Smart Investing

I'm sure you've heard the talk that PE (price to earnings) ratios are just too high. But no one, or very few people besides me, talks about or even looks at the P/S (price to sales) ratio.

This is a big mistake, because the price to sales ratio can keep you invested into companies that have artificially high PE ratios. Many years ago the price to sales ratio became well known from money manager Ken Fisher who writes for Forbes magazine. It worked well for him and still works today. You may have heard of the price to sales ratio before; if you've ever listened to me on the radio, TV or in my workshops, you've heard it many times. It is a very important ratio for me when it comes to valuing my companies that I'm investing in.

Price to sales ratio is a ratio of a stock's price to its per-share sales. This is what I call a clean ratio, it can't be moved up or down by any accounting moves. Simply, sales are what they are, they are the top line of the profit and loss statement. Usually there is less movement in the sales of a business compared to the price to earnings, price to book value or price to cash flow. What happens when a company sees a decline in its earnings because of a write off or higher expenses? Its PE goes up as the earnings go down.

But what impact does that have on the sales or the price to sales? None. So while many are in a panic that the price to earnings is going up, the price to sales has remained the same. The business is still making the same sales as before and the PE will decline once the writes are over.

As always it is a good idea to compare apples to apples when comparing price to sales, the same as any ratio. Some industries do have a high normal price to sales when compared to other industries, so it would be foolish to compare a low price to sale industry to a high price to sales industry, an investor must understand what companies and industry you are comparing to. For example the price to sale of a retailer is usually much lower then the price to sales ratio of a high tech company.

As an example let's look at Cisco compared to JC Penny Co. If an investor were to look at investing in JC Penny first they would discover that the price to sales is only 0.48 compared to the industry average of 0.59. Then if the investor were to look at Cisco with a price to sales of 3.85, one may throw out Cisco thinking it was too expensive. That could be a mistake. Why? While the price to sales for Cisco may be eight times that of JC Penny price to sales, it is still below the industry average of 4.36.

And while the price to sales is very important I can't stress enough to look at all the valuation ratios and other data as well. As an example looking at the total debt to equity one will find that JC Penny has a debt to equity of 75 percent, the same as the industry. Cisco has a debt to equity of 27 percent compared to the industry average of 22 percent, slightly higher, but less debt then JC Penny.

Also the return on equity is 7.3 percent for JC Penny, half the industry average of 14.9 percent. Cisco has a return on equity of 16.8 percent well above the industry average of 5.9 percent. So as one can see from this example one should never use just one number to make a buy or sell decision. Look at the entire company.

While price to sales is a good ratio to use, don't get lazy and think you can skip using the other three ratios, price to earnings, price to book and price to cash flow.

You know what happens as soon as you begin to take a shortcut; you cut short your earnings.