"Astronomical," "ridiculous" and "overpriced" are some of the terms usually used to describe the valuations of most high-growth tech companies in today's market. Booming social media companies, software providers and clean-tech companies typically have price to earnings ratios in the hundreds, and some aren't even profitable. By looking at the quote for Tesla (NASDAQ:TSLA) on a typical financial website such as Finviz, one sees a Forward PE of ~70, a price/book ratio of 25 and an insane sales growth rate of 167% over the past five years. There are usually two arguments regarding the valuations of companies like Tesla. The bearish one is that Tesla is in a bubble which is destined to collapse, and that its fundamentals do not nearly justify its ridiculous valuation. The bullish one is that Tesla's astronomical potential for growth, in addition to its strong brand and CEO, do not allow it be confined to valuations similar to most other companies. These arguments typically dominate the debates regarding the stocks of Tesla, Twitter (NYSE:TWTR), Amazon (NASDAQ:AMZN) and many other high-growth, high-value stocks. However, I would like to point out a different valuation metric that I believe provides a more rational insight into the valuations of such companies.
The PSG Ratio
The Price/sales to growth ratio can be very effective in evaluating companies relative to their growth potential, especially those lacking profits. It is calculated by dividing the price/sales ratio by the expected long term sales growth. Strangely, this ratio is very unpopular and is very rarely used. If one performs a Google search of "Price to sales to growth ratio" or "PSG ratio," they will receive nothing relevant. This is surprising due to the ratio's similarity to the price/earnings to growth ratio. The PEG is usually shown in financial quotes and is considered as a very effective way to evaluate companies relative to their growth. Earnings, obviously, are the essence of a company's value, but one cannot judge whether a company is succeeding in expanding its business without viewing its revenue growth. Thus, it makes sense that the PSG ratio is an effective indicator of a corporation's value, especially one that lacks profits.
This table compares the price/sales ratios, projected sales growth rates, PSG ratios and PEG ratios of the etfs of the S&P 500 (NYSEARCA:SPY) and Nasdaq 100 (NASDAQ:QQQ) to those of Amazon, Tesla and Twitter. I attained the sales growth data on the three companies based on the consensus estimates I found on Zacks Research Wizard. It was very difficult to find long-term sales growth estimates for the indices, so I assumed 5% growth for SPY based on last year's sales growth of 3.08%, and 10% for the Nasdaq based on last year's growth of 11.7%. The three stocks that I included are typically considered extremely overvalued, so I thought it would be insightful to view how their PSG ratios compare with those of major indices. As you can see, the results are quite startling:
|Ticker||Price||P/S||Projected Sales Growth
The PSG ratios of Tesla and Amazon are drastically lower than those of the major indices. This indicates that relative to their future sales growth rates, these companies may in fact be undervalued. Other companies not included in the chart that have PSG ratios lower than the Nasdaq include Stratasys (NASDAQ:SSYS), which has a PSG ratio of .14, Yelp (NYSE:YELP), which attains a ratio of .23, and GoPro (NASDAQ:GPRO), which has a PSG of .22. Because these companies are unprofitable and because of potential flaws in the calculation of the ratio, I believe that their PSG ratios have to be at least 25% lower than that of the Nasdaq ETF, in order to provide a cushion of safety. Therefore, Twitter would still be overvalued even when factoring sales growth into its price.
I strongly recommend to not buy stock based solely on the PSG ratio. First of all, it is very subjective, as one has to estimate sales growth for 3-5 years in the future. Additionally, this ratio is quite unpopular and does not seem to be used by financial institutions that trade very frequently, so it isn't an effective indicator of how a stock will fare in the short-intermediate term. Despite this, the PSG ratio provides an insightful contrarian view on the valuations of many quickly growing, high priced stocks, and this overlooked valuation metric deserves more attention. I encourage all of you to reconsider how you evaluate companies like Tesla and Twitter. Viewing various quantitative metrics such as the PSG ratio in addition to assessing a company's management and innovative abilities is an effective way to make sound investment decisions. Using the PSG ratio will be a beneficial addition to one's investment strategy and will provide one with a more rational approach to evaluating high growth companies.
Disclosure: The author is long TSLA.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.