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Thursday, December 10, 1998

An Investment Opinion
by Dale Wettlaufer

The PSR Pet Peeve

Do you happen to have an investment pet peeve? It may be those darned Internet stocks that have you upset. Or maybe it's overpriced blue chips. Maybe it's SOES bandits. Whatever, we all have them. Mine is the "PSR," or price-to-sales ratio. This ratio divides a company's market capitalization by its total revenue. If there were a group of valuation metrics that I had to take out on a search and destroy mission, this is the first one I'd go for. There are a number of problematic aspects with this ratio and the way it's interpreted.

1. All dollars of revenue should not be valued the same.

When you come up with a screen that arbitrarily cuts off companies at a PSR of 2.0, you'll cut off any company with decent margins. Even without a cutoff, if the point of the exercise is to find low PSRs, there will be an inherent bias toward lower-margin companies. If a company is able to achieve a net margin of 15%, it's natural that it will sell at a higher PSR than a company with a net margin of 3%. The former is bringing five times more sales dollars to the bottom line than the latter, so why would the lower-margin company be a better bargain at a PSR of 1.0 than the higher margin company at a PSR of 3.0? All else being equal, the company with five times the net margin and only three times the PSR will be a better value.

2. PSR is not an arbiter of value.

A company's value comes from the cash it can generate over its lifetime. Revenues don't mean a darn thing if over the long- run they cannot be converted into a cash return on capital invested in the business.

3. Revenues don't immediately turn into cash.

Revenues don't immediately turn into cash in most businesses outside of the cash-based retail world. In some businesses, revenues can be as ephemeral as "gains on sale" of loans and can turn into what are essentially long-term assets. In most manufacturing or service businesses, revenues turn into cash only after the receivable associated with the sale has been paid. But in some businesses, such as Home Depot (NYSE: HD), for example, not too much of the revenues get trapped on the balance sheet as receivables. For Home Depot, averaging daily revenues over the last nine months, the company ended the third quarter with 5.5 days' sales in receivables. That's not too much. Compare that with equipment and supplies distributor W.W. Grainger (NYSE: GWW). It had 41.2 days' sales in receivables at the end of September, owing to its status as more of a business-to-business retailer/wholesaler than Home Depot, which has a concentration of revenues from consumer retail sales.

Depending on how well those receivables are financed and the return on the receivables, there's a good chance that the revenues that turn into cash are worth more than the revenues that have to go through the balance sheet as receivables, margins and all else being equal.

4. Firm value isn't just price.

Probably my biggest hang-up with price-to-anything ratios, and the price-to-sales ratio in particular, is that a firm's value isn't indicated by only its equity market capitalization. A firm's value depends not just on the equity value but also on the debt the firm carries and cash on the balance sheet. Think of it this way -- when you look at a house that is for sale and the seller still has a mortgage worth $140,000 on the house with a market value of $180,000, it's not going to cost you the $40,000 residual to acquire that house. It's going to cost you $180,000, financed however you want -- out of cash, out of debt, or out of golden egg-laying gooses. But it's not just the equity value. It's enterprise value-to-whatever, which is equity market capitalization plus debt minus excess cash.

Here's another way of looking at it. Say I'm a buyout firm and I'm looking at a cigarette and branded foods company with and equity market value of $20 billion, no excess cash, and no debt. With revenues of $10 billion, the company has a PSR of 2.0 and an enterprise value-to-sales ratio of 2.0. If my firm engineers an leveraged buyout of the company and retains $5 billion in equity and takes on $15 billion in debt, the enterprise value hasn't changed. It's still $20 billion, and thus the enterprise value-to-sales ratio remains 2.0. But the PSR people will say the PSR has magically declined 87.5%, to 0.25. You might own all the equity, but it's not an unencumbered interest in the firm. Your debt holders get into the driver's seat as soon as you have any sort of serious problems.

So, PSR depends very much on leverage. If you're buying a highly leveraged company, the PSR is likely to be lower. But if you are examining the actual firm value-to-sales ratio, or enterprise value-to-sales ratio, you're not going to have problems with the capital structure of the firm throwing the ratio out of whack. That way, something like a beat-up integrated steel producer with tons of debt is not going to look more attractive than a beat up yet unencumbered company.

Overall, it's really meaningless to put a steel company on the same footing as a company making Internet routers. Internet traffic doubles every 100 days, or more than 12.5 times per year. It takes a steel company growing sales at 3% per year more 85 years to increase sales by a factor of 12.5. A router company with 3 times the gross margin and 15 times the net margin of a steel company and an addressable market growing at hundreds of times the growth rate of a steel company is worth far more on a PSR basis. Both sets of revenues can't be compared that meaningfully.

The bottom line on PSR -- use it in conjunction with other data to look at the value of a company, but don't use it alone as a meaningful screen. And don't use just market cap. Use enterprise value-to-sales as a better indication of how much you're paying for each dollar of revenue.

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