A number of research studies indicate that using price-to-sales ratios may lead to better investment results than price-to-book-value ratios or price-earnings ratios. Price-to-sales ratios (price divided by sales per share) may identify undervalued firms sooner than the price-earnings approach and avoid some of the accounting complications of the price-earnings and price-to-book screens.

Price-to-sales ratios are tied to expectations of future company growth, profitability, and risk. Industry knowledge is crucial. A simple screen for low price-to-sales ratios will tend to turn up firms in industries with low profit margins (income divided by sales) or poor sales growth prospects. The higher the expected growth, the higher the price-to-sales ratio that a stock can support. Higher profit margins should also translate into higher price-to-sales ratios. This issue’s First Cut looks for firms trading with price-to-sales ratios below the median for their industry, but with sales growth, profit margins, and price strength above the industry norm.

The stocks passing the First Cut are domestic exchange-listed companies with positive one- and three-year sales growth rates that are higher than their industry medians coupled with operating and net profit margins above their industry medians. Operating profit margin (operating income divided by sales) examines the relationship between sales and management-controllable costs. Net profit margin (net income divided by sales) is the “bottom line” margin frequently quoted for companies. It indicates how well management has been able to turn revenues into earnings and may highlight a competitive advantage. The First Cut stocks have liabilities-to-assets ratios lower than their industry medians to establish a maximum level of financial leverage. Companies in more stable industries can safely assume greater levels of debt. The 30 firms with the highest relative price strength over the last 26 weeks and that have reported earnings exceeding the market consensus made the cut.