The Price/Sales Ratio (PSR as commonly understood, is simply the subject company’s market capitalization divided by its most recent twelve months sales. The PSR was first popularized in Super Stocks in 1984 by Kenneth Fisher, the son of legendary investor Phillip Fisher. In subsequent years, studies have demonstrated the superiority of price/sales over price/earnings.

To be sure, Fisher never advocated the use of price/sales as a stand alone indicator of value. It is just one tool to use when in conjunction with other tools to estimate a company’s value. The PSR is particularly useful when looking at a company without earnings as the more commonly used P/E ratio is meaningless.

According to Fisher, the underlying strength of the PSR, when compared with the P/E ratio, is its consistency or predictability. Earnings can fluctuate widely as we know today. Sales, on the other hand, are more stable. Sales also have the advantage of being less likely to be manipulated. Earnings are, after all, estimates based on accounting assumptions. They fluctuate with one-time expenses, write-offs and short-term changes in margins.

Fisher has been a long time contributor to where he has advocated the use of the Price/Sales ratio. In a 1984 article in Forbes, Fisher provided an important and frequently overlooked modification to the PSR. In this article he introduced what he called the “Debt Adjustment Factor.” As the name implies, Fisher found it necessary to adjust the PSR to reflect both short term and long debt. His DAF can profoundly effect our understanding of the basic PSR. For illustration purposes, we can look at some companies in the aerospace industry and compare PSR’s with debt adjusted PSR’s:

Company PSR Debt Adjusted PSR
Alliant Techsystems (ATK) 0.62 1.93
Boeing (BA) 0.46 3.29
Ceradyne (CRDN) 0.84 0.30
Honywell Int’l (HON) 0.63 1.98
Locheed Martin (LMT) 0.75 15.00

Fisher developed a range of PSR values to measure a company’s popularity in the market. The ranges vary by size of company and between high margin businesses and companies operating industries with inherent thin margins such as supermarkets. Accordingly, small growth companies are unpopular if their PSR is under 0.75 and very popular when the PSR is over 3.00. Similarly, companies with multibillions in sales, such as LMT mentioned above, are unpopular when their PSR is below 0.20 and popular when they are over 0.80. Thin margin businesses are unpopular at the 0.03 level and popular at 0.12.

While the PSR is a key factor in Fisher’s approach, it is clearly not the only factor to consider. Terrible companies can have a low PSR simply because the market sometimes recognizes a badly run company. The other things we need to consider are profit margins, earnings growth and free cash flow.

There is any number of ways to determine if a company’s common shares are priced for positive future returns. Fisher offers us an insight to one such method.