When you're looking for attractively valued companies to add to your portfolio, it's always a good idea to compare current price to expected revenue growth. Comparing a stock's price to sales per share can give you an idea of how much investors are willing to pay for $1 of a company's revenue.
Although there are many exceptions to the rule, a low price / sales per share (P/S) ratio generally signals a potentially undervalued stock; conversely, a higher P/S ratio indicates premium pricing.
But, as with all valuation ratios, the P/S ratio should only be the beginning of your due diligence. The worst thing you can do is to fall into a "value trap" -- buying "cheap" stocks without looking at the underlying fundamentals of the company.
For this reason, we created a universe of about 250 stocks that have been more profitable than their competitors over the last 12 months, based on metrics like net profit and gross profit margins.
We also incorporated analyst revenue projections for the current financial year, and used a mathematical formula to establish theoretical prices for the stocks in our starting universe.
The math behind this stock screen is pretty straightforward. It begins with the basic principle that:
(price / sales per share) * (sales per share) = price
Then, we can use this equation to make the following statement:
(Last year's average price / Last year's sales per share) * (Next year's expected sales per share) = Next year's fair stock price
Note: The calculation of the average price is discussed at the end of this article
Put in plain English, the equation states that a stock's price should fluctuate relative to its expected revenue growth. By multiplying last year's average price by the ratio of (Next year's sales per share / Last year's sales per share), you can establish a theoretical fair value for the stock price. If revenue growth is positive, the price should also increase.
Of course, there are many limitations to this formula. There is no reason to believe that such a relationship between sales and price per share should always exist -- it is merely a simplifying assumption used to build a stock screen that can serve as a starting point for your own analysis.
For this article we ran the above-mentioned formula on the 250 profitable stocks in our starting universe, and identified the profitable companies trading at the deepest discounts to their (theoretical, revenue-based) fair values.
And finally, to make sure that our fair value estimates are as conservative as possible, we only used the lowest projected (sales per share) values from the analysts covering each stock.
History shows that these companies are consistently more profitable than their competitors, and it appears that the market still needs to price in the expected revenue growth associated with these names. Which of these names are you most bullish on? (Click here to access free, interactive tools to analyze these ideas.)
1. WMS Industries
2. Urban Outfitters
3. F5 Networks
5. Rock-Tenn Co.
Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research. Note: The numbers on top of items represent the forward P/E ratio, if available.
Kapitall's Eben Esterhuizen does not own shares of any companies mentioned.