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.
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.