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. Investing is similar to baseball. Years ago, no teams employed statisticians. Today, they are essential to predicting the right player for certain positions and which pitch for certain players.
Before taking any action, there is one number investing “statisticians” must ingrain in their memory. They must study this number. They must become obsessed with its historical levels. They must know where it came from, and should be able to roughly estimate its future levels. What might this number be?
The answer is the solution to these questions: Where do earnings come from? Where do dividends come from? Where do paychecks come from? All these things derive from one source: revenue.
If it were not for revenue, a company would not sustain the ability to pay employees, suppliers, and dividends to owners. Thus, understanding revenue is an essential ingredient to successful 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.
Often times, large institutions like insurance companies, pension funds, endowment funds, and hedge funds buy at a certain multiple of sales. They employ investment statisticians to study the numbers and determine the best stock at what price. You can do the same.
If you can identify the historical price these institutions have paid for the company’ sales, it could help indicate levels to buy or sell. Finding these past relationships seems complicated, but GuruFocus.com’s Interactive Chart feature makes it quite easy.
Let’s start with the chart of Chicago Bridge & Iron. This chart depicts CBI’s Market Capitalization in orange and annual revenue in blue.
Market capitalization is the price to buy all the stock of a company. It fluctuates up and down substantially as the investing public becomes greedy and fearful.
Annual revenue is the value of CBI’s sales for the past year. This blue sales line is less volatile but does change over economic cycles.
Notice how CBI’s Market Cap. (price) in 1999-2000 was below the blue line (annual revenue) and in 2004 and 2007 was above. Fast forward to 2009 and notice how Market Cap dropped below the blue line again.
What might explain why the investing public bid so little for sales in 1999 and so much in 2007?
Understanding why, by how much, and how often it occurs is paramount to an investment statistican's responsibilities.
Below is a chart of CBI’s price-to-sales ratio starting in 1998. This chart is created by taking the Market Cap 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, we take the recent level of .538 and compare it to the past. The range is from a low of .08 in 2009 to a high of 1.9 in 2007. We then examine what happened to price after it reached near these P/S ratio extremes.
What happened to the price of CBI after institutions bid .15 times the level of sales in 1999?
Below is a chart depicting CBI’s price increase in percent. Those buying near historical P/S lows experienced price gains.
Below is a chart of the price percent decrease after 2007 when CBI was above the 1.9x sales level. Those buying near historical P/S highs experienced major price declines.
One way we can understand the P/S ratio is by looking at it from a business owner’s perspective. If we predict CBI can maintain profit margins around 2% (see chart below), as a part owner, we estimate we will receive 2% of whatever sales are.
In 2007, when the P/S was 1.9x sales, the estimated owner's yield was 1%. This return was calculated by dividing the $0.02 earned on every $1.00 of sales and dividing it by the price we paid for those sales $1.90 ($.02/$1.90.)
However, if we purchased CBI sales at a large discount, as the market offered in 1999 & 2009, then our “owner’s earning yield” would actually be more than 2%. If we only paid $0.20 for every $1.00 of sales and our average return on every dollar of sales is $0.02, then our return is about 10% ($0.02/$.20).
Of course, this is a very rough calculation of owner’s profits. Actual profit margins or revenue change may substantially differ from our estimates.
At today’s level, the market is bidding .53x sales for CBI revenue. This is lower than the last couple years, but compared to the long term historical trend is slightly above average. If we estimate 2% profit margins into the future and we are paying $0.53x sales, then our “owner’s earnings” yield is about 3.7% ($0.02/$0.53). Perhaps 3.7% sounds fine if estimating large growth rates and comparing to CD rates, but the important thing is to compare this yield to its own historical levels. Otherwise, how will you be able to estimate a margin of safety?
Remember, we must put the odds in our favor by being our own investment statistican. And never forget, revenue is what you buy and price is what you pay.
