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 great starting point is to understand the most basic statistic. This statistic should be engraved in your memory. Know where it comes from. Become familiar with its current and past levels. Be able to make an educated guess on its future levels. Know when it can be flawed.
The word is revenue.
If it were not for revenue, a company would not sustain the ability to pay employees, suppliers, dividends to owners and taxes to our government. Thus, understanding you are buying revenue is essential.
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 insurance rates are cheap.
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.
You can do the same.
If you can identify the historical price these institutions have paid for the company’s sales, you 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; the good news is 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.
Let’s begin by studying a company that is ranked 1-Star in GuruFocus' Predictability measure, American International Group Inc. (AIG, Financial).
This chart depicts AIG's price in blue and revenue in green.
Price is what we pay to buy one share in a company. Similar to how insurance can be expensive or cheap depending on how risky the perceived liability is, stock prices have bargain and premium times too.
Protection against damage is what we buy through an insurance agent; revenue is what we buy in the stock market. Revenue is the value of AIG's sales per share for the past year. The green sales line can be volatile as it changes over economic cycles. Investors expect revenue to grow much like an insurance agent would be pleased raising your rates.
Understanding investors are paying for revenue and revenue growth is the golden ticket for investors. Knowing this can help prevent catastrophic losses that occur when overpaying.
Notice how AIG's price in 2001 was way above the green line but in 2009 was far below. Fast forward to 2014 and notice how price retraced towards the green revenue line.
What might explain why the investing public bid so much for sales in 2001 but so little in 2009?
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.
Below is a chart of AIG's price-to-sales ratio starting in 1995. 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 high of 5 in 2001 to a low of .04 in 2010. Next, examine what happened to price after it reached near these P/S ratio extremes.
What happened to the price of AIG after institutions bid 5 times the level of sales in 2001?
Below is a chart depicting AIG's price percent decrease. Those buying near historical P/S highs experienced price declines.
Below is a chart of the price percent increase after 2010 when AIG was priced .04x sales. Those buying near historical P/S low experienced major price gains.
However, there are limitiations to when the P/S ratio works. When money supply is tight, one may notice a substantial drop in revenue for banks and insurance companies.
Notice the drop in AIG Revenue in 2008.
As the P/S Ratio declined to new record low levels, it may have indicated a buy opportunity. However, one would have suffered massive losses buying at "record low" PS levels, for the P/S ratio kept going lower. In this circumstance, an enterprising investor will find two things important. The first is to find a margin of safety using another financial metric. This indicator, accounts receivable, is defined by GuruFocus below.
The second task for the enterprising investor is to identify other securities related to the original issue. Why invest in common stock when the bonds or preferred shares are offering a major discount plus a higher level of inherint protection?
For those enterprising investors willing to look underneath rocks what was the yield to maturity on this issue offered back in 2009?
Do your homework. Study the company. 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.
In addition, ask yourself these questions: What were past growth rates? What are the estimated future growth rates? Are profit margins contracting? Will profit margins expand? Are there other securities available that are more attractive than common stock?
We must put the odds in our favor by being our own enterprising investor. And never forget: Revenue is what you buy and price is what you pay.
Thanks to GuruFocusfor providing the Interactive Charts.
