Computerized Investing - Spreadsheet Collection/Spreadsheet Collection.iso/pc/prsales/psale.doc

Text File | 1991-07-11 | 13.2 KB | 318 lines

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.WKS), 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 priceearnings 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/Earnings (P/E) = Price per Share
Earnings per Share
= Price per Share
Sales per Share x Profit Margin

= Price per Share 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.
The sample screens on pages 3 and 4 show how to set this up.
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:

Relative P/S Ratio = Company P/S Ratio
Industry P/S Ratio

The second problem was the effect of different debtequity
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

Sales         Total Revenues (Sales)

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 substan-
tially 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 Sales
Earnings

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 Popu-
larity," by Kenneth L. Fisher. Mll Journal, June 1984.

"Stock Valuation: A New Technique to Adjust fDr Debt," by
Kenneth L. Fisher and Margaret A. Brill. AAII Journal, May
1985.

"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.

(c) Copyright 1991 by the
American Association of Individual Investors