I was listening to Bloomberg News on the radio the other day, when a stock market reporter began a segment of an afternoon show by mentioning a a study he’d received of US stock market valuation based on price to sales rather than PE.

“Why sales and not earnings?” asked the show host.

The reporter had no clue. (An aside: it’s not clear to me whether this host asks probing questions of this particular reporter despite the fact he never can answer them or because he can’t.  I also sometimes wonder how aware each party is of the dynamics of their interaction–showing I must have too much time on my hands.)

Anyway, I decided to write about using sales as an analytic tool.

First, I should be clear that I’m not normally a fan of price to sales.  That’s probably because I’m a growth stock investor and am most often seeking out situations where profits are going to expand faster than sales..

To answer the host’s question as best I can:

Some companies are highly cyclical, like American autos or semiconductor equipment makers.  In bad times, they still have sales but may be posting losses.  Yet nobody pays you to take the shares off their hands; the stock trade at a price greater than zero.  In other words, at market bottoms they trade on something (i.e., sales or assets) other than earnings.  Similarly, as the economy recovers and the profits of deep cyclicals begin to explode to the upside, the PE multiple they sport progressively contracts.  In many cases, profits continue to surge but the stock price stops going up–because investors are anticipating the next dip of the cyclical roller coaster.  Again, they’e not trading on earnings.

So, at market bottoms the losses from cyclicals reduce overall index earnings, making the market look more expensive than it arguably should be.  At market tops, the stingy multiples that investors apply to peak earnings can make the market look misleadingly cheap.

Both distortions are eliminated, or at lest mitigated, by using price/sales.

Also, one might maintain that price/sales allows a better comparison between past decades, when a large portion of the market consisted of deep cyclicals, and the present, when the cyclical content is much smaller.

More tomorrow.