Price-To-Sales Ratio (PSR)

The PSR is an invaluable tool for spotting recovery situations, especially with companies that are making losses and are therefore in a kind of 'black hole'. When this happens, there is no PER and sometimes no dividend yield against which to value the shares. The PSR then comes into its own and provides a measure of a business's potential value, if and when it recovers. All other things being equal, a share with a low PSR is obviously better value than one with a higher PSR.

Needless to say, turnover is only valuable to a business if it can eventually be converted into profit. Contracting companies, for example, report very high turnover, but, except in building booms, rarely make much profit. Profit margins, the trend of margins, and sector comparisons should, therefore, be studied in conjunction with PSR statistics. Sector comparisons often
reveal interesting anomalies and investment opportunities in particular industries.

Another important and variable factor is the level of a company's debt. A company with no debt and a low PSR is clearly a better proposition than a company with very high debt and the same PSR. At some time in the future, the debt will need to be repaid and further equity will almost certainly be issued. The extra shares then have to be added to the market capitalisation, increasing the PSR of the company in question.

It follows that gearing should be at reasonable levels to make PSR comparisons valid. Otherwise notional allowances need to be made to allow for the likely issue of further equity. The method of calculating the allowances would, of course, have to be consistent between the companies compared, but certainly the PSR should not be taken at its face value
for a company that is very highly-geared.

Many investors are used to looking at the market capitalisation of a company against its sales and are used to referring to sales as being a multiple of the market capitalisation. The PSR is the inverse of that ratio, and is used to be consistent with, and to make comparisons more valid
with, the other ratios used in REFS.

The PSR is calculated by dividing the company's market capitalisation by its total sales, excluding VAT. This is the same as dividing the company's share price by the company's sales per share.

To take a simple example, in March 1991, Next had a market capitalisation, based on a price of 30p, of £100m and sales of £400m. The PSR was therefore a very attractive 0.25 -£100m/£400m, and it is no surprise that, with new management, by August 1994 the share price had recovered to 261p.

It is interesting to note that Next still had such a low PSR even after the sale of Grattan, when some kind of recovery was foreseeable. Prior to that, in December 1990, its market capitalisation had slumped to £24m against forecast sales, including Grattan, of £800m. The PSR was therefore an astonishingly attractive 0.03, although, at that stage, recovery was very
difficult to foresee.

A low PSR is one of the best value measures, preferable in my view, to a low PBV. Kenneth Fisher, the American ace investor, in his excellent book Superstocks, writes about the PSR at length and believes it to be the most powerful single investment measure. Jim O'Shaughnessy, in What Works On Wall Street, found that during the period 1954-1994 stocks with a low PSR gave one of the best annual returns of 15.42% against the market average of 12.45%. Conversely, stocks with a high PSR gave a very poor return of only 4.15%.