Author: mungofitch

Subject: Re: Fun with valuation numbers

Date: 11/16/2013

Recommendations: 3

Price/sales isn`t good for any particular firm because so many firms have unusually high or low net margins by the nature of their businesses. But the median P/S ratio gets around that problem because the outliers won`t be in the middle of the pack. ... I use a ratio of the company P/S to the industry P/S. Otherwise, those "outliers" tend to be most of the companies in specific industries. For sure. That`s why I don`t use any screens based on market-wide P/S, but relative value makes sense. But I`m not *that* fond of P/S within industries, either, though it works OK. The reason is this: imagine a company with two players, one with great economics and an also-ran, say Intel and AMD when it was primarily a head-to-head contest for x86 CPUs. Most of the profits go to the leader. There are lots of examples: Coke and Pepsi in colas alone, Walmart and Sears. In that case, a low price/sales sort will always put you into and keep you in the loser. In effect, seeking low price/sales even within an industry is a wager on normalization of valuation levels within that industry: a bet that the one getting the rich valuation will underperform and the one getting the poor valuation will catch up. However, sometimes the valuations are right and the dud deserves lower multiples. It should work best in industries which are very commodity-like, and least well in those industries which might have economic moats which tend to be the industries with the highest long run returns. Here`s an idea if you`re a fan: Try a low P/S screen limited to industries with commodity-like competition. e.g., exclude drugs, medical devices, branded consumer staples, beverages, tobacco, arms. Rather than building a list, you could simply pick out (say) the 2/3 of industries with the lowest industry-wide return on sales or return on equity, then do relative P/S within just those lower-markup businesses. Jim