A Modified Price-Sales Ratio: A Useful Tool For Investors?

Abstract

This study compares returns for stock portfolios using low price-to-earnings, price-to-book, price-to-sales, and price-to-sales ratios modified for profitability of sales and long-term debt. Non-financial companies with fiscal years ending on December 31 were included in a sample covering a 17-year period (1988-2004). The resulting sample was sub-divided into six groups by level of market capitalization. A 25 stock portfolio was then compiled for each of six valuation ratios at each level of market capitalization. An index portfolio was also computed for each level of market capitalization. First, the results of this study showed that additional expected returns based on firm size, measured by the market value of equity, is found only at the micro-cap level (less than $25 million market capitalization). The index portfolios of mini-caps ($25-100 mill.), small caps ($100-500 mill.), and mid-caps ($500-$1 bill.) did not show any additional returns in comparison to the large-cap index portfolio. Second, no "value" portfolio for mid-caps provided significant returns above the index portfolio, suggesting a much greater level of market efficiency at this level of market capitalization. Finally, the most significant findings of our study were that the portfolios constructed from low price-to-sales and modified price-to sales ratios performed as well or better than the more traditional price-to-earnings and price-to-book ratios. The price-to-sales ratio adjusted for profit margin (based on the prior three years) was statistically significant in three of six portfolios in comparison to the more traditional valuation ratios.