The Investment U E-Letter: Issue # 116
Thursday, February 28, 2002

Stock Trading Analysis: Size Up Any Stock… Quickly and Easily
By Dr. Steve Sjuggerud, Chairman, Investment U

The old way to size up a stock doesn’t seem to be very valuable any more… so it’s time to take a different look at things. Let me show you what I mean

The Price-to-Earnings Ratio - the old standby measure of value - has become much less valuable in today’s stock trading analysis as we strive to size up our investments. With companies like Enron out there pulling every accounting trick in the book to fudge its earnings, the “E” in the “P/E” equation is now highly questionable.

More Than Just Shady Accounting

But it’s not just Enron - even the revered institutions are “messing” with their earnings numbers. The folks at Standard & Poors for example, who publish the S&P 500 Index (the general gauge of the overall stock market) have even gotten into the act of “messing” with earnings.

A few weeks ago, S&P told us that the P/E for the S&P 500 index was 40. But - in a matter of a week - that figure changed to 28. S&P said they “changed the way they calculate earnings.” Hmmm… how about that?

Research outfit IBES says the S&P 500 market P/E is 24. And Bloomberg says it’s 25. However, Bloomberg also lists the S&P P/E at a whopping 61 (counting write-offs and charges). So what’s the “true” answer? That’s still a mystery.

The Falling Out of Traditional Stock Trading Analysis

But here’s why the discrepancy is important to you as an investor: many of the traditional ways of stock trading analysis are simply no longer relevant. They’ve fallen victim to creative accounting and “changes in procedure.”

Whatever the real number is for the S&P 500, there is no doubt that by any measure, stocks are expensive. The historical average P/E is in the mid-teens. And the fudging of earnings numbers, Enron aside, is getting ridiculous by anyone’s analysis.

So let me offer up a simple solution for us. Let’s look at SALES instead of EARNINGS.

IntroducingThe Price-to-Sales Ratio

The Price-to-Sales Ratio (P/S) simply compares the price of a stock to the company’s sales for that year. But this is why it may be a better guide to determining the “true” value of a company: It’s much harder to fudge the top line (sales) than the bottom line (earnings). (Although companies like Global Crossing and Priceline.com found inventive ways to fudge the top line as well.)

And perhaps even more important, since most analysts and investors don’t look as closely at the top line, chances are it’s a “cleaner” number for us to consider.

For example, Wal-Mart’s stock market value is about $280 billion, while sales over the last year were about $200 billion. So Wal-Mart is trading at a P/S Ratio of 1.4. But what’s this mean?

Well, historically, stocks on average have traded for just under one times sales (0.9). So, at 1.4, Wal-Mart is expensive by historical standards but it’s still cheaper than most stocks today. And, in fact, you may be willing to pay that premium for Wal-Mart because it is a successful company, especially given some of the real dogs out there today.

How the Price-to-Sales Ratio Measures Up in Stock Analysis

Crunching the numbers, the Price to Sales Ratio turns out to be a very valuable indicator. Not surprisingly, if you buy stocks when they are “cheap” - based on this ratio - you do much better than if you buy when stocks are expensive.

Specifically, if you buy the S&P 500 index when the P/S ratio is below 0.9, history tells us that five years later, you’d be up an average of 81%. This works out to an annualized return of 12.6%. However, if you buy when the P/S ratio is above 0.9, five years later, analysis shows your average annualized return would be 4.7%. (A “buy and hold” strategy for the S&P 500 over last 50 years would have produced about 8.6%.)

Looked at another way, your trading returns would have been ALMOST 50% BETTER than “buy and hold” if you only bought “on the cheap.” And your returns would have been almost 50% worse if you bought when things were expensive.

What the Price-to-Sales Ratio Tells Us Today

By this measure, today stocks are expensive. A conservative estimate of the up-to-the-minute Price-to-Sales Ratio would be 1.3 - or about 40% higher than the 0.9 historical average. Stocks aren’t cheap.

The easy rule of thumb to remember as a rough “fair value” of a business is “one-times sales.” (A Price-to-Sales Ratio of one.) Again, this is just a rough gauge for whether or not you’re paying too little or too much to invest. This ratio is easy to find; it’s now listed on the Yahoo! Finance web page for each stock.

When you start applying this “one-times sales” rule of thumb, you’ll find that many companies that have fallen a lot lately are still far from bargains. Unlike Wal-Mart, Cisco for example trades at 5.7 times sales - nearly 500% overvalued by the “one-times sales” rule of thumb. Intel trades at 7.6 times sales. And Microsoft trades at over 11 times sales. Friends, these stocks are not cheap. GM, on the other side of the coin, trades at a scant 0.17 times sales.

Now I’m not saying you should “avoid all stocks that trade above one-times sales.” What I am saying is, the Price-to-Sales Ratio is a tool you can use in your stock analysis that is both easy to understand and easy to find. And it’s a simple gauge - one that you don’t have to be an accounting expert to use - to know if a particular company is dramatically overpriced.

Today’s IU Crib Sheet

• Changes in accounting procedure - and flat-out deceptive accounting practices - have made many of the traditional analysis of stock market value obsolete. Price-to-Earnings Ratio is one such trading indicator that has become increasingly less reliable.
• Price-to-Sales Ratio is a much easier - and, arguably, more reliable - way to measure an investment. Try out the Price-to-Sales Ratio with your stocks. Chances are, you’ll be surprised and shocked by how expensive some stocks still are, even after they’ve fallen so much.
• And if you’ve got some dogs in your portfolio that are very expensive by this measure, what are you waiting for - clear them out now!

Good investing,

Steve

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