Comparing Price To Sales As A Value Flag—With 20 Cheap Stocks

Bargain-hunters should look beyond the P/E to its cousin, a measure that zeroes in on revenue-generating power.

By William Baldwin, Senior Contributor

T

he price-to-earnings ratio is basic. Price-to-sales is somewhat obscure. This article aims to lift the latter ratio out of obscurity and show its purpose.

If all you know about a stock is one fact, you’d get a better idea of what it’s worth by knowing that the earnings per share are $3 than by knowing the sales per share are $60. But if you have time to study a lot of numbers, the price-to-sales ratio, or PSR, should be on your list not far behind P/E.

Earnings are important because they supply the dividends you want to collect. Why care about sales? Because they offer some hint about future earnings.

The notion behind PSRs is that unusually high or low profit margins tend to regress toward the middle. The sterling outfit with a high margin may eventually attract imitators who compete away its profits. The clunker with the low margin might clean up its act. If these trends prove out, the low margin company, now trading at a low multiple of sales, will turn out to be the bargain. Companies trading at high PSRs, in contrast, are likely to get more competition and might be due for a correction.

Trex and Jeld-Wen are in the same industry: building products. Trex, very au courant with its enviro-friendly product line (deck boards from recycled plastic and reclaimed sawdust), is an enterprise valued on Wall Street at just under 7 times revenue. Jeld-Wen, which is into rather old-fashioned millwork, is valued at half of revenue. If the two companies’ sales grow at similar rates, and if Trex loses some of its luster while Jeld-Wen improves its profit margin, Jeld-Wen will beat Trex in the stock market.

An even more stunning contrast is between Tesla and Stellantis. The market values Tesla at 649% of its trailing 12-month revenue. Stellantis, married for now to the internal combustion engine (in Ram trucks, for example), is valued at 22%.

A regression toward the mean? Could happen. Maybe Elon Musk will have a hard time fighting off Chinese competition. Maybe pickup buyers will fall in love with the 2025 all-electric Ram.

There’s a simple relationship between the P/E and the PSR: Multiply a company’s price-to-earnings number by its net profit margin and you get the ratio of price to sales. PSR = net margin x P/E.

Example: Stock trades at $45, sales per share are $60, and the profit margin is 5%. Then earnings per share would be $3 and the P/E would be 15. Multiply 15 by 5% and you get the price-to-sales ratio of 0.75, which is to say 75%.

The table displays an assortment of companies with unusually high or unusually low ratios of price to sales. The calculation makes two refinements to the simple PSR. One is that the price used in the numerator is not the market value of common shares but the more all-encompassing enterprise value, defined as common market capitalization plus net debt (debt minus cash on hand).

The other modification is to score a company not on the price ratio but on how that ratio compares to the median ratio for the company’s industry. One cannot expect the PSR of a fruit vendor to be anything close to the PSR of a software company, so food companies should be compared to food companies and software suppliers to software suppliers.

To be sure, the industry classifications in the YCharts database, the source of most of the numbers in this and the other Market Lessons reports, are necessarily simplistic and do not capture the nuances of different business models. Still, the industry-adjusted PSRs do a far better job than raw PSRs of highlighting outliers.

The tables display an assortment of companies at the extremes—those whose PSRs put them either well ahead of industry peers or well behind. A regression toward the middle in profitability would give a boost to the cheap companies and drag down the expensive ones.

Can you make money from the PSR? There’s at least one guy who did.

Forty years ago Kenneth Fisher was a little-known money manager who turned up in a magazine profile touting PSRs as a powerful tool to use alongside traditional stock analysis. That story led to a long-running gig as a Forbes columnist, which led to ever increasing visibility and more clients. He has gone far beyond this one shtick, and now employs an army of analysts doing all sorts of computations, but the simple PSR approach got his ball rolling.

Today Ken Fisher oversees $276 billion. It’s a nice business. We have him on our Forbes 400 Ranking of the Wealthiest Americans as worth $11 billion.