In the current low-growth economic environment, some equity investors have chosen to focus on companies exploiting a disruptive technology. Their logic is that even if the overall economy is growing at less than 3 per cent, companies that offer a product or service that disrupts existing channels of distribution can still grow rapidly by taking market share away from slow-to-react incumbents.
Examples of listed companies which spring to mind include Amazon.com Inc., Netflix Inc. and Tesla Inc.. Closer to home, Ottawa-based Shopify Inc., a retail-payment intermediary, qualifies as second-quarter revenue jumped 75 per cent over the same period last year. At the micro-cap level, Electrovaya, a Mississauga developer of Lithium Ion battery technology, hopes to be a beneficiary of the trend toward clean electric transportation, although the increase in revenue has been sporadic.
A company with a legitimate claim to a disruptive technology is clearly worth far more than a run-of-the mill company in a mature industry, but how should an investor set about valuing such a stock? The company almost certainly has no reportable earnings per share, so a price-to-earnings ratio analysis is out of the question. It may not even have operating earnings, however defined. In fact, a lack of earnings at Shopify was no impediment to the sell-side analysts who raised their target prices following the second-quarter conference call.
In these situations, I suggest that investors adopt the price-to-sales ratio (PSR) as the best metric for valuing an explosive growth company. You can calculate this either on a per-share basis – stock price divided by sales per share; or on a total-company basis – market capitalization divided by revenues. The number will almost certainly be large, maybe even in the double digits. Which raises the next question: When is the PSR so high that even a hyper-growth company cannot live up to the expectations built into the stock price?
More than 30 years ago, investment legend Kenneth Fisher popularized the use of the price-to-sales ratio in his 1984 book Super Stocks. His No.1 rule: Avoid stocks with PSRs greater than 1.5. Never ever buy any stock with a PSR greater than three. A stock selling at a PSR this high can increase rapidly, but only based on "hype."
You might think that things have changed a lot in the past 30 years and that we have a more sophisticated understanding of disruptive technologies, but I suspect not. Floppy disks were leading-edge technology back in the mid-1980s and Verbatim Corp. was a major player with a market capitalization of $610-million (U.S.). Mr. Fisher conceded that Verbatim was a great company with a spectacular future in floppy disks, but a poor investment at a PSR of 5.1. Two years later Verbatim received a takeover bid from Eastman Kodak valued at $174-million. Some of today's technology upstarts are the floppy-disk manufacturers of yesterday.
A more recent appraisal of the PSR can be found in James O'Shaughnessy's 2012 edition of What Works on Wall Street. Value investors will be interested to know that in the original edition of this book, the author found that the single best value identifier was a stock's price-to-sales ratio. The more recent edition found that the low PSR continued to perform well, but that it had been supplanted by enterprise value-to-EBITDA (earnings before interest, taxes, depreciation and amortization).
Since we are interested in the performance of high-PSR stocks, his opening comment on the topic is alarming: "High PSR stocks are toxic." Mr. O'Shaughnessy goes on to document that stocks with PSR in the top decile (10 per cent) routinely underperform the market, regardless of the market environment. The only exception appears to be during extremely speculative markets, such as the tech bubble in 1999.
The following quotation from Scott McNealy, chief executive of Sun Microsystems is lengthy -- part of an interview that appeared in Business Week -- but it is the best non-financial explanation I have seen of why a high PSR is toxic for investors. Note that he was speaking in early 2002, so when he refers to "two years ago" he is talking about early 2000, which was the peak of the last technology bubble in the stock market.
"Two years ago, we were trading at 10 times revenue. … At 10 times revenue, to give you a 10-year payback, I have to pay you 100 per cent of revenues for 10 straight years in dividends … That assumes that I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes that I pay no taxes, which is very hard. … And that assumes that with zero R&D for the next 10 years, I can maintain the current revenue rate. … Do you realize how ridiculous those basic assumptions are? You don't need any transparency. You don't need any footnotes. What were you thinking?"
Seven years later, in April, 2009, Sun Microsystems was acquired by Oracle at a PSR of 0.57.
Out of curiosity, I calculated the PSR of the companies listed in the second paragraph, based on the current market cap and the trailing four quarters of revenues. (Current full-year management forecast in the case of Shopify to give credit for the explosive growth trajectory).
- Amazon: 3.1;
- Netflix: 7.2;
- Tesla: 5.7;
- Shopify: 15.5;
- Electrovaya: 7.0
You can decide whether the ratios are toxic.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.