Ken Fisher's Price-Sales Ratio Strategy
As the second earnings season of the year winds down, we're reminded of how much investors and the media focus on a company's profits and a stock's price-earnings ratio, the ubiquitous share valuation measure, says John Reese, editor of Validea — a service that assesses the strategies of legendary investors.
Price-earnings ratio, calculated by dividing a stock's per-share price by the amount of per-share earnings it generates, is used to give investors an idea of how much bang they're getting for their buck.
For decades, the P/E ratio has been the most frequently used and discussed stock analysis ratio and, in many newspapers, it's the only valuation metric included in their daily stock listings.
While P/E is indeed a key tool to use when evaluating whether a stock presents a good opportunity, investing guru and author Kenneth Fisher will tell you it definitely isn't the only measure worth considering.
In 1984, Fisher's book Super Stocks poked holes in the usefulness of the P/E ratio. His rationale: Even earnings of good companies can fluctuate significantly from year to year due to activities such as equipment replacement or facilities acquisitions, research and development costs, or even changes in accounting methods.
Fisher argued that a company's sales, on the other hand, were far more stable and a better way to gauge the strength of the underlying business.
He cut a new path for valuing stocks by using the price-sales ratio (PSR), which compares the total price of a company's stock to the total sales it generates.
Since he was a student of investor psychology, Fisher strongly believed that investors tend to raise expectations to unrealistic levels for companies that have periods of strong early growth.
But when these favored companies experience a setback such as reporting earnings below analysts' estimates (during earnings season, for example), investors can overreact and send the stock price plummeting.
Fisher, however, believed this to be part of a company's maturation process, and that a strong management team would be able to identify and correct any issues.