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Is P/S the Best Valuation Metric in This Environment?

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The pandemic has introduced never-before dynamics into investment decisions, pushing people to develop both short-term and longer-term strategies to minimize the risk to their portfolios.

If you’re already scarred from the initial hit and haven’t quite recovered yet, this is going to be a tough situation to play. Especially because the markets have rallied hugely since then, with most companies resoundingly beating lowered expectations and leading analysts to readjust their estimates for the rest of the year. Obviously, this situation isn’t going to continue forever.

And when things get tougher, you have to be that much more careful about what you invest in. One thing that the decision to buy, sell or do nothing depends on is the valuation. But since there are so many ways of valuing a stock, it can be difficult to select a suitable method. Moreover, even after you’ve chosen a particular method, it pays to check the valuation based on the historical performance and compare with a broad market index like the S&P 500 and/or the market segment in which the company operates.

So let’s say for example that we are valuing on the basis of the price-to-sales ratio (P/S). This is basically the market value of all the shares of the company (market capitalization) divided by the sales in the last-completed year or expected sales in the current year.

If this value is less than 1, it means that the market values the stock at less than its annual sales, which would seem to indicate that the stock is undervalued.

Of course, a company has to incur expenses in order to generate sales, so the value left over after accounting for these expenses, i.e., the profit, is what investors are usually more concerned about.

In unforeseen situations like the pandemic however, companies may have to incur extra expenses. These could be in the nature of adjusting processes to facilitate social distancing and providing masks and PPE (like Amazon had to do). Or it could be tied more directly with operations (as Beyond Meat did when it re-allotted products meant for foodservice to retail and discounted these to capture market share). If financially sound, companies could also be driven to increase headcount more cost-effectively as labor is more easily available in this environment (it’s what Facebook, Amazon and Alphabet did among many others).

In general, larger companies or those with substantial revenues are better positioned to take charges against revenues with minimal impact on profits, while smaller, relatively new, or those generating only a small amount of revenue could find themselves making losses even while posting impressive revenue growth. This doesn’t mean they don’t have value. If they have for example key technology or information that they are in the process of monetizing (like a small tech or biotech company), this innovation could be valuable, although not on the basis of earnings. This is typically the kind of situation where the P/S metric is very useful.

Taking the P/S a step further, we can deduct balance sheet debt and add cash on hand to the market value before dividing by the annual revenue. This EV-to-sales (EV/S) metric as it’s called is useful for valuing companies that also have a certain amount of debt.

That’s because it’s a more exact tool, representing the true purchase value of the company per unit of sales. When this value is less than 1, there’s a good chance that the shares are undervalued. When at a discount to the industry to which it belongs, it’s an additional sign of undervaluation. Make sure that the forward sales growth estimate is positive, add other valuation metrics like the PEG (which should ideally also be below 1) and combine with other positive indications to pick your stock like I’ve done below-

Aarons, Inc. (AAN - Free Report)

Aaron's is a major omni-channel provider of lease-purchase solutions, mainly to underserved and credit-challenged customers. Through its various business segments, the company primarily deals in sales and lease ownership, apart from specialty retailing in furniture, home appliances, consumer electronics, as well as accessories. Popular brands at Aaron's include Philips, Samsung, Whirlpool, Hewlett-Packard, LG, Simmons, and Ashley, among others.

The company announced that it is splitting into two (Progressive and Aaron’s) by way of a tax-free distribution of shares to improve focus and increase long-term shareholder value. The reconstruction is expected to be completed by year-end.

Zacks Rank #1

VGM A

Industry: Retail - Consumer Electronics (top 8%)

June quarter earnings surprise 43.9%

2020 EPS estimate up 42 cents (12.1%) in the last 7 days

Estimated 2020 EPS growth 0%, 2021 growth 11.0%

Estimated 2020 sales growth 4.4%, 2021 growth 8.6%

Valuation: EV/trailing 12 months’ sales of 0.88X is below the median value of 1.03X over the past year while the industry is at its annual high of 0.44X. The PEG is 0.94. Therefore, on both counts, the shares are undervalued.

Companhia Brasileira de Distribuicao (CBD - Free Report)

Founded in 1948 and headquartered in Sao Paulo, Brazil, Companhia Brasileira de Distribuicao or Grupo Pao de Acucar ("GPA") is the largest traditional retailer in the food segment in Brazil and the second largest player in the cash and carry segment. It sells food, clothing, home appliances and other products by means of hypermarkets, supermarkets, specialized stores and department stores.

Zacks Rank #2

VGM A

Industry: Retail - Supermarkets (top 43%)

In the June quarter, it reported earnings of 19 cents, up 10 cents from the year-ago quarter

2020 EPS estimate up 5 cents (7.6%) in the last 7 days

Estimated 2020 EPS growth 61.4%, 2021 growth 47.9%

Estimated 2020 sales growth 39.8%, 2021 growth 8.4%

Valuation: EV/TTM sales of 0.28X is below the median value of 0.32X over the past year while the industry is at its annual high of 0.66X. The PEG is 0.85. Therefore, on both counts, the shares are undervalued.

Graphic Packaging Holding Company (GPK - Free Report)

Graphic Packaging, headquartered in Marietta, Georgia, is a leading provider of paperboard packaging solutions for a wide variety of products to food, beverage and other consumer products companies. Graphic Packaging's customers include some of the most widely recognized companies in the world.

Zacks Rank #2

VGM A

Industry: Containers - Paper and Packaging (top 8%)

June quarter earnings surprise 36.8%

2020 EPS estimate up 9 cents (9.4%) in the last 30 days

Estimated 2020 EPS growth 20.7%, 2021 growth 6.0%

Estimated 2020 sales growth 4.5%, 2021 growth 1.5%

Valuation: EV/TTM sales 1.11X is at a discount to the median value of 1.15X over the past year although the industry, at 3.27X is at a steeper discount to the median value. Although above 1, this stock is still worth investing in because the value is lower than the average the historical average. The PEG is 0.55. Therefore, the shares are undervalued.

Meritage Homes Corporation (MTH - Free Report)

Based in Scottsdale, AZ, Meritage Homes Corporation is one of the leading designers and builders of single-family homes.  It builds and sells its single-family homes for entry-level, first-time, move-up, luxury and active adult buyers in historically high-growth regions of the United States.

Zacks Rank #1

VGM A

Industry: Building Products - Home Builders (top 2%)

June quarter earnings surprise 56.6%

2020 EPS estimate up $3.08 (50.6%) in the last 30 days

Estimated 2020 EPS growth 42.8%, 2021 growth 13.3%

Estimated 2020 sales growth 16.4%, 2021 growth 8.2%

Valuation: EV/TTM sales of 1.07X is 1.8% off its high point over the past year while the industry is 5.6% off at its annual high of 1.24X. The S&P 500 is off by 3.8%. The PEG is 0.94. Therefore, the shares are undervalued on PEG and given all the other positives, there may be further upside.

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