There is one metric that has been proven to be a good predictor of future stock performance. A researcher named James P. O’Shaughnessy looked at all of the data he could find for a forty five year span and he studied every company’s financial statements for each year relative to its stock price. He looked at every ratio and did a lot of number crunching and actually found one that had a positive correlation with the stock’s performance. If you want to read the book it’s called What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time, but since I have you on the edge of your seat I’ll save you the trouble and reveal this earth shattering statistic:
It’s the Price to Sales ratio (P/S).
Specifically, the lower the P/S ratio the better predictor of future price appreciation it is. If you think intuitively about what the ratio is telling you this actually makes a good deal of sense. The ratio takes the current stock price and divides it by the amount of sales. So in order for the ratio to be small it means that the amount of sales needs to be high relative to its share price. High sales means that the company’s products are succeeding in the market place and a low relative price means that those sales may not be fully reflected in the stock price.
So there you have it. I have revealed the secret to stock market investing and you never have to do any research again except for screening stocks by the P/S ratio right? Well… Not so fast. While the P/S ratio may have been shown to have a positive correlation to stock price it doesn’t tell you anything about the health of the business. It doesn’t reveal the level of debt, economic moat, or the intrinsic value of the company.
So how should you use this information in your research? The P/S ratio can be an input to screen companies to narrow the universe of stocks to look at, but it should not be used as the sole metric to determine whether it’s a good stock or not. The goal of any stock analysis should be to see if it’s actually a good value, and all of the normal assessment of management, financial statements, and the company’s strategy should be reviewed before making an investment decision.