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. The investor able to target such companies, according to Fisher, could make a bundle.
By looking at sales, according to Fisher, an investor could find opportunities in the form of companies that are operating at a loss and have low PSR's but still have good prospects for growth (such companies wouldn't have P/E ratios as earnings would be less than zero).
In Super Stocks, Fisher defined PSR as the total market value of a company (total number of shares multiplied by stock price, or market capitalization) divided by the last 12 months' corporate sales.
In his book, Fisher explained his thought process as follows: "To buy stocks successfully, you need to price them based on causes, not results. The causes are business conditions-products with a cost structure allowing for sales. The results flow from there-profits, profit margins and, finally, earnings per share."
The following are the PSR benchmarks that Fisher outlined in his book (and are the same values we use in our Fisher-based stock screening model). Note: While PSR is at the center of the Fisher strategy, he also analyzed debt-equity ratios, free cash-per-share, profit margins, and EPS growth rates:
For non-cyclical and technology stocks:
Best case: PSR of 0.75 or below
Good value: PSR of above 0.75 and below 1.5
For cyclical stocks:
Best case: PSR of 0.4 or below
Good value: PSR greater than 0.4 and less than or equal to 0.8
Here's five stocks in our Fisher-inspired model portfolio with a high 90% ranking based on the Fisher strategy: Foot Locker (FL), ManpowerGroup (MAN), Magna International (MGA), Omega Protein (OME) and Cooper Tire & Rubber (CTB).
