The problem of inconsistency and how it can lead to erroneous conclusions…
Ratios (or multiples) are a popular tool that many analysts employ to identify cheap stocks. Similar ratios (such as a Price-to-Earnings, Price-to-Sales, etc.) are compared across firms and a company with a lower multiple is considered cheap relative to one that has a higher multiple.
When using multiples, however, the one thing to remember is that the numerator and the denominator must be consistent – i.e. they both need to be either an equity number or a firm number. Not being consistent can lead to unintended consequences. This article aims to explain one of the consequences with the help of Price-to-Sales, a ratio which is in popular use today.
A Price-to-Sales ratio is calculated by dividing the market capitalization of the company by its sales.
While using this ratio however, many overlook the fact that ‘Price’ is an equity number while ‘Sales’ is a firm number. This anomaly can lead to misguided conclusions about the cheapness (or otherwise) of a stock. Let’s see how:
Take the case of two hypothetical companies – A & B – that are similar in all respects except that A is entirely equity financed whereas as B is financed 50% with debt (interest rate of 10%).
As you can see, using the Price-to-Sales ratio will make companies that use a lot of debt appear cheaper relative to companies that don’t. This is simply because of the fact that claims of the debt holders have not been considered when we take sales whereas the price reflects the market value of the equity only. In other words, the lower market capitalization of 700 for company B already factors in the fact that some of the company has been financed with debt. The sales on the other hand, are available to both the debt as well as the equity holders of the company. A better ratio would be the EV-to-Sales which will avoid the mistake discussed above.
This problem is not just restricted to the Price-to-Sales ratio but, applies to any ratio which mismatches the numerator and the denominator. So the next time you use a ratio, make sure you are being consistent.