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Saturday, January 10, 2015 12:21:26 PM
His take...
In another post, I have stated that the P/S (Price to Sales) ratio is actually directly related to the better known P/E ratio, so using one method to determine the value of a company stock does not exclude the other. Both methods are actually just different ways of expressing the same thing, namely value based on profitability (as opposed to Book Value or Cash per share...). I will try in the following to show the direct (theoretical) relationship b/w P/S and P/E as valuation metrics.
We know that Sales (S) generate Earnings (E) via the overall Net Margin (NM) of a business:
E = S * (NM)
Depending on the consistency and growth of the earnings reported and/or expected, the market typically assigns a price to the stock, price per share (p) ,or equivalently Price P = Market Cap = p * shares outstanding via its P/E ratio (PE) which is:
PE = P/E = P/ [S * (NM)}
Thus a high-growth company will command a higher P/E than a slow-growth company with same earnings per share (eps). So:
Sales S --> Earnings E --> Price P
Specifically:
P = Earnings x (P/E) = E x (P/E) and
E = S x (NM) so:
P = S x (NM) x (P/E) meaning:
P/S = (NM) x (P/E)
--> the P/S of a stock is the product of overall Net Margin and P/E ratio.
Thus if a company sports a NM of 15% and a P/E of 40, its P/S is 6= 40 x 0.15 (Bill: sounds familiar?). But a P/S of 6 may also be obtained with a NM=30% and P/E= 20 since 6= 20 x 0.3 (maybe for a company with high profitabilty but inconsistent eps growth since a P/E is related to eps growth via the PEG ratio which is the (P/E) growth rate, often equal to 1. Hence the P/E also reflects the expected earnings growth rate of a stock based on its history and growth prospects. But this analysis shows that the P/S ratio as a valuation metrics is clearly related to the P/E metrics which itself contains not only profitability metrics like Net margin but also its growth pattern, reported and expected.
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