Do you consider a stock's price-to-sales (P/S) ratio to be an important factor in your purchasing decision? If you're like many investors, the answer is "yes" -- but if you aren't careful, being fixated on a high P/S ratio can lead you to miss out on some of the best growth stock opportunities. After all, sales aren't the only factor that you should consider when you're assessing a stock's value in comparison to its price.
In particular, P/S ratios can be appallingly high for stocks that are just starting to report sales for the first time. That's especially true in the biotech industry, where promising companies can spend years in the clinical trial process, reporting minimal revenue in the lead-up to a game-changing product launch. To illustrate this concept, let's investigate a pair of biotechs that appear dramatically "overvalued" on the basis of their P/S ratios and examine why they're ripe for a buy nonetheless.
| Stock | P/S Ratio (TTM) |
|---|---|
| Vericel Corporation (VCEL +0.06%) | 17.33 |
| Halozyme Therapeutics (HALO +6.73%) | 23.13 |
| Biotech industry average | 8.09 |
Data source: YCharts, Yahoo! Finance. TTM = trailing 12 months.
1. Vericel Corporation
It's easy to see why the market is paying a premium for Vericel Corporation (VCEL +0.06%) stock. The specialty therapy developer reported that fourth-quarter revenue increased by 15% year over year, mostly as a result of hot sales of its MACI drug for healing damaged knee cartilage. Management expects its annual total net revenue to grow rapidly this year, estimating an increase of around 30%, meaning that it could reach $164 million by the end of December. To top it off, the company has no debt, and around $100 million in cash. That opens up clear skies for investing in new growth opportunities.
More importantly, by the end of June, Vericel expects to hear back from the U.S. Food and Drug Administration (FDA) about its NexoBrid therapy for severe burns. NexoBrid has already been proven safe and effective in phase 3 clinical trials, so it's approaching the final steps before obtaining regulatory approval in the U.S. It's already been authorized in the EU. This means that the company could have a new revenue stream by the end of the year, which is doubtlessly being factored into the stock's price right now. Likewise, it reported positive net income for the first time in 2020, and its earnings will probably increase by a substantial amount over this year and next.
In short, Vericel's trailing valuation metrics are reporting on its earnings-free past, not its future financial strength. In my view, the revenue it'll gather from NexoBrid makes it worth a purchase -- even if it keeps its P/S ratio of 17.
Image source: Getty Images
2. Halozyme Therapeutics
It's pretty safe to call Halozyme Therapeutics (HALO +6.73%) a growth stock due to its eye-popping 126.8% year-over-year quarterly revenue growth. If that doesn't entice you right away, consider that 2021 has all the makings of another bumper crop year for Halozyme.
According to the estimates released in its 2020 fourth-quarter earnings report, Halozyme's revenue may grow by as much as 48% this year. Incoming royalties could increase by a full 100%. And, according to its guidance on earnings per share, the company could experience growth of up to 70% compared to 2020.
How is Halozyme achieving that growth and expecting even more? The company's primary product is a technology that allows intravenously administered drugs to instead be administered under the skin. It allows drugs to be infused into patients in a few minutes instead of up to a few hours. Each drug that uses the technology earns royalties for Halozyme, so the company doesn't need to do much to keep raking in the cash. Five drugs already use the system for their administration, and 17 more are in development across Halozyme's collaborators. Even if these in-development projects don't pan out, the company still makes money based on the milestone payments throughout the clinical trial process.
Considering that its stock more than doubled over the last 12 months, shareholders may be in for a real treat of an encore performance. Don't let its P/S ratio of over 23 fool you: Revenue and earnings are rising rapidly, and they'll soon pull the price up even higher.
