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

Akamai Technologies, Inc. (NASDAQ:AKAM) has also been a dominant player in its field. The company provides content delivery infrastructure/services for transmission over the internet. It’s been known as the backbone on the internet. As a leader in their space, they’ve been able to maintain high margins in a fast growing industry. But the combination of high growth and high margins eventually brought fierce competition. This ultimately leads to pricing issues – which may lead to deteriorating margins. In fact, although AKAM is a wonderfully profitable company, margins may be already contracting. Higher spending on R&D as a percentage of sales will be necessary to maintain share leadership. A reading of 23.1 is too pricey for me for this uncertainty.

Lastly, NetApp Inc. (NASDAQ:NTAP) is in the storage business. The storage business has experienced price compression over the past decade. While the need for storage has grown exponentially, it seems that the cost for that storage has declined almost as fast. It requires constant innovation to stay ahead of the pricing curve and NTAP has done an admirable job defending its turf. However, margins will eventually suffer in this type of environment – no matter how fast the industry is growing. With this in mind, a reading of 15.6 is more than I’m willing to pay.

A quick recap – based on my expanded PSR to operating margin metric, I consider MSFT to be attractively valued given its consistently high margin structure. While both AKAM and NTAP are more vulnerable (and potentially over-priced) given their competitive markets and uncertain margin trends.

A few caveats to remember; first it’s important to use a normalized operating margin over at least a three or five year period. A company with an unusual jump in margins may lead to a misleading conclusion. Secondly, one must feel relatively confident that a company can maintain that operating margin in the future. Deteriorating margins will almost always lead to lower stock prices. Lastly, any static measure such as this doesn’t account for future growth prospects.

Price to Sales is a useful metric, but should never be used on a stand-alone basis. Always qualify it with proper due diligence, thorough earnings quality review, and sound judgment. Finally, consider using enterprise value instead of market cap. This helps to level the playing field for companies with a great deal of cash or debt on the balance sheet. Hopefully, this additional step in the PSR calculation will make it a more useful tool in the future.

The article A Deeper Look Into the Price to Sales Ratio originally appeared on Fool.com and is written by William DeRosa.

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