P/S as Gauge for Optimism

The price to sales multiple is not a valuation metric, contrary to how popularly it is used in this way. Even in such cases, it’s really a comparison tool…of apples to oranges. 

That’s not to say the P/S doesn’t hold value. It does in that sales are the first line item on the income statement. It’s the line that’ll go through the least massaging of all the other subsequent lines thereafter. Not just because it’s the rawest of numbers that show the transfer of money from customers to the organization….but also because if one were to ever trust the auditors that audit the financials, know that priority is placed on the revenue item. It is indeed a case by case with each business model but in my experience, the revenue audit is where all the eyes of partners, senior managers, and managers are focused on. Most other segments are audited by 22-year-olds who realize audit class didn’t teach them anything useful for work. At least, that’s my empirical bias. 

Now, to optimism. 

To make money in investing, one needs to have a different opinion from the majority. This is the case with most pari-mutuel systems. You bet when the odds are highly in your favour and that will only be the case when there is a divergence of your views with the market. This could be the discovery and understanding of a company before others (i.e. AMZN in the early 2000s after the Dotcom bubble). It could also be a difference of outlook where your optimism for the business stretches out for a decade longer than others. Inherent in a long-term outlook is optimism. Hence, one’s ability to look out longer-term could be synonymous with a greater level of optimism than others. 

Such optimism comes into play by making money when the business grows and through the rerating of multiples, usually in reference to the P/S multiple. For any multiple to rerate positively, it requires everyone else in the market to conform to the view that you had before. Everyone else gets optimistic on the idea as well and all kinds of ignorance and cynicism turn to optimism that is taken as a ‘matter of fact’ on the business’s present and future prospects. 

That’s what I think when I see a great business at a P/S of 30. It doesn’t mean the business isn’t great. But there is a whole lot of optimism baked in. It might be just on the fact that everyone else agrees this is a great business. It might also be that they not only know it’s a great business but expect it to great or even better going forward. At the very least, it tells me it’s been discovered.

I could say I have a longer time horizon so it’s okay. But how much more optimistic am I going to get? The longer out I decide to look the greater and greater my optimism need be. This might indeed work but this tight game of eking out a sliver more of optimism seems misaligned with how one would make money in investing. In the movie Margin Call, there is a line on how one makes money in the finance business and the chairman says something along the line of “be first, smarter or cheat”. 

Betting on a 30x P/S definitely means you aren’t first. So, it probably means you think you are smarter but now….are you just falling into the Feynman trap of fooling yourself? Such is the risk. At the very least, the P/S may give me an indication of whether I’m not first and trying to play a game of smarts.