|Five Year Return:||12.7%||13.2%|
|Ten Year Return:||8.7%||5.4%|
Numerous studies are in agreement about the desirability of investing in out-of-favor stocks as a strategy for obtaining above-average long-term rates of return. The market often overreacts to news—good and bad—bidding up the prices of companies doing well to the point that they are overvalued, while whittling down the prices of troubled companies to the point that they represent an attractive value. Whereas previous research hinted that the price-to-book-value ratio was superior to the price-earnings ratio in selecting undervalued stocks, recent research indicates that using price-to-sales ratios may lead to better investment results than price-to-book-value ratios or price-earnings ratios.
Screening for undervalued stocks on price-to-sales ratio (current price divided by the sales per share for the most recent 12 months) is not a new concept. The technique was first popularized by Kenneth Fisher in his 1984 book "Super Stocks." Proponents of the price-to-sales ratio argue that earnings-based approaches to selecting stocks are inferior because earnings are influenced by many management assumptions trickling through the accounting books. Basing value relative to sales tends to be more reliable than basing value relative to earnings. Temporary developments such as costs incurred in the rollout of a new product or a cyclical slow-down can influence earnings more than sales, often leading to negative earnings. The price-to-sales ratio can provide a meaningful valuation tool, when negative earnings render earnings-based models useless. Many investors turned to price-to-sales ratios to help value Internet stocks that when public without any sign of positive earnings.
Sales levels tend to be more comparable across different firms—leading to a valuation tool that is more comparable from firm to firm within the same industry. Asset-based models such as low price-to-book-value screens can be influenced by company factors such as specific depreciation schedules, age of assets, and even inventory accounting methods. The market may not be able to properly adjust for these company-specific factors, which leads to mispriced securities.
…To read more, please become an AAII member or login.