How to use the Market Cap to Sales (or Price to Sales) ratio to value stocks

Before learning when and how to use the Market Cap to Sales (or Price to Sales) ratio, some definitions may be in order.

Market Capitalisation (Market Cap) = Total number of equity shares x Price per share

If the equity capital of a company is Rs 10 Crores and the face value of each share is Rs 10, then the company has issued 1 Crore shares. If the share price is Rs 50 (on a given day), the Market Cap (on that day) is Rs 50 Crores. As is evident, the Market Cap is a number that changes with the share's price.

Why should we be concerned about this number? It represents the total value of the company in the stock market. In other words, if you had a lot of money and you wanted to buy the entire company (which has to be listed in the stock exchange), then you will have to pay an amount equal to the Market Cap, i.e. Rs 50 Crores.

The Market Cap to Sales ratio, also referred as the Price to Sales ratio (P/S or PSR), is calculated by either dividing the Market Cap by the total sales of the previous 12 months, or by dividing the share price by the per-share sales of the past 12 months.

P/S or PSR = Price per share/Sales per share = Market Cap/Total Sales

If the company in our example had sales of Rs 80 Crores in the previous year, its Market Cap to Sales ratio will be 50/80 = 0.625. A ratio less than 1 is considered a sign of 'under-valuation'. Why? It means that for each Re 1 of sales you will be paying 62.5 paisa if you were buying the entire company.

If another company in the same sector has a similar equity capital, but a share price of Rs 60 and sales of Rs 100 Crores, then its Market Cap to Sales ratio will be 60/100 = 0.6. That means, the higher priced share is actually 'cheaper' valuation-wise.

This is an important point for small investors to note. Many say that they have limited capital and therefore, opt to buy shares that are cheaper in price. They end up buying a small cap or mid cap share. Valuation-wise, a higher priced large cap may be a better buy.

Please remember that different sectors have different operating criteria. Some require heavy capital expenditure, others don't. Some sectors have low sales and high profit margins. Others have large sales but low profit margins. The Market Cap to Sales ratio should be used only for comparing companies within the same sector.

Several other ratios, like Debt to Equity, Interest Coverage and Return on Assets, had been discussed earlier. Do we really need to look at another ratio? The Market Cap to Sales ratio is particularly useful in valuing companies which are incurring losses. Because they have no earnings, the more popular valuing metric P/E can not be used.

As a general thumb rule, small investors should avoid loss-making companies. What if an otherwise fundamentally strong sector or company gets into a temporary difficulty and incurs losses? It happened to Tata Motors and Hindalco. It happened to the export-oriented textile sector. The Market Cap to Sales ratio will help to separate the men from the boys.

Many analysts prefer to use the P/S ratio over the P/E ratio, because it is easier to fudge earnings, whereas sales can be more readily verified. That does not mean a 'creative' company like DLF can't fudge their sales figures!

It is best to check both the P/E and the P/S ratios when selecting a company from a particular sector. If both indicate 'under-valuation', then the stock can be included in a 'buy' list. If the indications are contrary to one another, it is an alarm signal that management is probably doing some fudging.

Debt-burdened companies often trade at low Price to Sales ratios. Their sales may not be affected and may actually be growing, but interest and capital repayments may be causing a drop in margins and cash flows. Investors should avoid such 'value traps' by checking the Debt/Equity and Interest Coverage ratios.

(A short exercise for readers: In the recent stock selection exercise, most readers chose Stock 'N' as the best of the three. However, on the basis of the Market Cap to Sales ratios, Stock 'N' is more expensive with a ratio of 0.79. Stock 'S' and Stock 'I' have ratios of 0.47 and 0.46.

Will readers still choose Stock 'N' over the other two? If yes, why? If no, why not?)

How to select a stock - an analysis of the exercise for readers

Before I get into a detailed analysis of last week's stock picking exercise, I would like to extend hearty congratulations to all of you who participated.

Regardless of your answer, the willingness to participate in an open forum indicates a desire to learn and share - which are great qualities for success in life (and in investments). As far as I am concerned, you are all winners.

The information given about the companies was brief. But it was adequate to decide which of the three should be added to a list for more detailed analysis. Thousands of stocks trade every day, and it is not possible for small investors to check the fundamentals of even a fraction of the traded stocks.

One uses short-cuts to create a short list. I start with the cash flows from operating activities. Why? Because a listed company is in existence for one reason only - to generate cash. Cash in a manufacturing business is like gasoline to an automobile. Without a regular supply of it from its operations, a business can run for a while but will eventually come to a halt.

All three companies have positive cash flows from operations and negligible debt. But sales are low and so are the NPMs - an indication that the sector is a profitable one but has low volume and low margin. That is why, it is a bit surprising that all three have outperformed the Sensex by moving above their Jan '08 prices.

The fact that all three have been around for at least 30 years means that the business models are sustainable. The low P/E is an indication that the market is not enthused by the low growth of the sector.

As small investors, we don't have huge capital at our disposal. To make sure our limited resources are not frittered away in chasing multibaggers, the prudent option is to look for companies where internal accruals are sufficient to pay for expansion and investments.

Debt is not bad per se - if it can generate more cash than the debt repayments. But when debt is incurred merely for rapid growth - disaster happens. The sorry state of the high fliers in retail and real estate is a clear example.

So we have three companies - all with good fundamentals in a sector with low risk and low growth. How do we choose one over the other?

Most of you chose Stock 'N' and there were several reasons for doing so. Highest sales, highest EPS, best RoE, strongest technicals. The clinching reason - not mentioned by any one - is that its sales are more than the combined sales of the other two! Even in a low growth sector, one company is growing faster than its two closest and older competitors.

Though it is trading at a much higher price, Stock 'N' is available at a Market Cap to Sales ratio of less than 1. Some of you have mentioned about this ratio (without explaining why it may be relevant). Others haven't. Next Tuesday's post will explain the importance of the Market Cap/Sales ratio.

The exercise was an effort to demonstrate what kinds of stocks can be added to a 'watch list' for more detailed analysis. A 'buy' decision can only be taken after a more thorough look at past performance and business outlook.

Now for the awards announcements.

VJ gets the nod (and applause) for the most logical explanation covering all the important points. Just follow your investment plan, and you will retire a rich man!

sreyO gets an "A" for effort. Though his explanation wasn't brief, he pointed out that a comparison is possible only if all three stocks have the same face value. Pretty impressive for some one who hasn't started investing yet.

A big 'THANK YOU' to the rest of you for taking part in the exercise.