Alan Brochstein, CFA is one of our favorite analysts and a highly regarded member of the Seeking Alpha community. Alan's recent piece titled Why Price/Sales Is A Dangerous Valuation Metric offered a candid assessment to the disadvantages of relying on the more traditional valuation metrics when analyzing investment opportunities.
In his P/S piece, Brochstein highlights key elements of the analysis that a P/S metric won't capture: margins, growth rates, and the balance sheet. In our article we will attempt to build upon his thesis that enterprise value-to-sales may offer a clearer picture to the capital structure of the underlying investment. Below are several considerations we use when connecting the dots.
Quality-of-Earnings: In our work, we tend to focus on the quality-of-earnings as a starting point. Critical to this exercise, is to gauge where the "cash flow" used to support earnings is coming from. The basic premise being that cash flows generated from actual operations are the essential components to earnings construction. Thus, earnings that are supported largely by "paying customers" will be of higher quality than earnings produced with accruals and non-cash accounting changes.
When income producing assets are used efficiently, returns on those assets will invariably reflect this. Similarly, when capital is used productively, the enterprise will likely benefit from a healthier liquidity profile. Of course, this would depend on the capital intensive nature of the business and its industry.
For example, a software company will likely produce higher margins than say an airline company. Each has a uniquely different capital structure and their balance sheets won't look similar.
What other distortions might there be to traditional valuation metrics? Using price-to-earnings as an example, the "P" is what the market assigns to the multiple of "E", but the quality of "E" may not justify the "P". In the case of P/S, revenue recognition is one potential distortion. How does it account for credit sales?
Balance Sheet Maneuvering: Non-cash adjustments are another potential pitfall to conventional valuation metrics. There might be messy adjustments to depreciation or anomalous spikes in the use of accruals as a tool to "generate" cash. When managers need cash, one of the first places they run to is the balance sheet. However, a liquidity constrained company (regardless of whether they are in a growth phase or not) only has so many levers to pull before the cash runs out.
A perfect example of a liquidity challenged company during a parabolic growth phase is Green Mountain Coffee (GMCR). The reported sales and earnings reports in recent years looked terrific, but management found themselves having to raise capital via several well-timed secondary stock offerings. Ironically, now that GMCR's growth is moderating, instead of benefitting from its previous capex investments, it appears it will be initiating "optimization" initiatives, referred to more commonly as a restructuring.
Management Effectiveness: This gets to another very important piece of the puzzle, management. The difference between a well managed firm and one that is not is determined by how efficient they operate the business.
Intel (INTC) for example has a very good long-term track record at building shareholder equity over time. The company has been fairly aggressive in its cash-return strategy, but it beats the pants off of the coffee company who couldn't produce positive cash flow in ten years.
To be fair, it is difficult to compare a cyclical industry (semiconductors) to consumer discretionary, but INTC management was/is simply better at running its business than the folks selling coffee and brewing machines. There are high expectations that GMCR's new CEO Brian Kelly will get GMCR ship-shape, but he clearly has his work cut out.
The point here is that there are so many intricate and moving parts to valuing a stock. And, as Alan points out, P/S and EV/S can be useful when attributes are similar. However, an investor also has to pay attention to the margin story, the financial statements and the growth potential when trying to value a company. Such an exercise requires (as Alan succinctly points out) putting it all into context.
Don't forget about liquidity: As earnings are the catalyst for future stock price movements, liquidity is the primer for realizing it. How a company manages its liquidity is the key to building the cash flow from which earnings are built. Think of cash flow as the oil in a car's engine. Without it, you won't get very far. And, if the earnings yield comps below are a telling sign, INTC's engine has been running just fine.