Valuations Using the Price-Sales Ratio and the Price-Book-Value Ratio
Computerized Investing March/April 1990
By Fred Shipley
Many analysts use the price-to-sales ratio as a screening technique for selecting undervalued, or unpopular, out of favor companies. This ratio has been popularized by Ken Fisher in his book, "Super Stocks." In addition, a number of articles on the use of the technique and its variants have appeared in the AAII Journal over the past several
years--they are listed at the end of this article. We will describe the calculation of the price-sales ratio and some of its variants. We will also discuss some of the on-line information services and disk-based databases that can be used to screen on the price-sales ratio.
The price-sales ratio (P/S or PSR) is just a company's stock price per share divided by its sales per share. It can also be computed on a total dollar basis, using total market value divided by total revenues, where total market value is the per share stock price times the number of shares outstanding. Our stock valuation template, described in Chapter 4 of the 7th edition "Individual Investor's Guide to Computerized
Investing" (see MODELS2.XLS), already contains sales and market price on a per share basis. If you are evaluating a company for which this information is not available, you can compute the price-sales ratio on a total dollar basis. On a per share basis, use the formula:
Market Price per Share
Price/sales (P/S) = -------------------------
Sales per Share
On a total dollar basis, use the formula:
Total Market Value
Price/Sales (P/S) =-------------------------
Total Revenues (=Sales)
Where: Total Market Value =
Stock Price per Share x Number of Shares Outstanding
One of the reasons for using the PSR is that sales are less affected by different accounting treatments than earnings. Indeed, the price-sales ratio and the price-earnings ratio must be related, since earnings are equal to sales times the profit margin. This observation allows us to evaluate changes in these two variables:
Price per Share
Price/Earnings = --------------------
Earnings per Share
Price per Share
= --------------------------------
Sales per Share x Profit Margin
Price per Share 1
= ---------------- X --------------
Sales per Share Profit Margin
= P/S x 1/pm
Where: pm indicates the profit margin--net income divided by sales.
The price-sales ratio indicates how much an investor must pay for a dollar of sales when buying the stock. Presumably, companies with higher profit margins, and higher earnings per dollar of sales, have higher price-sales ratios. This suggests the possibility of comparing stocks on the basis of their price-sales ratio. Companies with a low PSR may be bargains, offering a low cost per dollar of revenue. If the company can turn these revenues into profits, then the stock may be attractive.
Investors must exercise care, however, in making this comparison. First, different industries normally will have different profit margins. For example, wholesalers typically have relatively low profit margins and thus lower price-sales ratios than, say, manufacturers. It is important to make comparisons within an industry--one you feel is attractive for fundamental reasons.
Second, some companies are highly leveraged. Companies with a relatively large amount of debt may have lower price-sales ratios than less leveraged companies in the same industry. This happens because the debt, making up a substantial amount of long-term financing, does not visibly show up in stock market value. If investors perceive such stocks as being very risky, they will bid down the price of the stock, lowering the price-sales ratio. Investors must be careful in analyzing stocks to examine the company's degree of leverage.
Value Line, which we have used as the source of our company information in the past, does not provide historical total debt figures. You can use long-term debt, but this represents only a portion of total debt. In addition, Value Line provides only a total for long-term debt, not per share figures. Investors can also obtain total debt data from a source such as Standard and Poor's Stock Reports.
Finally, there are many companies that rightly deserve low PSRs. These are companies with a long history of being unable to generate earnings. To a large extent, shopping for investments that are unpopular involves dredging up companies that are unpopular because they are bad investments. There is a good reason a low PSR screen is referred to as "bottom- fishing." It is important, then to look beyond this ratio.
Modifying the Existing Spreadsheet
You can add the price-sales ratio to an existing stock valuation spreadsheet by simply adding the computation to the rest of the calculated financial data. Then add the historical averages to the other averages already calculated.
We use the two blank columns starting at column V in the MODELS2 spreadsheet for the high and low P/S ratio: V6: High Stock Price / Sales per Share
W6: Low Stock Price / Sales per Share
The formula in cell V6 is G6/$B6. Copying this from V6 to the range from V6 to W15 will complete the necessary information. In addition, we copied the average function over from U17 to V17 through W17.
To include the average and high and low P/S ratios, we inserted a row at row 36 and made cell D36 compute the average of the high and low P/S ratios. That is, D36 contains the formula (V17+W17)/2. The high and low values in F36 and F37 use the maximum and minimum functions.
Price-Book-Value Ratios
The price-book-value ratio (P/B or PBR) is another commonly used screening criterion to find unpopular companies. Book value is the accounting value of a firm's equity, representing the value of all the company's assets less the value of its liabilities. Book value is considered by many securities analysts to represent a low-end estimate of a stock's value. This is true especially after periods of inflation, when the replacement value of assets can be substantially in excess of their (depreciated) cost. As with the other ratios discussed here, you must use a certain amount of care in interpreting this ratio.
Underlying the use of PBR is the assumption that a company's assets are (or at least can be) used productively. Some companies with a low PBR have obsolete or economically unusable assets; they deserve a low price-book-value ratio.The price-book-value ratio can be easily calculated using data we have already entered into the MODELS2 spreadsheet. It is simply a matter of inserting two columns at X to determine both a high and low P/B ratio. We inserted two columns starting at column X for the high and low P/B ratios:
X6: High Stock Price / Book Value per Share
Y6: Low Stock Price / Book Value per Share
The formula in cell X6 is G6/$F6. Copying this from X6 to the range from X6 to Y15 will complete the necessary information. In addition, we copied the average function over from W17 to X17 through Y17.
The data for the industry can be manipulated to infer industry-wide PBRs for comparative purposes, just as we did for PSRs.
Modifications to the Price-Sales Ratio
Since there can be some comparability problems with the price-sales ratios for firms in different industries and with different capital structures (debt-equity mixes), there are some modifications of the price-sales ratio that you can make. Since these modifications will entail the use of information that we have not previously entered into the stock valuation spreadsheet, we will create a new spreadsheet with the necessary information. Alternatively, you can create additional columns in the existing spreadsheet with the needed information.
The first problem we noted was that of different industries with differing profit margins and therefore differing price-sales ratios. To deal with that problem, we can determine a relative price-sales ratio. The relative price-sales ratio is simply the company price-sales ratio divided by the industry price-sales ratio:
Company P/S Ratio
Relative P/S Ratio = --------------------
Industry P/S Ratio
The second problem was the effect of different debt to equity mixes on the price-sales ratio. To deal with this problem, we use data on the company's debt and compute a total value (or capitalization) by adding the market value of the company's debt to the market value of its equity. That is:
Total Capitalization = Market Value of Debt + Market Value of Equity
The total capitalization-sales ratio (TCS) then is just total capitalization divided by total revenues. Since the data available for debt is seldom expressed on a per share basis, it will typically be easier to determine this ratio using total dollar figures.
Total Capitalization Mkt Value of Debt + Mkt Value of Equity
These figures can also be computed on a high and low per share stock price to obtain a range of values for future comparisons.
There are some problems with this definition of debt. Calculating the market value of debt is a difficult task. First, many companies have a number of different issues of debt outstanding. Some of this debt may be publicly traded, and getting current market value quotes on publicly traded debt is not easy, although it is possible.
Second, much corporate debt is bank debt, and determining the current market value of bank debt is difficult at best. For a good portion of bank debt, the interest rate will float with current market conditions. Consequently, the market value will be the same as the book value. Using book values for this debt will not distort the total value-sales ratio. For fixed interest rate debt, which includes most, but certainly not all, publicly traded debt, the market value will change inversely with changes in market interest rates. Thus many companies will have outstanding debentures issued in periods of low interest rates, whose market values will be substantially less than book value. Using book values in this case will result in high total value-sales ratios.
Book value of debt is from the Standard and Poor's Stock Reports. The total value-sales ratio and the original value- sales ratio are calculated for comparative purposes.
Also included are similar figures for the industry from Value Line. These industry figures present a small problem because the information needed to get a price-sales ratio is not directly available. Using a little algebra, however, will get us the necessary information:
Price/Sales (P/S) = (Earnings x Price/Earnings) / Sales
Fortunately, Value Line provides earnings figures, trailing price-earnings ratios and sales calculations for industry composites. This information can then be used for selecting companies with a low PSR or PBR. You must be careful in interpreting these numbers, however. While such criteria are often applied in the selection and screening process, they are no guarantee of successful stock picking.
These criteria allow comparisons among companies that appear to be attractive for fundamental reasons. Screening on the basis of a low P/S or P/B ratio may highlight a selection that offers value relative to other desirable stocks. In making such an evaluation, though, you must consider the issue of comparability. Construction of the appropriate industry ratios and the determination of relative figures give you standards to compare the ratios against.
Screening on Price-Sales Ratios
With this background, it is useful to ask how effective the price-sales ratio is as a screening device. The following examples were generated using Standard and Poor's Stockpak II, Value Line's Value/Screen II and MarketBase by MP Software. In addition, a number of the on-line information services, such as CompuServe, allow similar kinds of screening.
Creating the screens is relatively simple. You must first create a sales per share variable, then a second variable, which is the price/sales ratio. The second step is to create some criteria on which to screen. This step requires some thought and experimentation.
On my first run through Stockpak II, using only a P/S screen, almost 90% of the available companies passed what I thought was a fairly strict screen--P/S less than 0.5. Fisher recommends a screen using a PSR less than 0.4. With this screen, almost 70% of the companies passed. Clearly some other criteria are essential.
To guard against finding companies with no profitability, I added a requirement that the most recent earnings be positive and the profit margin be greater than 3%. With these criteria, only 10% of the companies in the database passed.
References
"Price-Sales Ratios: A New Tool for Measuring Stock Popularity," by Kenneth L. Fisher. AAII Journal, June 1984.
"Stock Valuation: A New Technique to Adjust for Debt," by Kenneth L. Fisher and Margaret A. Brill. AAII Journal, May1985.
"Price-Sales Ratios," by John Markese. AAII Journal, Stock Selection Models, July 1985.
"Super Stocks," by Kenneth L. Fisher. Dow Jones-lrwin (1984).
"The Price/Sales Screen: How It Compares to the P/E Screen," by A.J. Senchak Jr. and John D. Martin. AAII Journal, November 1988.
