Table of contents
Disclaimer: This communication is provided for information purposes only and is not intended as a recommendation or a solicitation to buy, sell or hold any investment product. Readers are solely responsible for their own investment decisions.
Why You Should Avoid Investing in Companies with PS Ratios Above 18X.
In the world of investing, it's crucial to identify and avoid potential pitfalls that could lead to financial losses.
One such pitfall is investing in companies with excessively high price-to-sales (PS) ratios.
A high PS ratio indicates that investors are paying high premiums for each dollar of revenue generated by the company.
This can be a red flag, as it suggests that the company's stock price is inflated and may be due for a correction.
Why 18X?
The number 18X is not arbitrary.
It represents the median PS ratio of popular companies during the peak of the dot-com bubble in 2000.
The dot-com bubble was a period of widespread speculation and overvaluation in the stock market, and many companies with high PS ratios ultimately experienced significant price declines.
Reasons for Using the Dot-Com Bubble as a Gauge
While there have been other stock market crashes and corrections throughout history, the dot-com bubble stands out for a few reasons:
It was a period of widespread overvaluation, with many companies trading at PS ratios significantly higher than historical norms.
The bubble was driven by speculation and exuberance.
By using the dot-com bubble as a gauge, we can get a sense of the range of PS ratios that should be considered risky. A PS ratio of 18X or higher suggests that a company's stock price may be inflated and could be due for a correction.
Why not use the other previous stock market crashes as gauge too?
It is important to understand that not all stock market crashes are caused by lofty valuations. In some cases, external factors can trigger a sudden and severe decline in stock prices.
Stock Market Decline 2022
The Stock Market decline which started at the end of 2021, and resulted in S&P500 moving sideawys for up to 2 years was not mainly due to overvaluation concerns. Rather it was caused from ongoing uncertainty from the COVID-19 pandemic, compounded by the Russian invasion of Ukraine, which heightened fears of energy disruptions. Concerns over a potential global recession also played a role, also because interest rates was raised during that period (United States Fed Funds Interest Rate.)
COVID-19 Crash in March 2020
The COVID-19 crash in March 2020 was a prime example of a market downturn driven by panic rather than valuation concerns. The rapid spread of the COVID-19 virus and the associated economic uncertainty caused investors to fear for the future of businesses and the overall economy. This led to a wave of selling, causing stock prices to plummet across various sectors.
Global Financial Crisis (GFC) in 2007
The GFC of 2007 was another instance where a loss of investor confidence, rather than inflated valuations, triggered a market crash. The crisis originated from the subprime mortgage market, where risky mortgages were issued to borrowers with poor creditworthiness. When these mortgages began to default, it caused a ripple effect throughout the financial system, leading to a crisis of confidence and a subsequent stock market crash.
Black Monday Crash in 1987
The Black Monday Crash of 1987 was indeed caused by lofty valuations, but it's important to note that it was a relatively short-lived event. While the crash was attributed to overvaluation and concerns about program trading, it only lasted for about two months, and the market recovered relatively quickly.
Also there are not many stocks’ PS ratio data available for that period for analysis.
Wall Street Crash of 1929
The Wall Street Crash of 1929, also known as the Great Depression, was another crash driven by excessive valuations. During the Roaring Twenties, the stock market experienced a period of unprecedented growth, with stock prices soaring to unsustainable levels. This speculative bubble eventually burst, leading to a severe economic downturn that lasted for over a decade.
However, like the Black Monday Crash in 1987, there are also not many stocks’ PS ratio data available for that period for analysis.
Refer to Wikipedia's List of stock market crashes and bear markets for more info.
Conclusion
In order to determine the appropriate PS ratio threshold for identifying overvalued stocks, it is essential to exclude instances where market downturns were not primarily driven by excessive valuations.
The COVID-19 crash and the GFC are examples of such cases, where external factors played a more significant role in triggering the market sell-offs.
Additionally, due to limited data availability, the Wall Street Crash of 1929 and the Black Monday Crash of 1987 are also excluded from this analysis.
Decision Tree: What to do when the stock's PS ratio is >18X?
To help you decide whether or not to invest in a company with a high PS ratio, consider the following decision tree:
Assuming if:
The stock's fundamentals are good
It's growth prospects are appealing to you and
You are interested in investing in it
Tools mentioned:
Bonus: Identifying Potential Bargains
For stocks that have experienced a significant decline from their all-time high prices, a favorable PS ratio calculation when the stock price reverts to its previous peak can indicate an oversold condition. This analysis involves projecting the PS ratio back to the all-time high price level, assuming the company's trailing twelve months (TTM) revenue remains constant.
Examples (as of 12Jan25):
Airbnb: Currently down 39% from its ATH, Airbnb's projected PS ratio at the previous peak would be 12x. This suggests that even if the stock price recovers to its all-time high, the valuation would still be reasonable, potentially indicating an oversold opportunity.
Semrush: Down 63% from its ATH, Semrush's projected PS ratio at the previous peak would be 13x. Similar to Airbnb, this suggests that even with a full price recovery, the valuation remains attractive.
Cautionary Tales (as of 12Jan25):
Shopify: Currently trading at a PS ratio of 16x and down 39% from its ATH, Shopify's projected PS ratio at the previous peak would skyrocket to 27x. This highlights a potential overvaluation concern for investors holding Shopify, as a return to the all-time high price would likely result in an unsustainable valuation.
Atlassian (TEAM): With a current PS ratio of 14x and a 47% decline from its ATH, Atlassian faces a similar situation. A return to the previous peak would push its PS ratio to 26x, indicating a significant overvaluation risk.
You may use this spreadsheet for to perform the calculation: Future PS ratio est after price bounce back to Alltimehigh,
just fill in the cells in green.
Investor Considerations:
These examples underscore the importance of analyzing a stock's potential valuation at its previous peak. While Shopify and Atlassian may currently appear reasonably valued, their projected PS ratios at the ATH highlight the potential for overvaluation in the event of a full price recovery without a corresponding increase in revenue.
Existing investors in these companies should exercise caution and potentially adjust their portfolio allocations if the stock price experiences a rapid rebound without a commensurate increase in revenue. This analysis provides a valuable tool for identifying potential bargains and managing risk within your investment portfolio.
Key Takeaways:
Favorable PS ratio at ATH reversal: Suggests potential undervaluation.
Unfavorable PS ratio at ATH reversal: Warns of potential overvaluation.
Existing investors: Monitor price movements and adjust holdings accordingly.
Focus on fundamentals: Revenue growth is crucial for justifying higher valuations.
By incorporating this analysis into your investment decision-making process, you can make more informed choices and navigate market fluctuations more effectively.
Conclusion
While PS ratios are not a perfect indicator of a company's value, they can be a useful tool for identifying potential risks.
By avoiding companies with PS ratios above 18X, you can reduce your chances of investing in overvalued stocks that could experience significant price declines.
Please note that this is not financial advice and you should always do your own research before making any investment decisions.
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