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Why 95% of Traders Fail

Valuing Cyclical Companies by Using the Price/Sales Ratio

InvestorEducation / Corporate Earnings Sep 30, 2008 - 03:55 PM GMT

By: James_Foye

InvestorEducation The price/sales multiples is one of the most often quoted investment valuation ratios. Even the legendary James O'Shaughnessy is not immune to the ratio's charms; he even went as far as to call it “the king of the value factors”. I've always found the ratio's popularity strange as the measure is dangerously flawed.


Sales represent income for both equity and debt holders: having this divided by market capitalisation means that there is a complete inconsistency between the numerator and the denominator. The logical solution would be for investors to use enterprise value to sales. Enterprise value is calculated by adding debt to market capitalisation, adjustments are also made to add in minority interest and preferred stock and also to strip out cash.

The differing results obtained from price/sales and enterprise value/sales are clearly apparent by way of an example:

 

Market Cap

Sales

Debt

Price/Sales

Enterprise Value/Sales

X € 20,000 € 100,000 € 0 0.2 0.2
Y € 20,000 € 100,000 € 50,000 0.2 0.7

X has no debt and Y is leveraged to the hilt. After operating costs, the sales from company X can be paid to shareholders or ploughed back into the business. On the other hand, Y has so much leverage that there is nothing left after interest payments. These two companies are clearly in very different financial positions, yet the price/sales ratio takes no consideration of this as it is the same for both companies. Enterprise value/sales, on the other hand, shows that company Y is significantly more expensive than company X.

The main advantages of using price/sales over price/earnings are that it can still be used for loss-making companies and sales are considered to be less subject to management manipulation than earnings. Enterprise value has both this qualities, but also squares the inconsistencies inherent in the price/sales ratio. Strangely, while enterprise value/EBITDA is used as an ancillary ratio, enterprise value/sales rarely gets the attention it deserves.

A note of caution to users of enterprise value multiples should be added. To be correct, enterprise value should be calculated using market values rather than book values. Because of the difficulty of calculating market values of bank debt, book value of debt is often used instead. While book and market values of debt are normally close, there are occasions when significant differences between the two can occur. Investors need to be aware of this when using enterprise value-based multiples.

Given the deteriorating macro economic situation the issue is particularly pertinent as more companies make losses forcing investors to place more emphasis on sales-based multiples. While no ratio can capture all information about a company, I truly believe that if investors added this ratio to their arsenal their returns will be enhanced.

By James Foye

I'm an analyst for Medvešek Pušnik in Slovenia, I'm also studying part-time for a PhD at the University of Ljubljana.

© 2008 Copyright James Foye - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

James Foye Archive

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