"What should this stock be worth?"
That's really the fundamental question, isn't it?
If we can answer that question, investing decisions become much simpler. Using Ben Graham's concept of "margin of safety", we use our target price and aim to buy at a reasonable discount to it (say, 15-20% below, for example). Conversely, when we need to raise cash or rebalance, we can use our target prices to determine which over-priced stocks might be worth trimming a bit from.
Without a target price, we are just taking shots in the dark. Coming up with a target price is called stock valuation.Where Discounted Cash Flow Fails
There is no shortage of techniques for determining a target price for a stock.
Probably the most widely used and "technically" correct is the discounted free cash flow method (DFCF). We wrote a lengthy article on DFCF a while back - check that out for the details on how to do one. In a nutshell, DFCF takes the academic definition of any asset's value: the discounted present value of all future cash flows an asset can produce.
DFCF is certainly useful in a lot of cases. For large, mature companies with stable and predictable cash flows, a DFCF is the way to go.
But what about for companies that are early in their development, with limited or even negative cash flows? What about for companies facing (temporary) challenges that impair their earnings from historical norms? What about firms that are in transition and have numerous "one-time" charges that largely skew their earnings for the near future?
Fortunately, there is a relatively straightforward option for "spit-balling" a valuation for any of these kinds of firms.Revenues Don't Lie
Of all of the major valuation components, one above all is the most stable and the most predictable: revenues.
Even for companies undergoing extensive restructuring, or in the midst of a major acquisition, or investing heavily in growth, revenues are the rock in the storm. They are difficult to play accounting games with, simple to understand, and (relatively) predictable to forecast.
And they can also be used to estimate a fair value for a stock, by applying the price-to-sales (P/S) ratio.
The P/S ratio can be used to quickly (and "dirt-ily"?) generate a rapid reasonable valuation for a stock. You simply take trailing 12 month revenues, apply a P/S ratio to it and... voila!... a target market capitalization, which can then be divided by number of shares to reach a target stock price.
The P/S ratio valuation method is independent of all company "noise". It doesn't care if margins are low due to restructuring costs, if reported earnings were boosted by one-time tax benefits, or if a firm just completed a large acquisition. Revenues - the lifeblood of business - are all that matters.
But the question then becomes: what do I use for the P/S ratio multiplier?How To Generate a Target P/S Ratio
There are a number of simple ways to come up with a target P/S ratio. You could use a historic (5 or 10 year) average P/S ratio for the stock, particularly if you are looking at a company with a long history. Or you could look at some better-performing competitors and see what P/S ratio your stock could get to, ultimately.
But this wouldn't be a MagicDiligence article without adding some "magic", would it?
So I'm going to show you a few "Magic P/S" rules you can use to do some "quick and dirty" valuation on pretty much any interesting stock. Here is the process:
1) Determine a baseline P/S ratio. A baseline P/S ratio is a general rule of thumb for stock valuations, when a company is growing sales at "mature" rates (somewhere around 3-6% per year). To do this, determine what you think is a decent operating margin percentage target, given the company's history, competitor averages, or what you think the company can ultimately get to. Then divide that by 10 to get a target price-to-sales ratio. Example:
2) Adjust the baseline P/S for growth (or lack thereof). The baseline P/S assumes the company's prospects are decent going forward. If your stock is forecast to grow revenues much faster than average, you will want to up your target P/S ratio. On the other hand, if your stock is forecast to have worse-than-average (or declining) sales, you want to adjust it down.
Let's do one of each.Adjusting P/S Down
Sticking with Apple, we can see that analyst targets for sales this year are forecasting a 7.5% drop in revenues - far below our 4-7% growth baseline. Therefore we need to adjust our target P/S down from 3.09. But by how much?
Looking around a bit, we see that Cisco (CSCO) has similar margins to Apple and is forecast to have a modest sales drop this year as well. Its current P/S ratio is 2.8, so that gives us a rough estimate to use. Since Apple's revenue is forecast to go down a bit more, let's use 2.7:
Apple target P/S valuation = $227.5B (ttm sales) * 2.7 = $614.4B / 5,541 (shares) = $110.87.
Given this, Apple looks meaningfully undervalued at today's price of $93.Adjusting P/S Up
For this one, let's go with an example of where P/S can be helpful with a not-yet-profitable company: Twitter (NYSE:TWTR).
How do we do a baseline P/S without an operating margin? We make one up of course!
There are numerous ways to do this. We can look at some similar, more mature Internet-based businesses - like Alphabet's (NASDAQ:GOOG) 26% op margin. Or we can look at Twitter's reported "non-GAAP" op margin which is about 18%. OR we can use management's commentary in both its pre-IPO "road show" and in conference calls for what they think a long-term target is for profitability, in this case close to 40% (!).
Let's take all of these and assume that Twitter can ultimately be a 27% margin business. So our baseline P/S becomes 2.7.
Now, Twitter's revenue grew 58% in 2015, is expected to grow nearly 25% this year, and then another 20% in 2017, so the company is growing quite a bit more rapidly than your normal firm. Again going back to Alphabet, we see a firm with a similar margin profile growing revenues at 15% a year with a P/S ratio of 6.3. We have to realize that Twitter's competitive moat and future prospects are not as established as Google's, so let's split the difference and target a P/S ratio of about 5.25 for Twitter:
Twitter target P/S valuation = $2.38B * 5.25 = $12.5B / 691.6 = $18.04.
Twitter looked reasonably valued before its recent selloff and may once again be an attractive bargain.Conclusion
The price-to-sales valuation method is a good, quick method to test whether a stock's current price is reasonable or not. In most cases it is necessarily imprecise, but honestly ANY stock valuation method is by nature imprecise. With just a few piece of information, you can "spit-ball" a valuation for virtually any stock, regardless of whether its earnings are impaired, in flux, or even yet to exist. Add the P/S valuation method to your toolbox for finding attractive stock opportunities!