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 21X.
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 21X?
The number 21X 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 21X 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.
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.
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 >21X?
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 and
You are interested in investing in it
Important: Find out what is the PS ratio of the Stock when it goes back to All-Time High level.
Always obtain and use the PS ratio assuming the stock goes back to its all-time high. This will give you a more accurate picture of the company's valuation.
Do not make the mistake of buying into a stock when its current PS ratio is low. This is because the low PS ratio may be due to a recent decline in the stock price.
this is especially important during periods when many stocks' prices have fallen signifcantly from their all-time high levels.
Formula for PS ratio when the Stock goes back to All-time High
PS ratio when stock in on All-time high price
= (All-time high price x Shares Outstanding) / LTM Revenue
Examples
Consider the following examples:
Shopify's PS ratio when its stock hits its all-time high price ($176) again would be 34X.
calculation: = ($176 x 1,284 mill shares o/s) / Revenue of $6,651 mill = 34X
Nvidia's PS ratio when its stock hits its all-time high price ($504) again would be 28X.
calculation: = ($504 x 2,470 mill shares o/s) / Revenue of $44,870 mill = 28X
Fortinet's PS ratio when its stock hits its all-time high price ($81) again would be 12X.
calculation: = ($81 x 768 mill shares o/s) / Revenue of $5,173 mill = 12X
As you can see, Shopify and Nvidia have very high PS ratios, while Fortinet's PS ratio is more moderate. This suggests that Shopify and Nvidia may be overvalued, while Fortinet may be more attractively priced.
Readers can use this spreadsheet for this purpose: Future PS ratio est after price bounce back to Alltimehigh,
just fill in the cells in green.
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 21X, 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.
Looking for a set of checklists to identify great companies for your portfolio?
