Market Cap vs. Revenue: The Implications of 20x P/S Ratios

For a quick primer on price-to-sales ratios, please scroll to the end of this piece. This analysis was run at the request of the wonderful folks at Trapping Value from Seeking Alpha. We want to thank them for the thoughtful question and encourage our readers to check them out if you haven’t done so already!

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A Fast & Furious Review of Overpriced Stocks: Based on survival rates, batting averages, and analysis of 1-, 2- and 3-year holding horizons, investing in stocks valued at >20x P/S is a catastrophic decision.

• Buying stocks at 20x P/S ratios can be akin to placing some of the worst casino bets
• The outcomes of casino bets happen much quicker, so they are possibly worse but…
• …at least you get free drinks while you lose your money

Survival Rates: The Demerits of Delisting

• Figure 1 shows the percent of firms at > 20x sales that delist at the 1, 2, 3, and 10-year forward horizons
• The numbers for 2 & 3 years are catastrophic, with nearly a fifth of stocks gone by year 3 (18%)
• By the 10th year, so many firms have delisted, 55%, this is not a viable strategy to even try and test

The Brutal Beating of Batting Averages

Having shown that the 10-year holding horizon is a disaster, we looked at the 1, 2 & 3 year forward batting averages. By “batting average” we mean the odds a given stock valued at 20x sales beats the S&P500

• Stocks over 20x sales only beat the market 31% of the time over a one-year holding horizon
• Stocks over 20x sales only beat the market 25% of the time over a two-year holding horizon
• Stocks over 20x sales only beat the market 23% of the time over a three-year holding horizon

Per our lead in comments: This is not a strategy as much as it is a very bad gamble…

1 Year Buy & Hold of Stocks over 20x P/S

• The below shows how buying all the stocks > 20x P/S in each year and holding them for 1 year fared
• The results are horrible with very few exceptions, including 1998, 2003, 2019 and 2020
• The data here is useful as a possible flag for when speculation gets “hot” and when to be careful…careful is the word of the day!

Stocks valued at 20x price to sales or higher are chronic losers. After years they have won, they often go on to implode.

2 Year Buy & Hold of Stocks over 20x P/S

• The below shows how buying all the stocks > 20x P/S in each year and holding them for 2 years fared
• The results are horrible and merely amplify the findings of the 1 year buy & hold chart above
• The incredibly rare instances of 20x stocks actually outperforming are followed by disaster

3 Year Buy & Hold of Stocks over 20x P/S

• The below shows how buying all the stocks > 20x P/S in each year and holding them for 3 years fared
• The results are, with one exception in 1997, horrible
• The conclusion is: buying stocks over 20x sales is a terrible idea based on virtually all historical methods of analysis

This analysis is brief, brutal, and clear: buying stocks at these valuations is pure speculation. Ironically, recent promises of exponential returns often revolve around these overpriced stocks – an issue we explained in “Apple II Flashback.” With legendary investors like Jeremy Grantham warning that this superbubble is likely to implode, we believe the risks to these stocks are uncommonly high.

Price to Sales Ratio Meaning & Basics

KCR’s tools are intended for sophisticated investors, CFPs, FAs, and other RIAs. We recognize that a new investor or someone who is just rusty on basic investing terminology may have found this work with free posts like these. This post will walk through the basics of a price to sales ratio.

A stock’s price to sales ratio is calculated by dividing the total market capitalization of the firm by the total sales of the firm over the trailing twelve months. Firms where the price/sales ratio is high means that the stock market has valued the company at a high level relative to the amount of sales the company is generating.

Conversely, if the price to sales ratio is low (say below “1”), that means the company’s market cap is low relative to the firm’s revenues. One of the bizarre items we would highlight is that it is very common for stocks at these valuations to be issuing shares. For a quick example, read our notes on Robinhood, which increased its outstanding shares by over $1bn in a single quarter to pay executives.

In the paper above, we are using an obscene example of some of the most speculative stocks in US history – stocks that are valued over 20x price to sales. As we are fond of quoting, legendary CEO of Sun Microsystems, Scott McNealy explained why even 10x price to sales was an impossibly difficult valuation. More generally, however, price to sales ratios help us rank comparable companies’ valuations.

The KCR research team often uses price-to-sales valuation metrics instead of price-to-earnings as there are so many loss-making firms today that P/E ratios have become a noisy mess. If a firm is losing money, we are effectively forced to sort companies by their sales per share.

This becomes particularly useful when comparing companies with negative profit margins, negative cash flow, and very high share prices.