How to spot good value for money – with a big warning

Many valuation metrics can help investors to spot good buys in the stock market, like price-to-earnings and price-to-sales ratios.

However, these metrics should never be used in isolation as they can give a skewed view of the company’s financial performance.

To illustrate the risk of using a single metric to assess a stock, let’s take a look at the price-to-sales ratio – also known as price to revenue – for South Africa’s big telecoms companies.

The price to sales ratio tells you how much revenue per share the firm generates per rand paid for the stock.

It can, without much effort, give an investor a general idea of whether a firm is undervalued or overvalued relative to its competitors in an industry.

The premise is simple – if an investor pays less per unit of revenue, the stock is cheaper than the alternative.

We used this approach to try to spot value in the South African telecommunications industry.

We calculated the price to sales ratios of Vodacom, MTN and Telkom, which indicated that investors pay much less per unit of revenue at Telkom than at Vodacom.

However, this doesn’t necessarily mean that Telkom is a better investment, as the price-to-sales ratio has a significant drawback.

Even though this measure gives meaningful information regarding the valuation of the firm’s revenue, it doesn’t give any information about the profitability of the firm.

The table below provides the net income margin of the same three firms, which paints a completely different picture.

By considering the profitability of each operator, it becomes clear why Vodacom’s revenue is valued higher than Telkom – Vodacom’s revenue is much more efficient in producing net income.

One unit of Vodacom’s revenue produces almost three times more earnings than one unit of Telkom’s revenue.

Telkom may seem like a value opportunity when looking at its price-to-sales ratio, but its elevated debt levels and low profitability compared to its industry peers should raise concerns.

This example shows that price multiple analysis should never be done in isolation to value a company. You should also delve deeper to explain the difference in price multiples.

Only after the difference cannot be explained by other quantitative or qualitative information, you may have spotted a stock which provides good value.