Chapter 4: Sales Checks

Introduction

SALES (OR REVENUE) refers to the money received by a company from the sale of goods and services. Sales trends are an important measure of a company’s long-term performance and prospects, as achieving greater profitability over the long term requires growing revenues.

Sales information

Sales information for the past ten years is available on the Morningstar website. Sales figures for the past ten years can be found on the income statement in the financial section of the company profile. Sales per share (SPS) is sales divided by the number of shares outstanding.

Paid for data providers (such as Stockopedia, ShareScope and Zacks) provide consensus broker sales forecasts over the next two years.

Sales growth

Sales growth should be stable or trending upwards, signalling an expanding market for the company’s products or services. If sales are trending down, future rises in earnings are unlikely to continue unless sales growth resumes. Remove companies from the shortlist that have not grown their sales over the past five years. The only exception is if the company has a large market capitalisation (in excess of several billion pounds) and has already experienced a significant fall in price; it may then be worth looking at the company as a recovery play.

Example

Sales growth for XP Power is summarised in table 4.1. The five-year compound annual growth rate (CAGR) for sales is 12.2% (= (166.8 ÷ 93.9)^(1/5) – 1). XP Power has therefore managed to expand the market for its products, or charge more for those products, over the past five years. The CAGR of sales from 2010 to 2017 is 8.9% (= (166.8 ÷ 91.8)^(1/7) – 1). Sales growth has accelerated over the last few years with three-year growth of 18.2% and one-year growth of 28.5%. Broker consensus is that sales growth will slow to 19.3% in 2018 and 6.9% in 2019.

Table 4.1 Annualised sales growth – XP Power

(f) indicates broker forecasts, taken at December 2018.

Sales valuation

The price to sales ratio (PSR) for a company is calculated by dividing the company’s market capitalisation by its sales in the most recent year; or, equivalently, the share price divided by sales per share. It reflects the value placed on sales by the market. A lower value indicates that the company is less popular and potentially better value.

However, it should be noted that the PSR is sensitive to sector differences. For example, companies with high profit margins and strong growth (such as technology companies) typically have high PSRs, while companies with high turnover and low profit margins (such as supermarkets) typically have low PSRs.

In general, a useful guide is that a company with a PSR over 5 is deemed to be expensive, while a PSR below 3 is likely to be good value. A PSR below 1 may offer excellent value. However, companies with PSRs approaching or below 0.1 may be ‘too good to be true’ and should be avoided. Similarly, companies with PSRs above 20 are thought of as very expensive and should be avoided.

Looking at the highest and lowest PSR figures over the past five years helps to give an indication of where future PSRs (and hence prices) might lie. Ideally the current PSR should be below the average company PSR for the last five years. Eliminate companies from the shortlist if the current PSR is above the average of the highest PSRs over the past five years.

It is worth looking at the sector and market average PSRs. This gives an indication of whether the company is undervalued or not against its peer group. If the company PSR is more than 1.5 times the sector average PSR remove it from consideration.

Example

To calculate the PSRs you will need to calculate the sales per share, as Morningstar doesn’t provide this on their company pages or stock profile. Sales per share is sales revenue divided by the total number of shares outstanding. Sales information for XP Power is in table 4.1. While Morningstar doesn’t explicitly state the number of shares outstanding, it can be proxied by dividing the profit for the tax year by reported EPS and multiplying by 100. Alternatively, Stockopedia has up to five years of numbers on its company pages.

To estimate the number of shares outstanding in forecast years you can either use the current number of shares (if the number of outstanding shares has been gradually decreasing) or you can assume that the number of shares outstanding grows at a similar pace to recent history. The CAGR in shares outstanding is 1.0% (= 19.4 ÷ 19.2 – 1). The number of outstanding shares is therefore estimated to be 19.6m 
(= 19.4m × (1 + 1.0%)) in 2018 and 19.8m (= 19.6m × (1 + 1.0%)) in 2019. Sales per share can then be calculated.

Table 4.2 Sales per share calculation – XP Power

(f) indicates broker forecasts, taken at December 2018.

Table 4.3 shows the calculation of the PSR ranges for XP Power. The highest and lowest price the company’s shares traded at in each year are shown in the first two rows. The low price to sales ratio for a given year is calculated by dividing the low price by sales per share (SPS) in the same year. Similarly, the highest price sales ratio is calculated by dividing the high price by sales per share (SPS) in the same year.

Table 4.3 PSR ranges – XP Power

XP Power’s PSR has ranged from 1.8 to 4.2 over the past five years. The average low PSR is 2.2 (= (1.8 + 2.5 + 2.4 + 2.1 + 2.0) ÷ 5) and the average high PSR is 3.3. If the current PSR is below 2.2 the PSR is starting to offer good value, while a PSR above 3.3 is poor value.

Table 4.4 PSRs – XP Power

(f) indicates broker forecasts, taken at December 2018.

Table 4.4 shows the current and prospective PSRs, when the current price for XP Power is 2130p. The current PSR is 2.5 (= 2130 ÷ 860.3). The PSR is expected to fall to 2.1 (= 2130 ÷ 1014.4) in 2018 and 2.0 
(= 2130 ÷ 1072.1) in 2019. This suggests that the shares offer average to good value based on the past range (and good value based on the general guidelines).

Inventory to sales ratio

The inventory to sales ratio is average inventory divided by sales. Looking at this ratio over time provides an indication of how inventory is being managed, since it can signal potential problems with cash flow and profitability.

Ideally the current inventory to sales ratio should be stable or falling. The latter indicates that inventory is shrinking (because it is being sold) or that sales are growing more rapidly than inventory. An increase in the inventory to sales ratio signals that either inventory is growing faster than sales or sales are dropping. A sharp increase in the ratio is often a signal of problems ahead.

Example

Table 4.5 shows the calculation for the inventory to sales ratio. The ratio has remained stable over the past decade, so inventory has grown in line with sales and there is currently no immediate concern.

Table 4.5 Inventory to sales ratio – XP Power

Receivables to sales ratio

The receivables to sales ratio is average accounts receivable divided by total sales. This ratio gives the proportion of sales that are unpaid. If this ratio is high and approaching 1, it means that a significant amount of cash is tied up with slow-paying customers. A high ratio may also be a sign of aggressive or fraudulent booking of revenue, when little of the sales will be converted to cash and sales will be logged as high levels of accounts receivable instead, pushing the ratio up. You therefore want to avoid investing in companies with ratios above 0.70. The ideal situation is for the receivables to sales ratio to be low and for the historic trend to be stable or trending down.

Example

The calculation of the receivables to sales ratio (RSR) for XP Power is shown in table 4.6. The historic RSR is low and has been stable over the past. There are no red flags here.

Table 4.6 Receivables to sales ratio – XP Power

Summary

This chapter has covered a range of sales checks that start to provide insight into the performance prospects of a company. Companies on the shortlist should ideally have the following characteristics:

Revenue checks

· Sales growth is positive and is expected to continue.

· The inventory to sales ratio is stable or falling.

· The receivables to sales ratio is low and stable or declining.

Sales valuation

· The PSR is less than 5, although less than 3 is preferred.

· The company PSR is less than 1.5 times the sector PSR.