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Morningstar.com's Interactive Classroom

Course 305
Price/Book and Price/Sales Ratios

Introduction

Although P/E ratios get all the attention, there are other valuation measures which can be more useful in many cases. Two of the most common are price/book and price/sales ratios. Both appear on the Morningstar Stock Report. In this session, we'll cover each ratio in-depth and discuss the benefits and limitations of each.

Price/Book Ratio

Many investors use price/book because they believe that earnings are more variable and subject to accounting shenanigans than book value is. Book value is what would be left over for shareholders if a company shut down its operations, paid off all of its creditors, collected from all of its debtors, and liquidated itself. It's a more tangible measure of value than earnings, because book value tells you what you might actually get paid for a company in cold, hard cash. Even though book value is theoretically what shareholders would receive if the company were liquidated, this is rarely the case in practice. That's because the value of assets and liabilities can change substantially from when they are first recorded. For example, a railroad company that paid a few dollars for an acre of land out west 100 years ago would have a far more valuable property today. That acre of land, however, continues to sit on the company's balance sheet at the original purchase price. It's important to think about a company's basic characteristics when you're looking at its P/B ratio. A good proportion of a manufacturing company's worth is tied up in inventory and machinery, which are relatively well reflected in its book value. A software company like Oracle ORCL, on the other hand, has a lot of its worth tied up in intangible assets like patents, market share, and the talents of its programmers. Since intangible assets such as these aren't taken into account when book value is calculated, Oracle's book value isn't as good a measure of what shareholders would receive if the company were liquidated. It's also important to keep a company's return on equity (ROE) in mind when looking at its book value. If a company can make high returns on its book value, a high P/B is probably no cause for alarm. For these companies, the "B" is simply more valuable, because the firm can use the book value more efficiently to generate profits. For example, the relationship between Microsoft's P/B and ROE is a telling measure of its operating efficiency. Microsoft commanded a P/B of 17 at the end of 1999 because it continually earns returns on shareholder equity of 25% or more--something that relatively few companies are able to do.

Price/Sales Ratio

Perhaps the biggest advantage of the price/sales ratio is that it is based on the difficult-to-manipulate sales figure. Also, because sales are generally more stable than earnings, price/sales (P/S) can be a good tool for sifting through cyclicals and other companies with fluctuating earnings. Take a look at chemical company Du Pont DD. Although its P/E was as low as 13 and as high as 29 between 1994 and 1999, its P/S stayed between 1.7 and 2.7. The P/S ratio is also helpful in evaluating firms with negative earnings--which is why it's become such a popular tool for evaluating Internet stocks, which are often far from making money. Sounds pretty good, doesn't it? Bear in mind, however, that whereas a dollar of earnings means essentially the same thing regardless of what company is producing it, the value of a sales dollar varies quite a bit from firm to firm. This is because companies' profit margins, or the efficiency with which sales are translated into profits, are highly variable. A software company like Microsoft MSFT is able to convert every dollar in sales into more than 30 cents of profit, but computer hardware manufacturer EMC EMC is only able to wring about 20 cents in profits from each dollar of sales. So, each dollar of Microsoft's sales is more valuable than each dollar of EMC's. This is why, even though the two companies have roughly comparable growth rates, Microsoft's P/S ratio is 27 and EMC's P/S ratio is a much-lower 16. The strong effect of profit margins on P/S ratios is why they tend to vary tremendously across industries. For example, the retailers in Morningstar's stock database had an average P/S of just 0.8 at the end of 1999. That's because the average net margin for these companies is only 4%--only four cents of every dollar they make in sales translates into profits. On the other end of the spectrum, the average software company in our database keeps 15 cents of each sales dollar. It shouldn't come as a surprise, then, to find out that software companies have a P/S of almost eight--their sales dollars are simply worth a good deal more than those of the retailers are. Because both price/book and price/sales ratios aren't really comparable across industries, they are best used when comparing similar companies with each other or the current valuation of a particular company with its historical levels. As long as you stick within these boundaries, these ratios are a useful addition to the toolbox of every investor.

Quiz 305
There is only one correct answer to each question.

1 What is one advantage that price/book and price/sales share over P/E?
a. They're less subject to accounting manipulation.
b. They both give a truer picture of how profitable a company is.
c. They're better predictors of where the stock's price is going.
2 What is one disadvantage to using book value in a valuation measure?
a. It doesn't reflect the changing value of assets (such as land) over time.
b. It automatically increases with the stock's price.
c. It's very volatile, often changing substantially from day to day.
3 How does a high return on equity (ROE) affect a company's price/book ratio?
a. It makes it lower, by making the company's book value less valuable.
b. It makes it higher, by making the company's book value more valuable.
c. It makes it higher, by reducing the company's book value.
4 Which of the following is <em>not</em> an advantage of price/sales over P/E?
a. It tends to be more stable.
b. It can be used for companies that are losing money.
c. A dollar of sales is always worth the same, whereas the value of a dollar of earnings can vary quite a bit.
5 If two companies both have the same amount of sales, but Company A has a net margin of 30% while Company B has a net margin of 2%, which will probably have a higher price/sales ratio?
a. Company A.
b. Company B.
c. It's impossible to tell from this information.
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