Many investors treat the stock market like a flea market, poking through overpriced merchandise to find a real bargain. But rather than studying furniture styles or the history of glassmaking looking for that low-priced deal, investors use statistical tools.
The price-earnings ratio, which compares a stock price to the company’s profits per share, may be the most common measure. Other bargain hunters compare a stock’s price to the company’s book value, or assets minus liabilities, per share. Some, however, turn to a lesser-known instrument: the price-sales ratio.
This measure compares a stock’s price to the company’s sales per share. At Disney, for example, the price-sales ratio is about 2.31 to 1, derived by dividing the current share price by the sales per share. Sales per share are calculated by dividing total sales by the number of shares outstanding.
The average price-sales ratio for the Standard & Poor’s 500-stock index is 1.60 to 1. Value seekers typically focus on companies with low-priced stocks–those with a ratio of less than 1.
Investors who look to the price-sales ratio say it has several advantages. Although sales figures can be manipulated, they are not subject to all the stratagems that companies can use to embellish earnings or distort book value.
“Revenue is one of the things that is least fiddled with,” said Kenneth L. Fisher, who runs Fisher Investments in Woodside, Calif.
The price-sales ratio can also be a window on a company’s near-term potential. A low price-earnings ratio–signifying a cheap stock–can simply mean the company has little revenue, and, therefore, little profit. Its shareholders are taking a leap of faith that the company can ring the cash register a lot more in the future than it has in the past.
But a low price-sales ratio often applies to a company that already has significant sales; its costs just eat up much of its profits. In that case, all the company may need is an economizing program that widens the gap between what it takes in and what it keeps.
“The price-sales ratio captures your imagination,” said Edward Bousa, portfolio manager of the Putnam Equity Income fund. “It gives you an idea of what an underperforming company could be worth if it got its margins up.”
In “What Works on Wall Street” (McGraw-Hill, 1996), James P. O’Shaughnessy, a money manager in Greenwich, Conn., found that from 1952 to 1994, companies with low price-sales ratios often sharply outperformed the market.
To study the ratio, the New York Times recently asked Compustat, a unit of Standard & Poor’s, to rank the S&P 500 companies by the measure, excluding financial services enterprises, which do not have sales.
Of the 432 companies in the survey, Microsoft had the highest price-sales ratio, at 12.5, while the Fleming Companies, one of the nation’s largest food wholesalers and distributors, had the lowest ratio, at 0.04.
A total of 179 companies might draw the immediate attention of bargain hunters: they all had ratios of less than 1.
But one of the first lessons of the price-sales ratio, O’Shaughnessy and others said, is that a low ratio by itself does not necessarily signal a good investment.
For example, many companies in the survey have low price-sales ratios because they are in inherently low-margin businesses–discount retailers, say, like Woolworth and Walgreen, which had ratios of 0.37 and 0.84, respectively. (When profit margins are so narrow that only a few cents land on the bottom line, investors pay less for a dollar of sales.)
Generally, improving the margins of companies in such industries is not as easy as in other sectors.
Other enterprises with low price-sales ratios belong to out-of-favor industries like paper and forest products, which are under pressure from lower-cost foreign producers and hurt by the strong dollar, according to Bousa. This group includes Boise Cascade (0.28), the Mead Corp. (0.59), Union Camp (0.81) and Westvaco (0.89).
In other words, a low price-sales ratio is just the beginning. Investors must also scrutinize the company to see if it has the potential to improve its margins.
In this further inquiry, O’Shaughnessy looks for companies whose earnings and stock prices have risen in the last year. “This helps you find cheap companies that are on the rebound,” he said.
Such an approach has lead O’Shaughnessy to Kmart and TJX, retailers with price-sales ratios of 0.19 and 0.51, respectively, in the survey.
Bousa also seeks companies that have low price-sales ratios and are cutting costs. He likes Whirlpool, Ryder System and Delta Air Lines.
Whirlpool, with a ratio of just 0.40 in the Compustat survey, “looks cheap for a company that is a leader in its business,” Bousa said.
Profits have been weak in its European divisions, he said, adding that he believes that the company has been “very busy restructuring there, and we will soon start to see results.
Ryder, a leader in truck leasing and business shipping, had a price-sales measure of 0.43, but it is economizing, too. Closing less profitable offices and cutting some layers of management will help it save $75 million this year–1.6 percent of annual operating expenses–and the same amount in 1998, Bousa said.
Cost-cutting at Delta, the third-largest domestic carrier, is also well under way. Delta has been eliminating unprofitable routes in Europe, where new marketing alliances with Swissair, Sabena and Austrian Airlines may also help earnings.
Delta, with a 0.51 ratio in the survey, is also trying to contain costs and increase productivity in the United States. “Delta has done a tremendous job of working with a largely nonunion labor force in an industry that tends to be union,” Bousa said.
What about high price-sales measures? Like the low ratios, they are just a guide. Drug companies, for instance, often have wide profit margins. Thus, the Pfizer and Schering-Plough ratios of 4.9 and 4.8 do not necessarily mean the stocks are pricey.
But a lofty ratio can be a red flag. Microsoft’s ratio of 12.5 is a caution for Richard H. Fontaine, portfolio manager of the Fontaine Capital Appreciation fund.
“Microsoft is a great company,” Fontaine said. “But it is so big, it can only grow as fast as the industry. The premium the market is asking you to pay grossly overestimates the growth of this company.”
