Beware of High Price to Sales Ratio Stocks

Looking at the long-term picture, the multiple you pay today makes a big difference in the long term.

Jun 28, 2014 at 9:00AM

Warren Buffett has been able to outperform the market for so many years because he buys companies at a fair price. Looking at the long-term picture, the multiple you pay today makes a big difference in the long term. While innovative companies and exotic technologies make investors excited, be very careful before buying those companies for the long term.

P/E isn't enough information alone to determine if you're overpaying for a stock because earnings are susceptible to cyclical swings. In fact, you typically buy a cyclical stock when the P/E is high and sell it when it's low.

But, one metric that might give you insight about whether you're overpaying for a stock that's susceptible to cyclical swings is the price-to-sales ratio. Basically, the price-to-sales ratio indicates the multiple of annual revenue you are paying for a stock. It's not a lot of information, but when coupled with other information and with some historic content, it may help you avoid overpaying.

Let me give you some examples

CSCO PS Ratio (TTM) Chart

Source: CSCO PS Ratio (TTM) data by YCharts

Cisco (NASDAQ:CSCO) is a textbook case of how to use the price-to-sales ratio to avoid buying stocks that will underperform over the next decade.

At the height of the market mania in late 2000, the market valued Cisco as high as 35 times revenue. The logic is that high-growth disruptive stocks deserve a premium. However, several months before 2002, when the market realized that Cisco's revenue growth could not be sustained, the stock crashed from a high of nearly $75, landing around $15 per share. 

Cisco has actually doing great ever since, as both revenue and EPS has been climbing. However, shareholders who bought the stock in 2000 are still losing money. Presently, Cisco trades near 1/3 of its all-time high. Today, the stock trades at a down-to-earth price-to-sales ratio of 2.8, but the fundamentals still haven't caught up with the nominal price of the stock in 2000.

MSFT PS Ratio (TTM) Chart

Source: MSFT PS Ratio (TTM) data by YCharts

Like Cisco, Microsoft (NASDAQ:MSFT), at one point, had a price-to-sales multiple as high as 28. In Microsoft's case, its revenue growth never slowed, and similar to Cisco, the fundamentals have never been better. However, investors who bought the stock when the P/S ratio was at its high are still losing money.

Two stocks that never had an irrational Price/Sales ratio 

GD PS Ratio (TTM) Chart

Source: GD PS Ratio (TTM) data by YCharts

General Dynamics has never had an irrational P/S ratio. As a result, the stock was never priced at impressive valuations and has always been considered relatively safe. Note that the P/S ratio in this case never passed three (in the mid 1990s), and even then it during the company's reorganization. The result was that there were no losers in General Dynamics -- anyone who ever bought this stock is making money.

AAPL PS Ratio (TTM) Chart

Source: AAPL PS Ratio (TTM) data by YCharts

Believe it or not, Apple also never had an irrational P/S ratio. In fact, the highest it ever reached was near 7, at about the time the iPhone came out. Today, the stock's P/S ratio stands at a modest 3.26, and like General Dynamics, there are no losers in Apple stock.

When investors pay an irrational P/S ratio, they pay for irrational growth
When investors buy stocks with high P/S ratios, those stocks need to grow revenue at least 30%-40% on a yearly basis for many years into the future. This is because investors are paying a big premium today for growth that is expected to happen in the future. But, with any deviation from future growth expectations, the premium paid today may no longer be deserved. As a result, and because an irrationally high P/S ratio cannot be maintained by an increase in revenue growth, the stock is likely to collapse. 

That's what happened to Microsoft and Cisco. But, even after the initial collapse, both stocks were still extremely expensive, and it took over a decade for the fundamentals to catch up to the nominal price of the stock. As a result, investors holding these stocks for the long term have either underperformed or are still losing money.

Some high Price/Sales ratio stock to keep your eye on
Voxeljet currently has a P/S ratio of 15 with a projected P/S ratio for 2014 of 14. Keep in mind this stock traded as high as $70 in November 2013.

LinkedIn (NYSE:LNKD) currently has a P/S ratio of 12, with a projected P/S ratio of 10 for 2014. LinkedIn reached a high of $257 in September 2013, and currently trades at $165 after recently hitting a low of $140.

From the fuel cell space, Plug Power currently trades at a P/S ratio of 30, with an estimated P/S ratio of 11 for 2014. Plug Power currently trades at $4.80, but traded as high as $11.70 in March, meaning its P/S ratio was near 70.

What is a normal P/S ratio?
This is a difficult questions to answer, as there is no concrete answer. However, as the chart from Standard and Poor's illustrates, the long-term median average of the S&P 500 has been about 1.5, with the current being 1.69.

G

Bottom line
The P/S ratio is not the only financial metric by which to judge stocks. There are many other metrics, but history has shown that, when investors pay an abnormally high P/S ratio, it can be dangerous if revenue growth can't outpace the multiple contraction of the ratio. As the case of Cisco illustrates, having paid an irrational P/S ratio, even after 15 years the fundamentals might still be behind the curve of the nominal price of the stock.

Warren Buffett just bought nearly 9 million shares of this company
Imagine a company that rents a very specific and valuable piece of machinery for $41,000 per hour (That's almost as much as the average American makes in a year!). And Warren Buffett is so confident in this company's can't-live-without-it business model, he just loaded up on 8.8 million shares. An exclusive, brand-new Motley Fool report details this company that already has over 50% market share. Just click HERE to discover more about this industry-leading stock... and join Buffett in his quest for a veritable landslide of profits!

 George Kesarios has no position in any stocks mentioned. The Motley Fool recommends 3D Systems, ExOne, and Stratasys. The Motley Fool owns shares of 3D Systems, ExOne, and Stratasys. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers