Price Earnings Ratio vs. Price Sales Ratio
For much of the late 1990s, the Price/Sales ratio was more important than the Price/Earnings ratio. Therefore, you needed to know the price/sales ratio of every stock you owned by heart. Though the market is not always willing to focus on sales over earnings, it still happens when new companies have not yet achieved profitability. When that's the case, the P/S ratio is the best single indicator of what the market expects from the stock.
The End of Price/Earnings
Every now and then we get an email with a question like this:
How can anyone justify paying a P/E of 400 for XYZ?
It's a valid question. But the real answer is that, for most stocks with incredibly high price/earnings ratios (or no P/E ratios), no one is really looking at earnings.
They are looking at the promise of future earnings. And the promise of future earnings comes from high revenue growth curves with a scalable business model that produces higher earnings in the future.
So, any company with a proven high revenue growth curve, and a scalable business model, can be expected to have strong future earnings. Therefore, paying more on a price/earnings ratio basis is worth it.
That is how stocks get P/Es of 400. The current P/E ratio, however, is meaningless in this line of thinking.
It is far more important to gauge the stock's valuation by the price/sales ratio because all the assumptions of future earnings are based on the revenue projection, not the earnings history.
The price/sales ratio is: Market Capitalization/Trailing Twelve Month Sales
Internet Stocks Started It
Internet stocks first put the price/earnings ratio on the back burner. After all, most IPO’d long before they showed profits. Many never did.
But with the public eager to help finance the future of the Internet, profitability wasn't important. Many were willing to invest in a company on the promise of future earnings.
Anyone who invested in America Online in 1995 or Yahoo in 1996 was initially rewarded for accepting the promise of future earnings, rather than insisting on current earnings.
The appetite for "private venture investing" was so large, that even a company like Sirius Satellite Radio (SIRI) was able to go public without revenues, much less earnings. For Sirius, you couldn't even calculate the price/sales ratio. It was a pure venture investment.
But for companies with existing revenue curves, the price/sales ratio is a measure of what the market expects and is based on the existing revenue history.
Price/Sales Implies Growth
A high price/sales ratio implies a high future revenue growth curve.
Most stocks with high price/sales ratios have at least a few quarters of demonstrated high revenue growth. Based on that proven revenue growth curve, the future revenue growth curve can be projected.
And the higher the future revenue growth curve is, the higher the price/sales ratio that investors are willing to pay.
Price/Sales Ranges
Mature companies of great size ($1 billion or more in sales), that have revenue growth prospects of 5% or so are generally accorded low price/sales ratios of between 2 and 4.
Large technology stocks with larger revenue growth prospects can achieve larger price/sales ratios. Cisco, for example, had a one-year growth rate of 50% in 2000 and a price/sales ratio of 30.
Smaller technology stocks with higher revenue growth prospects can get even higher price/sales ratios.
Monitoring Price/Sales
So, your stock has a high price/sales ratio. What do you do?
If you are a long-term investor, you need to make sure that the price/sales ratio is justified. First, you should examine whether your price/sales ratio is in line with other stocks in the same industry. This can be done by checking the 3-year and 1-year revenue growth curve for companies of a comparable size.
Secondly, because a high price/sales ratio implies strong revenue growth, you need to make sure that revenue growth is continuing to grow.
This is done by calculating not just the revenue growth percentage increases, but the rate of revenue growth.
A decline in the rate of revenue growth is normal as revenue increases. After all, it is harder to grow the larger you get. But there are many small stocks with current increasing revenue growth rates, which implies even higher future revenues. When these stocks show a decline in the rate of revenue growth, the stock can get creamed as the price/sales ratio is knocked down to a lower level.
Price/Sales as a Measure of Risk
Stocks with high price/sales ratios have more risk associated with them.
The reason is simple. The assumption of higher growth, on which the high price/sales ratio is based, is dependent on higher growth happening. When it doesn't, the high price/sales valuation comes down, usually significantly, and the stock price falls, often dramatically.
To fully judge how much risk is in your stock, you need to make a comparison of how your stock compares to other stocks in the same industry, with the same revenue expectations.
A Common Misunderstanding
A high price/sales ratio implies high expectations for revenue growth.
Some readers might infer from that statement that the message was "the higher the Price/Sales ratio, the better," since high revenue growth is a good thing.
Nothing could be further from the truth.
In fact, because a high price/sales ratio implies a high revenue growth curve, any failure to live up to that expectation is severely punished by a drop in valuation.
Anyone investing in a stock with a high price/sales ratio needs to understand that the rate of revenue growth is more important than revenue growth. An unexpected slowdown in the rate of growth will cause a sharp drop in the stock, even if the actual growth is positive.
If you currently own any stocks like this, you should realize that the revenue numbers will be more important than actual earnings numbers.
This becomes especially tricky, because while all these companies have projected earnings numbers, projected revenue numbers from sell-side analysts are not widely publicized.
Revenue, though, will be the first number that money managers look at in these reports, with earnings and margin trends next. A sharp increase in operating margins won't help these stocks if the revenue projections fall far short of expectations.
