Many investors use the price-to-earnings ratio as a valuation tool to pick stocks with the goal of finding those that are trading at low valuations, either relative to the market or to the company's historical range. During a recession, this method can prove to be problematic the earnings number used in the denominator can shrink so much that a false signal is created, making this ratio relatively useless.
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Price to Sales
A preferable method might be to use the price-to-sales ratio as a valuation tool. Sales will also decline during a recession, but by less than earnings, which are influenced by the degree of operating leverage the company employs. However, investors should tread carefully before jumping into any low price-to-sales stock on that basis alone, as is demonstrated in the analysis below. (Find out how fixed and variable costs interact to shed new light on old companies in our related article Operating Leverage Captures Relationships.)
I did a screen on the S&P 500 to find the companies selling at the lowest price-to-sales ratios. This list excludes financials, since so many are selling at artificially low valuations.
General Motors (NYSE:GM) and Ford Motor (NYSE:F) are among the top five stocks on the list, trading at 0.01 and 0.06 times sales, respectively. General Motors, of course, is on the brink of bankruptcy and just submitted a financial plan to the U.S. government that outlines its plan to survive both the recession and all the poor business decisions it has made over the last few decades. Ford is only slightly better off, and didn't have to ask for any funds from the government last year to operate.
The third name on the list is retailer Office Depot (NYSE:ODP), trading at 0.02 times sales. Office Depot lost $1.54 billion in 2008 and recently had its debt downgraded by Moody's to 'B1' from 'Ba3'. Office Depot has the misfortune of having its store base concentrated in the formerly coveted states of Florida and California.
Tenet Healthcare (NYSE:THC) trades at 0.06 times sales. Hospital-owner Tenet has never fully recovered from an accounting scandal that occurred almost a decade ago. Tenet recently completed an exchange offer for some of its debt that extended the maturity out to 2015 and 2018. The company posted a loss of $33 million in the fourth quarter and forecasts a loss in 2009, despite sales of approximately $9 billion.
Sunoco Inc. (NYSE:SUN) trades at 0.06 times sales and is notable for being the only company on the list that is profitable. Sunoco is a refiner and marketer of gasoline and other products and also manufactures chemicals. The stock also has a dividend yield of 4.5%.
Price to sales can be a better valuation tool to find stocks during a recession, but the method is not without problems and "cheap" companies found using this method should be examined carefully for defects before purchasing. Investors should apply fundamental analysis to make sure that they aren't buying value traps.
For more on picking stocks in a market downturn, be sure to read Four Tips For Buying Stocks In A Recession.