The price you have to pay for sales is a favorite indicator of the value investor, and is far more robust than PE ratios. For example, a few months ago everyone treated INTS as a relatively low PE stock, but now its PE is three-digits. After it reports its next quarter earnings, it will be higher yet. Microware doesn't even have a PE ratio, since it is losing money. But both of these companies and WIND have a PS ratio that seem to make better sense of value: 5.31 for INTS, 3.35 for MWAR and 13.9 for WIND. All things being equal, these PS ratios seem to indicate that MWAR is the cheapest buy, followed by INTS, with WIND being most expensive.
Does this mean that WIND's high PS ratio should be a cause for concern, that the stock shouldn't be bought at less than the industry average, and perhaps the stock deserves to be shorted at these high levels? Would professional traders short WIND because of its excessive PS ratio?
The answer is that the high PS ratio is not a problem, it is not a signal for professional traders to short, and like it or not, WIND's PS ratio may be headed higher, not lower. While it is true that value investors like really low PS ratios, nevertheless some companies have and deserve to have exceptionally high PS ratios for a very good reason. To see this more clearly, consider the following:
PE ratio = Price/Earnings = Price/(Sales*Net Profit Rate)
Thus, PS ratio = PE ratio * Net Profit Rate.
This means that the PS ratio is the combination of two factors: the PE ratio and the Net Profit Rate. The PE ratio reflects the price the market is willing to pay for current earnings in order to have a share of future earnings, and thus contains all market expectations concerning growth in earnings as well as the time value of money. If all the embedded systems companies were expected to grow earnings at the exact same rate, their PS ratios still would differ in direct proportion to their respective rates of profitability.
INTS currently has a 3.2% net profit rate, and a five year average rate of net profit of 8.2%. The industry average currently is 4.3%. As you look to the future, a reasonable expectation for INTS rate of net profit would be around 5%, i.e., about the average for its industry. The reason for not expecting more is that the company is growing its low-margin services business at a much faster clip than its high-margin product sales. Similarly, one might presume optimistically that one day MWAR will reach the average of its industry, say 5%.
WIND is different. WIND's net profit rate has been steadily growing as product license sales and royalties have grown robustly over recent years. Net profit rate grew from 12.2% in FY 1996 to 17.6% in FY 1997, and is on track to end this fiscal year at 18.8%. The increase in the rate will continue steadily almost reaching 25% by FY 2001.
This means that, under identical assumptions of earnings growth, WIND normally will enjoy a PS ratio four to five times greater than INTS and MWAR's. Viewed differently, if one adjusts for WIND's extraordinary rate of net profit, then WIND's PS ratio of almost 14 equates to ordinary PS ratios of around 3.25. While this is not low enough for classical value investors, it is reasonable for software companies.
All this means that WIND's high PS ratio is justified as long as both its PE ratio and the net profit rate remain high. I would expect the PE ratio to gradually decline to 50 or 60 over the years. But this decline will be offset by a gradually increasing net profit rate, resulting in a relatively stable, and possibly increasing, PS ratio.
How do I know WIND's PS ratio will not trigger professional short sellers? The proof is by taking the negative and showing it reduces to the absurd. Suppose a professional short seller shorts WIND on the basis of its high PS ratio. That professional will get his/her clock cleaned, and will no longer be a professional short seller. This contradicts the assumption that he/she is a professional short seller, proving my proposition.
In all seriousness, traders that sell WIND short are doing it on the basis of momentum, not the PS ratio.
Allen |
