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When should you sell?
By Bob Tattersall
January 6, 2010
Many investors devote a great deal of time and effort to the search for attractive purchase candidates. A value investor, for example, will likely focus on stocks trading at low multiples of book value, cash flow or earnings. An investor with more of a growth orientation might look at the ratio of price/earnings to growth (the PEG ratio) or attempt to calculate a discounted cash flow valuation based on earnings not yet visible to the naked eye.
Now, let's be optimistic and suppose that your purchase decision has worked out just fine and the stock is up dramatically from your entry level. Or, maybe your broker and friends are promoting their favourite stock, which is up sharply from its low and you fear that the valuation is a little rich for the late arrivals. What ratio can you calculate which tells you it may be time to head for the exit door?
Obviously, you can use the same ratios that triggered the purchase decision: If you had an opinion on what constitutes a low price to book ratio, then presumably you are equally adept at spotting high price to book ratios and this could be your sell decision trigger. Unfortunately, if the stock has gone up a lot, the company's fortunes have also probably improved, along with the profitability, so these higher valuations now seem quite defensible.
In my experience, the best single ratio which tells you that a stock is reaching nosebleed altitude is the price to sales ratio. You can calculate this by dividing total market capitalization (stock price times number of shares outstanding) by latest revenues, or by dividing revenue by shares outstanding to derive sales per share and dividing this into the price per share. Either way, you have a measure of the value the stock market is placing on every dollar of sales revenue.
The benefit of this ratio is that, no matter how fat the profit margins or how fast the revenues are growing, an awful lot of costs, interest payments and taxes have to be paid before a cent of the revenue dollar can flow to the ultimate shareholder.
Clearly, some industries should trade at low price to sales ratios a supermarket chain would be happy to earn a 2-3% after tax margin on sales, whereas a drug company may be unhappy with anything less than 10%, so supermarkets as a group trade at lower price to sales ratios than drug companies. It also means that a low ratio doesn't necessarily represent a bargain it may simply be the norm for the industry. But, a higher ratio is a cause for concern simply because the sales dollar is at the top of the income statement, not at the bottom, when it comes to shareholder value creation.
What represents a high ratio? Think of it this way. If you are paying one times sales for a company and it can generate a 10% after tax profit margin, then you are paying 10 times normalized earnings. That is not an extravagant valuation by anyone's measure, but the after tax margin assumption probably is. So, using a more realistic 5% after tax margin assumption means that at one times revenues you are paying twenty times projected earnings. That may not be nosebleed territory, but the air is getting pretty thin. Which is why I think that when a stock price moves materially above one times sales, you should start looking at it as a sale candidate. If this seems unduly conservative, consider the following quotation from Scott McNealy, CEO of Sun Microsystems in early 2002, following the collapse of the dot-com bubble.
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% of revenue for 10 straight years in dividends That assumes 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 I pay no taxes, which is very hard. And that assumes 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?