for firms are more industry-specific than price-earnings ratio screens.

25 stocks pass the price-to-sales screen (ranked by price-to-sales ratio)

Stocks that pass the AAII price-to-sales screen

American Association of Individual Investors

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Stocks that meet the methodology’s criteria do not represent a “recommendation” or a “buy” list. It is important to perform due diligence.

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