Best of the Week
Most Popular
1.Stock Market Continues Defying Gravity, Dow New All Time High - Nadeem_Walayat
2.America Superpower 2016 - Ian Bremmer
3.The US Dollar and the Precious Metals Complex - Rambus_Chartology
4.UK Immigration Crisis Could Prompt BREXIT, Propelling Britain Out of EU Despite German Factor - Nadeem_Walayat
5.The “Real Flash Crash” Will Scare You to Death - Shah Gilani
6.Gold Price Trend Forecast - Bob_Louka
7.UK Deflation Warning - Bank of England Economic Propaganda to Print and Inflate Debt - Nadeem_Walayat
8.Gold Lifeboat to Global Economies “Titanic Problem” Warn HSBC - GoldCore
9.Will Interest Rates Ever Rise? - BATR
10.Who’s Killing the Stock Market? - Shah Gilani
Last 5 days
Stock Market Choppy Uptrend May Have Topped - 30th May 15
Options Pricing - Covert Gamma, Portfolio Insurance, and STDs - 30th May 15
U.S. Crude Oil Production Sets New Modern Record - 30th May 15
Gold Still Waiting - 30th May 15
Investing’s Great Struggle - 29th May 15
How Rich Countries Get Rich - Freedom, Global Poverty, and the Failure of Foreign Aid - 29th May 15
Goldman Sachs Warns “Too Much Debt” Threatens World Economy - 29th May 15
Skunk Works Engineers Supersonic Profits - 29th May 15
Gold, Silver and US Dollar Strength - 29th May 15
This New Currency Could Wipe Out the Euro - 28th May 15
US Housing Market - Something Smells Fishy - 28th May 15
US Economy – Semi b2b Amps Up its Trend - 28th May 15
U.S. Fed Exported QE Travesty: Meet The BLICS Nations - 28th May 15
World War D—Deflation - Secular Bear Markets Analysis - 28th May 15
George Soros Warns of “Third World War” - 28th May 15
Why You Shouldn't Try to Invest Like Warren Buffett - 28th May 15
Stock Markets Buy and Hold is Back! - 28th May 15
We're Now Frighteningly Vulnerable to a Bond Market Crash - 28th May 15
Austerity, Economics and Religion - 28th May 15
National Holidays London and the Magic of Legoland UK Review - 27th May 15
Imminent Stocks Bear Market Signaled by Dow Theory ... - 27th May 15
Gold Price Has Bottomed – More Evidence - 27th May 15
Three Reasons You Shouldn’t Try to Invest Like Warren Buffett - 27th May 15
Gold Is “100% Guarantee from Legal and Political Risks” States Russian Central Bank - 27th May 15
Don't Drown in the Sea of Global Debt - 27th May 15
Three Reasons Why Carl Icahn Is Wrong About Apple Stock - 27th May 15
Crude Oil Price Stochastic Signals - 26th May 15
Why the Stock Market Will Crash - 26th May 15
GDP, Inflation, Employment Economic Statistics: It’s All a Lie - 26th May 15
Introduction to Peak Food - 26th May 15
Should We Dump the Euro? - 26th May 15
A Geopolitical Net Assessment of Europe - 26th May 15
Stock Market Top in Place? - 26th May 15
Best Cash ISA SBI 2.3% - 2.8 Year Fix, UK Interest Rates 2016 - 26th May 15
China Sets Up Gold Bullion Fund For Central Banks - 25th May 15
Is The Silver Trade Getting Crowded? - 25th May 15
Money Murder Mystery: Who Killed the Stock Market? - 25th May 15
Why Do We Celebrate Rising U.S. House Prices? - 24th May 15
Mario Draghi’s Slippery Downward Slope - 24th May 15
Gold : Truth is Stranger than Fiction - 24th May 15
Facebook Stock Price Forecast - 24th May 15
Make a Killing on the Coming Energy "Debt Bubble" - 24th May 15

Free Instant Analysis

Free Instant Technical Analysis


Market Oracle FREE Newsletter

Biggest Debt Bomb in History

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

© 2005-2015 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Biggest Debt Bomb in History