Valuation is a concept that Saul self-admittedly does not emphasize. I think I can quickly summarize why. Let’s take two companies:

Company A is at a PS of 15, but the next three years sales will triple (growing at 45%!)
Company B is at a PS of 6, but the next three years sales will be approximately flat

Let’s assume profit margin, etc, are all equal between these two companies. Which company would you want to own? If the share prices do not change by the end of 3 years, company A would now have a PS of 5, while B would still have a PS of 6! But as we know, Company A’s PS wouldn’t come down to 5…the share price would go up. Company B’s share price might actually come down, because a PS of 6 is likely too high for a company that isn’t growing.

Unlike Saul, I do actually look at PS ratio for every company I own. I look at it like a price tag. SHOP goes for 19, Wix only costs me 9. Those are the prices. But that’s all they are. Which is the better company? Which is “worth more” in terms of a PS multiple? I would say Shopify! It’s growing faster, has more sources of revenue, more optionality, etc, etc, etc. Therefore I will just as gladly “pay a PS of 19” for SHOP as I will a PS of 9 for Wix.

That’s how I look at it. You have to be careful not to think that a lower PS means a “better bargain.” Lower PS might just mean less impressive company. In fact, if markets were efficient, that’s exactly what they mean. Thankfully, they are not.

Good example though I think you are not doing a fair comparison.

Company A is at a PS of 15, but the next three years sales will triple (growing at 45%!) Company B is at a PS of 6, but the next three years sales will be approximately flat

In this example you are comparing a high growth company to one with no growth. Once again with both companies we need more information though with company B it is much more important. First of all what are some of the other metrics of company B helping it maintain a P/S of 6 with no growth? Is this a high gross margin SAAS company generating tons of free cash flows? What if company B had a market cap of say $1 billion but it is generating free cashflow of $100 million a year. (not sure if this is realistic or not but just an example) You now have company B generating a 10% return on investment from free cash flows alone. Lets say we had a management that is very shareholder friendly returning 50% of cash flows as share buybacks, 3% dividend yield and retaining the extra 2% on the balance sheet for a rainy day. Now you have a company that is relatively stable with many strong metrics that may appeal to investors. In 3 years the share buybacks will either reduce the P/S valuation or increase the share price through capital gains.

Company B you have a company growing 45% with negative cash flows and negative earnings. They will continue to burn cash from their balance sheet weakening the company’s true value over time as it grows into its market. Yes there is a potential of high returns but at 15x P/S much of that growth over the next 3 years is priced in and the valuation is backed by nothing but this ASSUMED 45% growth rate. What if this growth rate slows? What happens to the 15x P/S since it has no cashflows to put in a bottom. What if the growth rate slows to 20% or 10%? What if the economy slows? Consumers quit buying and in turn companies start cutting costs? This may cause a slowing growth rate at no fault to the company at all. Their product may be wonderful but if consumers aren’t buying they aren’t buying. It happens and there are plenty of examples of once powerful growth companies to prove just that point. All the sudden your high flyer 15x sales company will fall and fall fast. Where will it stop? 10x sales? 5x sales? 3x sales? There is nothing tangible to support the price until the company stops spending and starts generating real cash flows. It really depends on what caused growth to slow and how fast they can turn it into a cash generator instead of a cash burner.

My point is that there are many other factors that go into valuing a company. P/S is just one tool to be used along side many others in determining a fair valuation. High growth and P/S companies are very speculative and a lot of their valuation will come crashing down if that growth slows for any reason.

My point is that there are many other factors that go into valuing a company. P/S is just one tool to be used along side many others in determining a fair valuation.

Maraj,

I appreciate the response, and you’re right, but I believe you missed where I said:

Let’s assume profit margin, etc, are all equal between these two companies.