Using the PSR

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It's one of the simplest ratios you can use in investing. Yet paying attention to what it tells you can really make a difference to your market performance. It can avoid you getting too carried away with the latest 'concept stock'.

The price-sales ratio (PSR) is sometimes called as the 'revenue multiple'. It is the market capitalisation of the shares divided by the company's annual sales. An alternative definition is share price divided by sales per share.

Where experts disagree over the calculation is normally over whether or not you should take the sales for the last reported year, or the last 12 months. The share price and market capitalisation are based on today's share price: so it makes sense to take the latest 12 months sales figure.

So for companies reporting twice yearly, if a half year has been reported, sales in the first half of the current year would be added to those of the second half of the previous one. Second half sales are normally calculated by subtracting the first half of the prior year from the full year number.

When to use PSR

Using the PSR effectively requires discipline and a bit of common sense. For example, there are industries (broking, supermarkets and the like) that operate on high turnover and low margins. The PSR is unsuitable for analysing these. It's also unsuitable for analysing asset stocks like real estate, or financial institutions like banks and insurance companies. But for mainstream companies, and especially for simple straightforward smaller companies, it works just fine.

It can, however, also be misused. The unscrupulous can twist its meaning to give a spurious value to an investment that would otherwise not have much merit. For example, the PSR became increasingly widely used in the late 1990s as investment bankers realised that it could be used to provide a valuation measure, however tenuous, for companies with no foreseeable prospect of making a profit, notably in the TMT sector.

To recap. In this case analysts ignored profits (there weren't any) and concentrated on forecasting revenue numbers in order to assign a value to a stock. This method of valuing companies has now been thoroughly discredited, not least because some companies artificially inflated turnover to meet investor expectations, and because ultimately it is profits, cash flow and assets that determine a company's long-term underlying value.

Assessing stock

While there is some justification (in the same way as with price-earnings ratios and earnings growth) for companies that can demonstrate high and consistent levels of sales revenue growth to sell on higher multiples of revenue than those whose sales are static or growing more slowly, it is open - as these examples show - to serious misinterpretation. The cold reality is more mundane.

The PSR can be used as a way of assessing the cheapness or otherwise of a share. But there is a catch. The normal rule of thumb is simple. Companies that have a PSR of significantly less than one can be considered cheap (those that have a PSR of more than one are expensive).

In well-known book What Works on Wall Street, US fund manager and quant guru James O'Shaughnessy examined US share price and accounts data for an extended part of the post-war period and found that a historic PSR of less than one was the most reliable indicator of the future share price performance of companies. So it pays to look at it closely when assessing whether a stock is cheap or expensive.

Peter says

Like most financial ratios, the PSR isn't infallible. It doesn't work every time and it doesn't work for every company. I do use it, but in a slightly more selective way. I prefer to employ it as one of a small group of ratios (return on equity, price to cash flow, and operating cash flow to operating profit are the others), to filter out companies that look interesting, or to test the numbers on a tip or a new issue.

Paradoxically, it works best if most of the market is ignoring it, when the temptation for companies to pay attention to revenue forecasts is less persuasive. Be aware that, unlike cash flow, sales numbers (and profits) can be temporarily manipulated to show a company in a more flattering light. Those companies that attempt this should be avoided. Puffing up sales in the short term only leads to trouble further down the line. Equally, beware of using forecast sales figures in the calculation.

O'Shaughnessy's exercise used only historic data. Who are we to disagree?