Wednesday, April 17, 2013

Stock Valuation Method - Average P/S Ratio

This is the 4th part in my series on stock valuation methods.  I've previously covered the Graham Number, Average Dividend Yield and Average P/E Ratio.  Today I'm going to take a closer look at the average low P/S ratio method.  This one is pretty much the same as the dividend yield and price-to-earnings ratio methods except now we focus on the revenue side of the business.

Sales are the number one thing a company is after.  You can't make a profit if you don't bring in any revenue and you can only increase your profit margin to a certain extent before you have to increase revenues to grow your business.  I like to look at the price in relation to the revenue or sales per share that a company can generate.

Like almost any other metric this is very specific to each industry.  I wouldn't be willing to pay as much on a P/S basis for say Apple as I would for Proctor & Gamble.  Why you might ask?  Well that's because the revenue for PG is much more stable, reliable and predictable than the revenue for Apple.  Apple's products could no longer be sought after by consumers in the next month, whereas we all need toilet paper, laundry detergent, razors, toothpaste and the rest of the PG product line in our every day lives.

In order to calculate the P/S ratio you simply look on the income statement of the most recent annual report or the last 4 quarterly reports for whichever company you're interested in.  The total revenue will be listed at the top of the income statement.  Now that we have the total revenues we need to convert to a per share basis by dividing it by the shares outstanding.  You can find the shares outstanding near the bottom of the income statement as well.  As I've mentioned before, I prefer to use the fully diluted shares outstanding since that accounts for all potential shares due to options, convertible bonds, etc.

The rest is easy.  Just take the high and low prices for each fiscal year and divide that by the revenue per share value for the corresponding fiscal year.  From here it's just a matter of taking the average of the last 5 or 10 years to come up with the historical trend.  Then I compare the analyst estimates for revenue to the current price to see whether it's currently under, fairly, or over valued.

As I've mentioned in every single post on my stock valuation series, each valuation method should not be taken as gospel.  They each have their strengths and weaknesses and should not be taken as the be all end all to determine a entry price for a company.  The market is very fickle and companies go through different growth phases at different times in the economic cycle.  Some companies barely even register a recession because they are consumer staple companies that provide products we all use every day.  Others such as industrial companies will have wild swings in the revenue and profitability because they are so closely tied to how well the economy as a whole is doing.  This is why I prefer to use multiple valuation techniques to be able to determine a valuation range and compare across the different methods.

7 comments:

  1. I am nearing the end of my masters in financial management and found this post informative. I like the fact that you point out that each valuation method has its strength and weaknesses. When valuing stocks you should never just use one method.

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    1. Alan,

      I'm glad the post helped. And congrats on nearing graduation with a Masters. That's amazing. I've thought of maybe going back to school, but I don't think that's going to happen. I don't really want to go into the business side, so it'd have to be the investment arm of the financial industry. It'd be interesting to get to learn more and have more exposure, but I just don't see that in my future at this time.

      I don't ever rely on any single metric and I make sure I post about that in every part of this series. There's no one tool that could possibly incorporate everything that can go into valuing a company.

      Thanks for stopping by!

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  2. Thank you for this write up. I've really enjoyed this series and need to try out a few of these methods going forward.

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    1. MyFIJ,

      No problem and glad you've enjoyed the series thus far. I need to see if there's a way to compile the data better than my process of hand entering it in my spreadsheets, but it works for me and it's not that difficult. It's one of those situations where I've gotten used to it and can compile all the data in about 30 min, then it's just a matter of adjusting my spreadsheet some since the FY's for companies are different.

      There's still more to come so stay tuned.

      Thanks for stopping by!

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  3. Very true, sales are responsible for bringing money into a company. I like this metric.

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    1. Marvin,

      If anyone thinks that revenues aren't that important all I have to do is point them to the number of dotcom stocks in the late 90's that brought in no money but sure could spend it. I like the P/S ratio because you either sold your products or you didn't. The headline earnings figures take into account depreciation and all sorts of other things that don't effect the operation of the company.

      Thanks for stopping by!

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  4. Any chance you might post your spreadsheets for these valuation methods? I've tried creating my own, but am stuck in a few places (especially with the P/S ratio). Also, when researching for these valuation methods, I'm not always sure about which numbers I need to be looking at; I currently use Morningstar since it is the only site I have found that goes back 10 years instead of 5 years, and Yahoo! Finance when I need the analyst estimates.

    Thanks so far. I just started my journey with dividends in January and this site has helped a lot!

    Shawn

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