Part one of a series, on the need for a Tactical Allocation Strategy
By Richard Morey
September 2021
The Price-to-Sales Ratio
The price-to-sales ratio (P/S ratio) measures a company’s value in terms of its stock price in relation to its sales.
If you had to pick just one variable to determine if stocks were over or underpriced, I would submit that the Price-to-Sales Ratio is not only good but somewhat better than Warren Buffett’s shorthand measure called “Market Cap to GDP.” (Of course, Mr. Buffett’s preferred indicator also shows stocks now far further overpriced than at any point in our history.)
There are several reasons why the valuation systems with the highest correlation to actual future outcomes are all, at heart, based on corporate revenues instead of earnings or any other variable. The first, and most important, is that revenues and long-term prices of stocks happen to have the highest correlation of any single variable – by a substantial margin. Adding in certain other variables which also have a high correlation can enhance the overall results, but revenues are by far the largest contributor.
This can be explained fairly easily. I’ve always said revenue growth was the one growth you could actually believe because if the CFO falsifies the company’s income he or she could go to prison. Plus, it’s so very easy to manipulate variables such as earnings which is where the media focuses.
In other words, revenue growth is the most trustworthy growth upon which to judge how the companies are actually performing in their actual businesses (as opposed to their financially engineered façade called earnings embraced by the media and therefore the investing public).
As an aside, I should mention that corporate earnings are even more volatile or variable than stock prices themselves. As a metric upon which to attempt to determine stock values, earnings can therefore be even less reliable than the other most notoriously wild and often far off the mark variable called stock prices. But these are the things we’re trying to measure through valuation methods. It’s a little like the blind leading the blind.
Using revenue growth we can therefore get a picture of underlying corporate business growth much more reliably – hence its high correlation with subsequent, actual outcomes in the real world.
Without further ado,
let’s look at the Price-to-Sales Ratio today to see if stocks are over or underpriced:
Today the P/S ratio sits at 3.18. The previous peak, in history, was achieved on March 24 of 2000 – a few days before the tech bubble began to collapse. In that instance the P/S sales ratio plunged from the previously unheard of level of 2.44 down to 1.31, a 46% drop. The broad stock market itself (S&P 500) lost 55% from top to bottom, while the tech market fell a staggering 82.5%.
Assuming this time doesn’t turn out to be different, a P/S ratio of 1.31 would seem to be a reasonable guess as to where it will end up this time around. This certainly can’t actually be pessimistic when you consider the P/S ratio has bottomed below 1 a full 40% of the time it has hit a cycle low since 1950.
Our “optimistic” analysis of a P/S retreat to 1.31, if similarly reflected in stocks as occurred at the previous top, would lead to a loss of 67.6% for the S&P 500. (By definition the P/S ratio must fall during every bear market for stocks – called lowering the numerator.)
A more pessimistic expectation would see the P/S ratio falling far below 1 at the end of this cycle. Since 1950 we have seen seven economic cycles in which stocks fell such that the P/S ratio fell below 1, averaging a low of .75 at bottom. This would equate to a loss of 76% for stocks. Even this optimistically assumes stocks don’t go down more than the P/S ratio as it did from 2000-2003. If it did, the losses would be a staggering 87%.
It can be argued that all of these dire projections could be invalidated in favor of more optimistic datasets. In fact I sincerely hope that wisdom and sound judgement will prevail on the part of investors and regulatory agencies to bring us through the next phase of our economic cycle. Yet all these uncertainties seem to me to bolster the need for an active investment approach similar to our Tactical Allocation strategy.
Richard