Look at a stock from all angles before buying it

Price-earnings ratio is important, and so is price-sales ratio

Stock evaluation

Dollars & Sense

April 16, 2000|By Laura Pavlenko Lutton | Laura Pavlenko Lutton,MORNINGSTAR.com

Great photographers know that some of the most memorable shots aren't taken straight on, but from a new, unexpected angle. Photos that show the swarms of media at a news conference -- not the subject speaking -- can put an event into context, while a shot of a fan at a sporting event sometimes tells the story just as well as a standard photo of the star athlete.

Investors should think about photographic angles when they are determining whether a stock is fairly priced. The straight-on shot -- the price-earnings ratio -- can give one perspective, but zooming in a different way can be helpful, too.

Take the price-sales ratio. It's similar to the price-earnings ratio, which is a company's stock price per share divided by its earnings per share. The price-sales ratio compares the stock price with a company's sales per share over the past 12 months.

Since sales at a company are usually unaffected by one-time events, such as a restructuring, the price-sales ratio can often give a more consistent view of the company's performance over time than can the price-earnings ratio. Price-sales ratios also come in handy when a firm is operating in the red. Companies without profits -- Internet start-ups come to mind here -- don't have price-earnings ratios. Internet retailer Amazon.com doesn't have profits or a price-earnings ratio, but its price-sales ratio is 15.

The price-sales ratio must be considered in context. Look at how the current price-sales ratio compares with a historical average and the industry's current average. Some industries, such as retail, have low price-sales ratios because their profit margins are low. At the same time, high-margin firms, such as software companies, usually have high price-sales ratios. (The average department store firm's price-sales ratio is about 2, while the software industry's price-sales average is 25.)

Investors should also keep in mind that companies can manipulate their total revenues based on when they record sales in their books. Some firms consider a product sold when a customer signs a sales contract. Others don't tally a sale until the product has been delivered.

To be sure, price-sales isn't a perfect valuation measure for stocks, but it can add valuable information -- just like the unexpected photo shot. Home Depot, for example, looks like an expensive stock on a price-earnings basis. The home-repair giant's P-E is at a slight premium to its industry average, but Home Depot's current price-sales ratio is in line with those of other home-supply store chains and below the S&P 500's price-sales average.

Sales growth at Home Depot has been booming -- up 26 percent in the fourth quarter over the fourth quarter last year, which is one reason why the firm's price-sales ratio is lower than average. The other factor holding down Home Depot's price-sales is its stock price, which has been off by more than 6 percent so far this year. Some investors are concerned that the company won't fare well in an economic slowdown, but, considering how well Home Depot performed during the recession in the early 1990s, those concerns may be overblown. In short, Home Depot's shares appear priced to move.

If you find a turnaround play more compelling, check out Compaq Computer Corp. Compaq's current price-earnings ratio is higher than average since earnings have been hurt by recent troubles at the company. But Compaq's price-sales ratio of 1.3 is slightly below its five-year average and less than half the industry average. Drops in earnings (and subsequent increases in P-E ratios) shouldn't always be forgiven. After all, Compaq is losing market share for some products. But Compaq appears to be on the mend. It has demonstrated recently that it can cut costs to improve profitability, and PC sales may pick up as corporate customers upgrade their operating systems this year. This stock is risky, but adventurous investors may find it appealing.

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