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    A Top-Line Approach: The Price-to-Sales Ratio Screen

    by Wayne A. Thorp

    Ken Fisher first popularized the strategy of selecting stocks based on price-to-sales ratios in his 1984 book, “Super Stocks.”

    However, price-to-sales ratios (current stock price divided by sales per share for the last 12 months) truly came into their own during the dot-com era, as investors sought ways to value companies whose negative earnings made earnings-based models useless.

    Several years after the bursting of the Internet bubble, price-to-sales ratios continue to be a useful stock selection methodology.

    Advocates of the price-to-sales ratio strategy argue that earnings-based approaches to selecting stocks are imperfect because management assumptions influence earnings. In addition, temporary developments, such as costs involved with new product rollouts or cyclical slowdowns can affect earnings more than sales, often leading to negative earnings. Having said this, price-to-sales figures are not infallible. Simply screening for low price-to-sales ratios will tend to uncover firms that deserve low valuations in addition to promising investment candidates.

    Low Price-to-Sales Screen

    AAII developed a low price-to-sales ratio screen that also considers industry factors and seeks companies with:

    • Price-to-sales ratios below historical and industry norms;
    • Sales growth above industry norms;
    • Liabilities relative to assets below industry norms; and
    • Relative price strength that exceeds the industry.

    Stock Investor Pro, AAII’s fundamental stock screening and research database program, includes this price-to-sales screen.

    Screen Performance

    Each month, AAII.com lists the companies passing the low price-to-sales screen and tracks the performance of these stocks in a hypothetical portfolio.

    Figure 1.
    Performance of
    Low Price-to-Sales
    Screen
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    The price-to-sales screen has produced solid performance since the start of 1998. In fact, it is one of only a handful of stock screening approaches AAII tracks that has not had a down year.

    Figure 1 illustrates how the low price-to-sales screen has easily outpaced both the small- and large-cap indexes over the study period. Between January 1998 and the end of June 2007, the price-to-sales screen returned 601.9%. Year-to-date, the screen is up 11.3%, while the S&P 500 has gained 6.0%.

    Profile of Passing Companies

    We present the characteristics of the companies passing the price-to-sales screen as of July 6, 2007, in Table 1.

    This screen takes a sales-growth-at-a-reasonable-price approach to isolating stocks, but uses industry norms instead of overall market averages for its growth and value benchmarks. At 23.5, the price-earnings ratio (current share price divided by earnings per share for the last 12 months) of the low price-to-sales stocks is above the median figure of 20.4 for all exchange-listed stocks. In contrast, both the price-to-book ratio (share price divided by shareholder’s equity per share) and price-to-sales ratio are below that of the typical exchange-listed stock.

    The screen also looks for companies with sales growth greater than their industry’s norm. The companies currently passing the screen have shown a 15% annual increase in earnings per share over the last five years, while all exchange-listed stocks have seen earnings growth at an average annual rate of 15.4% over the same period. Looking forward, both the companies passing the price-to-sales screen and the typical exchange-listed stock have a consensus estimated annual earnings growth rate of 14.6%.

    The median market capitalization (share price times number of shares outstanding) for the stocks passing the price-to-sales screen is $622.1 million, above the median for exchange-listed stocks.

    The stocks currently passing the screen have outperformed the S&P 500 by 4% over the last 52 weeks.

    Table 1. Price-to-Sales Screen Portfolio Characteristics
    Portfolio Characters (Median) Price-to-Sales Screen Exchange-
    Listed
    Stocks
    Price-earnings ratio (X) 23.5 20.4
    Price-to-book-value ratio (X) 1.97 2.27
    Price-to-sales ratio (X) 1.56 2.02
    EPS 5-yr. historical growth rate (%) 15 15.4
    EPS 3-5 yr. estimated growth rate (%) 14.6 14.6
    Market cap. ($ million) 622.1 524.4
    Relative strength vs. S&P (%) 4 –4
    Monthly Observations
    Average no. of passing stocks 46  
    Highest no. of passing stocks 82  
    Lowest no. of passing stocks 18  
    Monthly turnover (%) 40.1  

    Passing Companies

    Table 2 lists the 40 companies currently passing the price-to-sales screen, which is below the average of 46 observed over the last nine-and-a-half years.

    Table 2 ranks the passing companies in ascending order by their current price-to-sales ratios. Price-to-sales levels are tied to expectations of future company growth, profitability, and risk. The higher the expected growth, the higher the price-to-sales ratio a stock can support. Higher profit margins also translate into higher price-to-sales ratios. Profit margins measure the level of income produced for a given level of sales.

    Fresh Del Monte Produce (FDP) has the lowest price-to-sales ratio at 0.46 and the seventh-lowest annual sales growth rate at 10.8% over the last five years. Its price-to-sales ratio is well below the industry’s median of 1.5 and its 10.8% annual sales growth is significantly higher than the industry median growth rate of 4.9%. However, the company is losing money (net profit margin of -3.5%) in an industry where most companies are generating profits.

    At the other end of the spectrum is a silver mining company, followed by several biotech firms. Canada-based Pan American Silver (PAAS) is involved in the exploration, extraction, processing, refining and reclamation of silver. The median price-to-sales ratio for the gold and silver industry is 8.3. Pan American’s price-to-sales ratio is just below the norm for its industry. The company has expanded its sales from $37.3 million in 2001 to $255.4 million in 2006, a 46.9% annual growth rate. Pan American’s first profitable year was 2006, and over the last four quarters the company has earned $81.4 million on sales of $257.8 million for a net profit margin of 31.6%. The typical gold and silver stock only earned just over five cents for every dollar of sales over the last four quarters. These attractive company fundamentals, aided by a 40%-plus increase in the price of silver in 2006, helped Pan American outperform the S&P 500 by 28% over the last 52 weeks.

     

    Conclusion

    The low price-to-sales screen identifies companies with below-average price-to-sales ratios, sales growth that exceeds industry norms, reasonable levels of debt, and above-average price performance relative to its industry. However, you need to view the companies passing this screen as a starting point. The stocks passing this or any other quantitative screen do not represent a “buy” or “recommended” list.

    Overall, it is important to perform additional due diligence to verify the financial strength of passing companies and identify those stocks that match your investing tolerances and constraints before committing your investment dollars.

       What It Takes: Low Price-to-Sales Screen Criteria
    • The stock does not trade on the over-the-counter exchange
    • The company is not in the financial sector
    • The company is not in the real estate operations industry
    • The current price-to-sales ratio is less than the company’s average price-to-sales ratio for the last five years
    • The company’s current price-to-sales ratio is less than the median price-to-sales ratio for its respective industry
    • The company’s annual compound growth rate in sales for the last five years is greater than the median annual compound growth rate in sales for the last five years for its respective industry
    • The company’s total-liabilities-to-assets ratio for the last fiscal quarter (Q1) is less than the median total-liabilities-to-assets ratio for the last quarter (Q1) for its respective industry
    • The company’s relative price strength over the last 52 weeks is greater than the 52-week median price strength for its respective industry
    • The market capitalization for the last fiscal quarter (Q1) is greater than or equal to $50 million


    Wayne A. Thorp, CFA, is financial analyst at AAII and editor of Computerized Investing.


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