| Price to Sales Ratio - Better than P/E |
A standard benchmark for valuation of companies today is the Price/Earnings (popularly referred to as the P/E ratio). But the P/E ratio has its own limitations especially in the emerging economy. For one this ratio is susceptible to accounting jargon and secondly this ratio overtly biased in favor of low income / high growth companies. With the emergence of the dotcom era in the last couple of years, a new problem has cropped up and that is how to determine the P/E ratio of loss making companies.
This problem is faced both at home in India and abroad. How to value the P/E ratio of a loss making company like Amazon.com or Rediff.com. Obviously a negative P/E is an inconsistent situation because it is like saying that the investor pays an amount equivalent to the P/E for every rupee of loss made or that the investor takes away an amount equivalent to P/E for every rupee profit made, neither of which make sense in the real world.
What then is the answer ? Obviously the answer lies in the P/S or the price to sales ratio. Unlike the P/E ratio, the precondition for P/S ratio is only that the company should have running operations and hence should be generating revenue streams. The price to sales ratio is very relevant in two individual contexts. Let us consider :
Firstly, P/S ratio is more relevant when the P/E ration in case of companies which are going to through an infrastructure gestation period. Take a case like Hughes Tele.com which may take at least 5 years to break even, due to huge sunk costs. In such a situation the P/E ratio becomes largely irrelevant and the P/S ratio makes more sense.
Secondly, P/S ratio makes more sense when the company in question is likely to grow geometrically in the future and the current growth is normal. The dotcoms fall into this category. In case of most dotcoms the bottomline does not grow as fast as the topline due to huge promotional expenses and hence the topline growth is more indicative of future sustainable growth.
Last but not the least, in case of industries like cement the input costs are highly volatile and hence the sensitivity of profits to changes in sales is very high. In such cases again the P/E ratio may be too volatile and not indicative of the long-term discounting of the scrip and the P/S ratio may make more sense
The question then is, if P/S ratio is such a wonderful measure why is it not popular as an analytical tool. The main reason being that investors and analysts are more comfortable considering the profits because that is what businesses are supposed to do. But most investors forget that the bottomline is not necessarily the cash flows of the company. Instead of looking at the P/E ratio it may make more sense to look at a combination of P/S ratio and the P/Cash Flow ratio. This will serve three purposes.
Firstly, this combination can be applied across all companies. Cash flows should be interpreted here to mean not only the traditional depreciation and amortization added back to the bottomline but also a notional amortization on all capital and deferred revenue expenditure. Secondly, this measure will be less susceptible to vagaries of business cycles and input costs. Last but not the least this measure is more compatible with the concept of a new economy wherein investors are willing to put money in the quest for future capital gains than today' dividends. Give it a serious thought. P/S ratio if combined with the P/Cash Flow ratio may actually solve most of the problems associated with the the traditional favorite P/E ratio. Food for thought ain't it ?
T S Harihar
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