How to Value Stocks: Revenue-Based Valuations

Every time a company sells a customer something, it produces revenue. Revenue is the income generated by a company for peddling goods or services.

Whether or not a company has made money in the previous year, there is always revenue -- even companies that may be losing money temporarily and have earnings depressed due to short-term circumstances, such as product development or higher taxes. Companies that are relatively new in a high-growth industry are often valued off of their revenue and not their earnings. Revenue-based valuations are assessed using the price/sales ratio, or PSR.

The price/sales ratio takes the current market capitalization of a company and divides it by the past 12 months trailing revenue. The market capitalization is the current market value of a company, arrived at by multiplying the current share price times the shares outstanding. This is the current price at which the market is valuing the company. For instance, if our example company, XYZ Corp., has 10 million shares outstanding priced at $10 a share, then the market capitalization is $100 million.

Some investors are even more conservative and add the current long-term debt of the company to the total current market value of its stock to get the market capitalization. The logic here is that if you were to acquire the company, you would acquire its debt as well, effectively paying that much more. This avoids comparing PSRs between two companies when one has taken out enormous debt to use to boost sales, and the other has lower sales but no additional nasty debt.

            Market Capitalization = (Shares Outstanding x Current Share Price) + Current Long-term Debt

The next step in calculating the PSR is to add the revenue from the last four quarters and divide this number into the market capitalization. If XYZ Corp. had $200 million in sales over the past four quarters and currently has no long-term debt, the PSR would be:

            (10 million shares x $10/share + $0 debt) / $200 million in revenue = 0.5 PSR

Companies often consider the PSR when making an acquisition. If you have ever heard of a deal being done based on a certain "multiple of sales," you have seen the PSR in use. As a legitimate way for a company to value an acquisition, many investors simply expropriate it for the stock market and use it to value a company as an ongoing concern.

Uses of the PSR
As with the PEG and the YPEG, the lower the PSR, the better. Ken Fisher, who is most famous for using the PSR to value stocks, looks for companies with PSRs below 1.0 to find value stocks that the market might be overlooking. This is the most common application of the PSR and is a pretty good indicator of value, according to the work that James O'Shaughnessey has done with S&P's CompuStat database.

The PSR is also a valuable tool to use when a company has not made money in the past year. Unless the corporation is going out of business, the PSR can tell you whether or not the concern's sales are being valued at a discount to its peers.

If XYZ Corp. lost money in the past year, but has a PSR of 0.50 when many companies in the same industry have PSRs of 2.0 or higher, you can assume that, if it can turn itself around and start making money again, it will have a substantial upside as it increases that PSR to be more in line with its peers'.

There are some years during recessions, for example, when none of the auto companies make money. Does this mean they are all worthless, and there is no way to compare them? Nope, not at all. You just need to use the PSR instead of the P/E to measure how much you are paying for a dollar of sales instead of a dollar of earnings.

Another common use of the PSR is with the P/E to confirm value and compare companies in the same line of business. If a company has a low P/E but a high PSR, it can be a signal that there were some one-time gains in the past four quarters that were pumping up earnings per share.

Finally, new companies in hot industries are often priced based on multiples of revenues and not multiples of earnings.

For more lessons on valuation methods, follow the links at the bottom of our introductory article.


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