A Deeper Look Into the Price to Sales Ratio: Akamai Technologies, Inc. (AKAM) and More

Page 1 of 2

The price to sales ratio is one of my favorite metrics to quickly determine whether a stock is potentially over or under valued. The price to sales ratio (PSR) became popular when it was first introduced by Kenneth Fisher in his wonderful book - Super Stocks (a book I highly recommend). For those not familiar with the ratio, it’s simply a company’s market cap divided by revenue (trailing twelve months).

Why do I like it so much….? I believe it’s a much better indicator of valuation because revenue (as opposed to earnings in the P/E ratio) is much harder to manipulate. Yes, I understand that revenue can also be manipulated, but not as easily as bottom line profits. As with any ratio, it should be accompanied with a check of earnings quality, cash flows, etc.

Akamai Technologies, Inc. (NASDAQ:AKAM)Why is it so powerful? The PSR is a very good indicator of potential operating leverage. A company with a below average PSR that can boost profit margin – even slightly – will see a dramatic impact to earnings growth. So a company may see a big boost to earnings without having to grow revenue at an equal pace. For instance, an increase in operational efficiency leads to automatic profit increases. Yes, growing revenue is what we like to see long-term, but a immediate bump up in profits ain’t too bad either!

A deeper look – While a powerful ratio, using PSR as a static number can be very misleading and counterproductive. Many investors will screen for low PSRs (say less than 1x revenue). Although valid as a starting point, it completely ignores a company’s operating leverage potential. Comparing companies on a PSR basis may lead to an apples to oranges comparison. This is why I always incorporate a company’s normalized operating margins relative to its price to sales. My calculation = price / sales / normalized operating margin.

Let’s use a few example and attempt to draw some conclusions about valuations. I’ll be looking at three different companies in the tech sector; Microsoft Corporation (NASDAQ:MSFT), Akamai Technologies, Inc. (NASDAQ:AKAM), and NetApp Inc. (NASDAQ:NTAP). Although all companies are in the technology arena, they are all in different industries with very different operating structures. The results of the PSR / Sales / Operating margin calculation are MSFT = 8.9, AKAM = 23.1, and NTAP=15.6. The following chart allows us to compare:

Price to Sales Ratio 3 Year Oper Margin PSR to Oper Margin

Microsoft 3.1X                                             34.5%                                         8.9

Akamai Tech 5.6X                                              24.2%                                        23.1

NetApp 2.1X                                             13.5%                                         15.6

For example, we can easily observe MSFT’s valuation relative to NTAP. While MSFT trades at a loftier PSR of 3.1X, its normalized operating margin is almost three times that of NTAP. Thus, MSFT is a cheaper option, in my opinion.

Microsoft Corporation (NASDAQ:MSFT) is well known for its dominance in PC operating systems. Their 90% market share of desktops has consistently generated operating margins north of 30% – even as PC sales have been dormant. MSFT has maintained this market share for almost two decades – which is unbelievable. This tremendous cash cow has allowed the company entry into other markets with mixed results. However, it’s pretty clear that they should be able to sustain high margins (at least in the near term). A reading of 8.9 is a very attractive valuation for this type of business.

Page 1 of 2

Dividend Stock Alert - Billionaire Robbins' Top Dividend Idea With 70% Upside Potential

Get Paid 3.5% Per Year While Waiting For The Stock Appreciate 70%

Larry Robbins' Glenview Capital Opportunity Fund returned 101.7% in 2013 and Robbins personally made $750 million. The same fund returned 25.3% in 2014. In this FREE REPORT we will share Robbins' top dividend idea that yields 3.5% and has been increasing its dividends for 39 consecutive years. Robbins thinks the stock has the potential to appreciate 70%.

This is a FREE report from Insider Monkey. Credit Card is NOT required.
Click here to Read Comments
Insider Monkey Small Cap Strategy
Insider Monkey Small Cap Strategy

Insider Monkey beat the market by 74 percentage points in 2.5 years. Our beta is only 1.2 (download a FREE newsletter and see the details inside)

Lists

Best Selling Magazines in the World

Shortest People in History

The Most Celebrated Holidays in the World

Most Expensive Handbag Brands in the World

Top Selling Comic Book Issues of this Century

The Most Powerful Women in Politics

Best Paid DJs

Most Rebellious Female Artists

Best Paid TV Actresses of 2014

Best Paid Actors of 2014

Most Expensive Horses in the World

Tallest People Ever

Most Encouraging Feminist Celebrities

Best Paid Supermodels of 2014

Top 10 Suburbs for Retirement in 2015

10 Wealthiest Cities in America

Top 10 TED Talks for Entrepreneurs

Best TED Talks on Education

25 Most Dangerous Places to Live in America

Top 10 Ski Resorts in the United States – 2014 List

Top 10 Most Remote Places in the World

Most Visited Museums in the United States

Wealthiest Photographers in the World

Most Famous Gay Athletes

The World’s Most Famous Circuses

Best Hair Stylists

Most Popular NASCAR Drivers

The Best Romance Movies of all Time

The Most Wanted Drug Lords

The Oldest Money Managers

The Greatest Directors in the World

Largest Animals in the World

World’s Most Expensive Desserts

Best Selling Comic Books of All Time

A-list Actors who Sabotaged Their Career

Rappers With a College Degree

The Best Jazz Albums of all Time

The Most Influential Jazz Musicians

The World’s Most Famous Photographers

The Best Oscar-Winning Songs

Most Influential Choreographers Ever

Most Expensive Department Stores in the World

The Most Expensive Stolen Paintings in the World

The World’s Most Expensive Teas

Top Oscar Record Holders

The Most Expensive Flowers in the World

Countries With a Booming Film Industry

Most Expensive Cupcakes in the World

Uncommon European Escapes

The Most Stolen Artists in History

Subscribe

Enter your email:

Delivered by FeedBurner

X

Thanks! An email with instructions is sent to !

Your email already exists in our database. Click here to go to your subscriptions

Insider Monkey returned 129% in 2.5 years!! Wondering How?

Download a complete edition of our newsletter for free!