Insights

VI Quant - What Is Better Than Price-to-Sales (PS) Ratio?

Dear Valued Clients and Partners,

I would like to thank those who have been with us for a long time. You have seen us and our investing philosophies and practices evolve over the years. Rooted in the fundamentals of value investing, we have sought ways to improve and optimize our processes in utilizing quantitative analysis as a base, leading us to develop more sophisticated quantitative investing strategies compared to before.

Evolving from the good old days of using Excel spreadsheets to create our screeners and models to evaluate businesses, we now have team members who are specialized with programming skills to drive the vast improvements to our algorithmic process. This enables us to screen effectively and efficiently using our quantitative strategies through the wide universe of investible listed equities. This was borne from our experience in our Group while creating our FinTech tool, VI App. By harnessing the power of data analytics, we can tweak our parameters to best capture an optimum return based on our research. The number of data points used (due to the many different factors analyzed over time) is simply too much for a spreadsheet, which will take up too much computing power and time.

The insights brought about by the backtesting capabilities across multiple factors over many years and across large pools of companies' data have given us visibility in selecting strategies with the best performance while managing our risk exposure. This enables us to cut through the noise and only focus on the best-shortlisted companies where we can focus our efforts in weeding out anomalies or spotting tipping points for the companies that end up in our portfolios.

I would like to introduce Joshua Zhang, our investment manager in charge of the VI Quant Series of Funds in the next portion of the newsletter, as he dives deeper into some of the quantitative ratios used in our Quant strategies (such as Price to Sales P/S, Price to earnings P/E, current ratio, revenue growth rates, etc)and our sophisticated quantitative strategy are built on sound fundamentals.

You will discover (like the rest of us including myself when I first started) that there are many factors that can impact the basic financial ratios, and how accounting treatments, business models, prospects, expansion and growth needs, etc. can lead to these ratios being unfairly used and might even skew our analysis on the companies. As investors, we must endeavor to apply the appropriate financial ratios for the different companies to obtain an accurate analysis and insights into these companies.

After all, someone (often attributed to John Maynard Keynes and made famous by Warren Buffett) once said: “it is better to be roughly right than precisely wrong”. Life and investing are as such.


Warm regards,
Clive Tan | CEO
VI Fund Management
www.vifund.com


Using Price-to-Sales (PS) Ratio Correctly? Also, here's something better!

"This company is expensive at a PE multiple of 100x earnings!" or "...cheap at a PE multiple of 2x earnings!".

You might have heard comments on valuations like above. I now cringe whenever someone quotes the price-to-earnings (PE) ratio and for many good reasons.


WHAT'S WRONG WITH PRICE-TO-EARNINGS RATIOS?

We introduced price-to-sales (PS) ratio to the VI Community and implemented it on VI App after much research and back-testing back in 2019, sharing how taking bottom-line figures like ‘Free Cash Flow’ or ‘Net Income’ as a denominator can expose price-to-earnings or price-to-free-cash flow ratios to wild fluctuations.

Between the top-line (revenue) and bottom-line (net income), many non-recurring or non-operation related income and expenses stand in between us and our obsession for stable, predictable net incomes. The volatility ride gets even worse as accounting works its way to the free cash flow of the company.



Imagine a novice investor valuing a high-growth company with multi-year expenditures due to its expansion plans. Failing to adjust for one-off income/expenses, growth expenses, and changes in working capital can result in a company being wrongly labelled as “too expensive” or “very cheap”.

It would be equally dangerous to project earnings per share (EPS) or free-cash flow per share (FCFPS) using a discounted cash flow model (DCF) without adjusting for these one-off items and expenses. No wonder many of the highly pursued high-growth software-as-a-service (Saas) companies seem perpetually overvalued!



THE HERO: PRICE TO SALES (PS) RATIO!

PS Ratio is a relative valuation ratio made popular by Kenneth Fisher’s 1984 book titled "Super Stocks". With revenues, a company either makes a sale, or they do not!

Using the top-line (Revenue) as the denominator allows us to keep a finger on the pulse on the company’s fundamentals yet cut out all the fluff and noise we earlier discussed. Because of this, PS ratio is considered the “cleanest” valuation methodologies.

Some investors might use balance sheet-based denominators like price-to-book (PB) ratios. While they are also a relatively stable alternative, we discovered that high-growth software companies tend to reduce their equity base and take on more debt due to their strong recurring operational cash flow from their subscription service, resulting in occasional mispricing.

PS ratio is also suitable for valuing most types of companies like the unprofitable but fast-growing young companies, mature companies, or a turnaround. From the ‘Company Product Life Cycle’ Illustration, we can that a potential weak spot where we cannot use PS ratios. For companies with inconsistent or no revenues like early-stage biotechnology firms, e.g. CRISPR Therapeutics (CRSP), we would then need to revert to a balance sheet-based denominator.




ARE YOU USING PRICE-TO-SALES (PS) RATIO CORRECTLY?

“A PS ratio below 3 times cheap while the PS ratio of 20 times expensive!!”

Anyone anchoring on a fixed multiple value is also in danger of mispricing a company as both PS 3x and PS 20x can be the fair valued multiple for two separate companies with differing profit margins and growth rates.

To avoid over-complicating this formula, the right use would be to compare a company’s current PS ratio across its own historical mean. Ideally, over a minimum of 3 years weekly average PS Ratio.

3 years is needed to average out the peak and troughs of the market emotions cycle. Historically the average timespan is at about ~4 years. Weekly frequency is needed because we need sufficient data points to tap on the ‘law of large numbers’ and accurately find the average multiple the market would pay for the company.





PRICE-TO-SALES (PS) RATIO FOR PEER COMPARISON?

Things start to get tricky when we compare relative valuation multiples against other companies of the same industry, or worse, other industries. As profit margins and growth rates can vary, comparing PS ratios across companies would not be accurate.

“Can we borrow the price-earning-to-growth (PEG) ratio concept made famous by Peter Lynch to account for growth and create a PS-to-growth Ratio?”

That might be better, but it still fails to consider the profit margins each company can produce & the debt each company needs to service to fund its growth. For example, both Digital Turbine (APPS) and Fastly (FSLY) were priced at around PS 18x as of 31st Oct 2021. On closer inspection, we see how the ‘Gross Margins’ and ‘Revenue Growth’ vastly differ from each other.




WHAT IS BETTER THAN PRICE-TO-SALES (PS) RATIO?

The pricing multiple comparison tool that we use to measure valuation across its own historical values as well as across companies from various industries is the ‘Enterprise Value-to-Gross Profit-to-Growth (EV/GP-to-Growth).

It solves the issue of comparing companies with different profit margins by using a ‘cleaner’ Gross Profit Margins and it solves the growth issue by borrowing the concept from the price-earnings-to-growth (PEG) ratio to divide the EV/GP by its growth rates.

For example, the average EV/GP-to-Growth multiple of 0.70 times, Digital Turbine is priced at 0.25 times (below the mean) while Fastly is priced at a pricey 1.31 times (above the mean).


I have attached a list of US-listed software firms with their respective ratios in APPENDIX A for your reading pleasure. If I were still manually hunting companies, doing due diligence on companies starting near or below the line would be where I focus my research efforts.

At VI Quant Series of funds, however, we have automated the entire process of screening, stock selection, valuation, portfolio rebalancing to systemically unearth high-quality companies at a reasonable valuation.

If you are already a client with us, welcome onboard! If you are curious as to how we run the VI Quant Series of funds and how our performance has been, attached below is the link to the factsheet and owner’s manual.

VI Quant US Fund Factsheet
VI Quant Investors' Manual

Regards,
Joshua Zhang | Investment Manager
VI Fund Management (VI Quant Series)
www.vifund.com





APPENDIX A:

A list of Software businesses in the US markets.
Relative valuation multiples comparison be PS Ratio and EV/GP/G.
Chart values taken as of 31st Oct 2021.





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