Price and Sales Education Series
Understanding a company is essential to a successful investment program. The more familiar we are with a company’s statistics, the better chance of putting the odds in our favor.
A starting point is to understand the most basic statistic. This statistic should be ingrained in your memory. Know where it comes from. Become familiar with current and past levels. Be able to make an educated guess on its future levels.
The word is revenue.
If it were not for revenue, a company would not sustain the ability to pay employees, retirees, suppliers, taxes to our government, and dividends to its owners. Understanding you are buying revenue is essential to success in investing.
In particular, studying the price the market has historically bid for a company’s sales is of utmost importance in identifying when to buy or sell a stock. It is similar to understanding when a train ticket is a bargain.
Often times, large institutions like insurance companies, pension funds, endowment funds and hedge funds buy at a certain multiple of sales. They employ investment analysts to study the numbers and determine the best stock at what price.
We can do the same.
If we can identify the historical price these institutions have paid for the company’s sales, we can find areas when revenue was cheap and expensive. This can help in identifying buy and sell ranges.
Finding these past relationships may seem complicated. GuruFocus.com’s Interactive Chart feature makes it quite easy.
Let GuruFocus be your personal research assistant. Play with the charts. Learn the numbers and become familiar with a company you want to buy. Make it fun.
We begin by studying Cummins Inc. (CMI), a company held in theportfolio of Mario Gabelli, the 346th wealthiest American.
In order to master this concept, it is best to start with predictable companies. Cummins is ranked 4.5-Stars in GuruFocus' Predictability measure.
This chart depicts CMI's price in green and revenue in blue.
Price is what we pay to buy one share of Cummins. Similar to when purchasing a train ticket, the price may be higher during rush hours and lower during off hours, stock prices have bargain and premium times too.
A train ride is what we buy at the train depot; revenue is what we buy in the stock market. For Cummins, we are buying the sales of, “diesel and natural gas engines, electric power generation systems and engine-related component products, including filtration, after treatment, turbochargers, fuel systems, controls systems, air handling systems and electric power generation systems.” This blue sales line is less volatile; however, it does change over economic cycles. This is the golden ticket for investors.
Notice how CMI's price in 2002 was far below the blue line but by 2007 was above. Fast forward one year to 2008 and notice how price decreased below the blue revenue line.
What might explain why the investing public bid so little for sales in 2002 but so much in 2007?
Much of these trends are due to investor psychology. Understanding why, by how much and how often it occurs is paramount to an investment shopper's responsibilities. Ignoring it will lead you down a path to financial ruin, as happened to many after the 17th Century South Sea Bubble.
Having the character to not let greed overtake you will lead you on a path to success.
Below is a chart of CMI's price-to-sales ratio starting in 1998. This chart is created by taking the price and dividing it by revenue. It includes the same numbers as the chart above, but depicts it in an easy to understand chart. Click the “P/S Ratio” tab in Interactive Chart to enable this feature.
To interpret why this chart is important, compare the current level to the past. The range is from a low of 0.14 in 2002 to a high of 1.69 in 2010. It can be seen as a temperature gauge measuring the investing public's willingness to buy revenue. Next, examine what happened to price after it reached near P/S ratio extremes.
Below is a chart depicting CMI's price increase after the market bid 0.14 times the level of sales in 2002.
Those buying near historical P/S lows experienced price gains.
Price gains also occurred after the P/S ratio lows of 2009.
Below is a chart of the price decrease after 2007 when CMI was above the 1.11x sales level. Those buying near historical high P/S levels experienced major price declines.
Understanding how market euphoria or despair affect price is important.
One way we can understand the P/S ratio is by looking at it from a business owner’s perspective. From every $1.00 received in revenue, the company deducts money to pay for employee salaries, materials supplied, interest on loans, and taxes to the government. Only after paying these expenses come earnings and dividends.
In Cummins’s case, for every $1.00 in revenue CMI has on average $0.96 of expenses. What's remaining, $.04, is profit. Thus, $0.04 out of $1.00 is a 4% profit margin.
When we buy a company's stock, we pay a multiple of sales. Market conditions are often reflected in profit margins. During good times, witnessed by high profit margins, the market often demands a premium for each $1.00 of sales. In bad times, when margins are low, the market may offer a discount on each $1.00 of revenue.
In 2007, when the P/S was 1.11, the market was charging $1.11 for every $1.00 in sales. If we predict Cummins can maintain a profit margin of 4%, as a part owner, we estimate we will receive $0.04 on every $1.00 of sales.
Putting these numbers together, we calculate an estimated owner's yield. This "Owner's Yield" is revenue remaining after all expenses, divided by the price we pay for sales. For Cummins in 2007, that yield was 3.6%. This return was calculated by dividing the $0.04 earned on every $1.00 of sales and dividing it by the price we paid for sales, $1.11, ($0.04/$1.11).
However, if we purchased Cummins sales at a lower price to sales multiple, as the market offered in 2002, then our “owner’s earning yield” would be more. Had we purchased those same sales for only $0.14, as was offered in 2002, our return would have been about 29% ($0.04/$0.14).
Of course, this is a very rough calculation of owner’s earnings. Actual profit margins or revenue change may substantially differ from our estimates.
At today’s level, the market is bidding 1.4x sales for Cummins revenue. This is higher than the average reading after 1998. If we estimate 4% profit margins into the future and we are currently paying 1.4x sales, then our “owner’s earnings” yield is about 2.9% ($0.04/$1.40).
Perhaps 2.9% sounds comparable to 30-year government bonds. Remember, however, buying common stock provides no guarantee of yield. There is also no guarantee bonds will stay at these levels either. The important thing is to compare this yield to its own historical levels. Within those ranges we may identify a margin of safety where institutional investors are comfortable buying.
In addition, ask yourself these questions: What were past growth rates? What are the estimated future growth rates? Where are profit margins in relation to historical levels? Will more competition depress current high profit margins? How will a capital intensive business fair if interest rates rise?
Do your homework. Study the company. Study its history in good times and bad. Become familiar with the numbers backward and forward. Recite the historical bargain levels. Have fun with the numbers. Make it a game and create good-looking charts.
We must put the odds in our favor by being our own investment analyst. And never forget: Revenue is what you buy and price is what you pay.
Thanks to GuruFocusfor providing the Interactive Charts.
Thanks to the late anti-apartheid activist and Cummins leader Joseph Irwin Miller for exemplifying values, ethics, and a commitment to diversity in life and business.
