Price to Sales - No nonsense double check

Continuing from my previous post about Price to Book as a valuation metric, I though I would also have a quick review of Price to Sales. Generally, Price to Sales ratios are sold to analysts as performance metric that is less subject to manipulation by management accounting practices.

While that may be true from an earnings perspective, it isn't necessarily true when it comes to revenue recognition (aggressive mark-to-market or accounts receivable practices are still in the realm of management discretion and can affect reports sales numbers). Sales are a fundamental driver of business performance. However, they are not immune to tampering or manipulation.

[Case Study] For instance, in the internet boom, many "revenue" streams were recorded between growing internet companies who were simply bartering services (usually advertising revenue). They reported incredibly high (and growing) revenue streams despite the fact that no money changed hands (and the actual value of services exchanged was highly questionable). This lead to the inflation of the price of their equity and P/S would not have detected this inflation. This compounds the error caused by the fact that sales revenue was a primary metric in valuing internet companies. Anyone who neglected this truth (almost everyone, except investors like Warren Buffet in his correct but unfortunate short position timing) eventually paid for it when the internet bubble burst.

Also, P/S is meaningless without understanding profit margins (what did it cost the company to get those sales). One disastrous application of P/S I've encountered is in valuing a growing company. In it's early stages, a company had great profit margins but weak sales. In it's growth, sales grew dramatically, making the P/S look incredibly attractive. However, the profit margins weren't stable and as a result the company was not profiting as much as the P/S would suggest.

[Case study] This was the case with Surebeam and their product of irradiated hamburgers and the position Roberto Mignone takes as explained in Hedge Hunters. Surebeam's product initially had strong sales, but upon further investigation by Roberto's team, it was discovered that they were using discounts of as much as 20% to attract customers (destroying their profit margins relative to other similar products). A P/S ratio would have indicated that Surebeam was a good buy (as many on Wallstreet believed) which turned out to be disastrously incorrect.

I would propose that P/S is a ratio that is generally useful only as a secondary check. It should be done in tandem with a PE and EPS analysis to identify if any profit smoothing techniques have been used by management as an indicator of future trouble brewing.