How do profit margins affect stock returns?

In 1984, a value investor by the name of Kenneth Fisher wrote in his book “Super Stocks” that investors could find potential long-term winners in the stock market by investing in losing companies with good growth prospects.

Fisher, who popularized the use of price-to-sales (PS) ratio, claimed that a company’s sales are a better way to measure the strength of a business than its earnings, because it is more stable and harder to manipulate.

PS ratios, which indicate how much investors are paying for every peso of sales generated by a company, are ideal for evaluating companies that are incurring losses.

According to Fisher, stocks with low PS ratios, preferably 0.75 or less, have the potential to multiply in value over three to five years provided that they are supported by strong management, good market share and low debt level.

Fisher believes that stocks with high PS ratios can be dangerous, especially those with 1.5 times and above because the market may have already recognized a stock’s full potential, which could limit its further upside. But like PE (price-to-earnings) ratios, we know that stocks with low PS ratios are not always a bargain and those with high PS ratios are not necessarily expensive.

For example, the stock of San Miguel Corp. may look very cheap at PS ratio of only 0.25, but if we look at its 12-month trailing net profit margin of only 1.5 percent, we can say the stock is fairly valued.

On the other hand, SM Prime Holdings Inc. may seem expensive at PS ratio of 8.62 times but looking at its net profit margin of 34 percent will tell us that its premium is well-justified.

If we do a correlation between the Philippine Stock Exchange index (PSEi) stocks and its PS ratios, we can also find that investors tend to pay more for stocks that have higher net profit margin in 34.2 percent of the time.

This shows that the value of a stock as expressed by its PS ratio is driven mainly by its net profit margins. The healthier the profit margins, the higher the PS ratio of a stock.

Now, if a company is highly leveraged, the amount of interest expenses it has can significantly affect its net profit margin. For example, International Container Terminal Services Inc. generated an operating income margins of 55 percent for the past 12 months, which is great, but because it has huge interest expenses, its net profit margin was reduced to only 5.8 percent, making the stock look overpriced at PS ratio of 2.8 times.

Since the debt level of a company is not reflected in PS ratios, an alternative pricing multiple called enterprise value-to-sales (EVS) ratio can resolve this. The enterprise value of a company, which is calculated by adding debt into its equity’s market value and taking out cash, can be compared to its total sales.

Similar to PS ratios, the EVS ratio is an increasing function of operating income margins.

If we correlate the EVS ratios of PSEi stocks with their operating margins, we can find that companies with higher margins are priced higher by the market in 47.2 percent of the time. As a rule of thumb, we can determine the right EVS ratio of a stock by simply dividing its operating margin by 10.

For example, if we divide Jollibee’s operating margin of 7.7 percent by 10, we can derive that its fair EVS ratio is 0.77, but since the stock is trading at 1.14 times, it is considered overvalued. Conversely, Manila Water Co. Inc. may look expensive at EVS ratio of 3.34 but if we divide its operating margin of 57.7 percent by 10, we will derive an EVS target of 5.77, making the stock still undervalued.

The median EVS ratio of the PSEi has been falling over the years from a high of 3.63 in 2015 to 2.49 this year. But with the expected contraction in the economy, the decrease in operating margins may lead to further fall in EVS ratios.

PS and EVS ratios are useful metrics in picking stocks, but it is the profit margins that determine the value. INQ