The TEV Blog is growing, and more and more readers are writing me via the contact form or comment. Even if I prefer a comment, I am happy about all messages. One reader wondered why I only use profit and cash flow to assess the fair value of a stock. He argued that a stock with a price-to-earnings ratio (P/E ratio) of 150 could be cheap if it has a price-to-sales ratio (P/S ratio) of 5 and a price-to-book ratio (P/B ratio) of 0.9. So time for a few thoughts on the subject of fair P/S and fair P/B ratio.
Fair P/S ratio and fair P/B ratio
The TEV Blog is not meant to be an encyclopedia that copies what is written elsewhere. That is why I will not go into the terminology in great detail. P/S ratio and P/Book ratio are just methods to calculate the fair value of a share. Here, the price is put in relation to the annual sales/revenues or the book value. The traditional theory of value investing assumes that the fair value of a share is equal to its book value. In other words, the lower a stock’s P/B ratio, the better its intrinsic value.
I don’t pay too much attention to a fair P/S ratio or a fair P/B ratio
It’s true. When I evaluate whether a stock is worth investing in, I don’t pay too much attention to the P/S ratio or P/B ratio. The book value, in particular, does hardly reflect a company’s characteristic that is important to me. Intellectual property or soft factors such as customers, the company’s position in the relevant industries, long-term strategy, etc., book value tells me nothing about these aspects.
Of course, a P/B below 1 shows that the price for the company is lower than the current book value. But what is the point of connecting these two dots? It is almost a paradox. We calculate the book value retrospectively from the balance sheet. But the share price reflects future expectations of the company. It seems that we would rather take any calculation than none to determine the fair value. But that’s like using a map of the Himalayas when we’re lost in the Rocky Mountains.
What puts food on the table?
I know my approach may be a bit controversial. And of course, there is not only black and white. But I have the feeling that some investors take a very generic approach when it comes to buying stocks. They just look at specific metrics and then decide if a stock is a buy or not. And indeed, this is often successful, so fair enough. I don’t want to criticize anyone but merely provide food for thought.
My approach is straightforward. I look at those figures that are most closely related to the reason why I invest in stocks. I invest in stocks because I want to become an owner of companies. I bear the risk and benefit from the success… like a real entrepreneur. So I have to think like an entrepreneur.
In my view, a perfect entrepreneur must have only one goal: To create value in the long term. However, this value does not lie in selling as many products as possible. Just give me 1 million EUR/USD, and I’ll make 500,000 EUR/USD in sales. I promise. Hence, relying on a price-to-sales ratio to justify an investment is extremely foolish.
Likewise, increasing the book value does nothing for me. Does that increase my entrepreneurial freedom? My productivity? Does it help me to pay my staff? Does it put food on my table? I don’t think so.
These considerations are the main reason why I look so much at a profit and positive cash flow. Profits or cash flow are the parameters by which I measure value. They give a company room to maneuver. In short, they put food on the table. This circumstance applies to a company like Amazon, but also to the woodworker or shoemaker around the corner.
Do I ignore sales and book value?
Don’t get me wrong. Of course, sales figures and book value are criteria that should be taken into account when valuing a company. However, every investor should know the weaknesses of these figures. I have already talked about the book value and the limited information it provides above.
For me, sales become essential elsewhere. Sales and revenue are only soft factors in assessing the fair value (unlike profit and cash flow). They become a hard factor when determining how strongly and profitably a company is growing. Here I look closely at how sales have developed. Is the company growing? Are the costs for this growth increasing, or is the company benefiting from economies of scale? What growth can we expect in the future? Are there signs that sales will decrease or increase? Therefore, sales figures show me the business and not the valuation.
I only use the sales/price ratio if a company is not making a profit. But my readers know that I hardly invest in unprofitable companies. Why? You already know it. They don’t put any food on the table.
But as I said before, only a Sith deals in absolutes. Palantir is an example where I bought a non-profitable company. Here, however, the decisive factor for my investment was not the price/sales ratio. Instead, I liked the strategy, appreciated the development, respected the vision and mindset of the management, and was tempted by the general prospects. All this had nothing to do with the price/sales ratio. It was a somewhat risky long-term investment. And I am totally fine with calling this investment a bet because, given the uncertainty and dependence on many factors, it is almost impossible to make a meaningful forecast.
Be careful: No profit does not necessarily mean that there is no cash
Some readers may say that investors with this approach would never have invested in very successful companies like Amazon. True, Amazon has always had an extremely high P/E ratio. But Amazon has always had extremely high cash flow, and Jeff Bezos himself uses cash flow to measure his success. In his first letter to shareholders in 1997, Jeff Bezos clearly stated that he doesn’t care about profits and that he would always opt for cash flow:
When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.
Amazon was always in a position to make high profits. But Jeff Bezos preferred to invest every cent in further cash flows. Accordingly, profits in the company’s income statement were low. But cash flow was always positive. And that is the decisive factor – not some P/S ratio.
Conclusion: I try to keep it simple
In a world where others have better and faster access to information, I try to navigate my path. I do not compare myself with other investors and do not compete with them. I do not make complicated attempts to achieve simplicity where simplicity and certainty don’t exist. I ask myself, why am I investing? What criteria must be in place to achieve my goal? Am I still on track, are the criteria still present, or do I need to correct them? That’s all I do. It sounds so simple, but it gets harder and harder as things get crazier and crazier around you.
I keep my fingers crossed for all readers and hope that their path will lead to the intended destination.
All the best,