How to use the price-to-sales ratio to buy stocks?

The use of price multiples to determine the relative value of a stock is not uncommon in the investment community.

Price-to-earnings ratio (P/E) and price-to-book value ratio (P/BV) have been the most widely used valuation metrics in the market but the price-to-sales ratio (P/S) have yet to be appreciated.

The P/S ratio can be computed by dividing the market capitalization of the stock by the total sales. Alternatively, it can also be computed by dividing the price of the stock with sales per share.

Market analysts and bankers seem to use the P/S ratio when there is need to justify a stock valuation that the other multiples could not do. For example, when a company is losing or still in the early development stage, the P/S ratio is used to show how much investors are willing to pay for every one peso of sales generated.

The P/S multiple measures how much the market expect a company to grow its revenue base in the future, which would later translate to earnings. Some people argue that the use of P/S ratio is more reliable because the sales figures are harder to manipulate compared to earnings, which may be easily influenced by creative accounting policies.

Similar to other multiples, a stock with lower P/S ratio compared to industry or market average is considered to be an attractive investment opportunity.

A P/S ratio of 1 to 2 times means the stock is fairly valued but a ratio of lower than 1x may indicate the stock is cheap.

But how reliable is the P/S ratio as a valuation metric?

Remember that P/S ratio is based on the expectation that rising sales will generate profits at some point, let’s assume that the P/S ratio is a function of net profit margin.

Stocks that trade at high P/S ratio must have high margins while those with low margins deserve to trade at low P/S ratio.

Let’s validate this by determining the correlation between the P/S ratios of all the listed stocks at the Philippine Stock Exchange and their corresponding historical net profit margins.

The initial results of the exercise show that the P/S ratios are influenced by net profit margins in 17 percent of the time.

It is interesting to note, however, that if the losing companies with negative margins are excluded, the correlation is strengthened to 51 percent.

Now, let’s assume further that the P/S ratio is also function of earnings growth rate.

If profits are growing, higher dividends payout shall also be expected, which increases the value of the stock.

Earnings growth do not come without risk. The higher the risk a company takes, the higher the required rate of return on investment the company needs to deliver.

By complementing net profit margin as a key determinant of P/S ratio valuation with three more factors namely, earnings growth rate, historical payout ratio and beta into the model, the correlation is enhanced by about 1 percent more.

The current P/S average in the market is about 11x while the median P/S ratio is 3x. A stock that trades above market average may not necessarily be expensive because the premium is justified with high profit margins. In the same way, a stock may deserve to trade at discount because it has historically low income margins.

P/S ratios are useful in finding value stocks by spotting potential mismatch opportunities.

For example, there are stocks with relatively healthy profit margins that are not yet fully priced by the market.

Based on 218 stocks that have been subject to this exercise, more than 50 percent has been found to be relatively undervalued by P/S valuation.

Some of these stocks include GT Capital, East West Bank, Cebu Air, PNB, Vista Land, GMA7, Union Bank, Manila Water, Emperador and Universal Robina, Wilcon Depot, AEV, BDO, Ayala Land and SM Investments.