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I like the Price-to-Sales ratio as an alterntive to the PEG as well. Perhaps I'm obsessive, but I put it on (almost) an equal footing with the PEG. To me, a high PSR ratio is a greater warning sign than a high P/E. Here's why:

The real trick is to estimate FUTURE earnings--this is what will make the stock move. For a given company in a given industry, there's a fairly predictable range of long-term profitability (IF the company is managed well). A company above this long-term rate will find there's a ceiling to profits, but a company below this rate (or losing money) has quite a bit of upside potential if they take the right steps.

Let's say Company A is a growing, profitable small-cap stock. Eventually at least one of the following things will happen: (1) industry growth slows down, and it has no more room to grow, (2) it experiences diminishing returns (eg, overexpansion), (3) an unexpected event causes an earnings glitch, or (4) if the market is still growing and profitable, other companies will begin to compete, start a price war, and ALL companies in the industry will suffer. Because Company A had previously done a good job of maintaining high margins, it has a long way to fall when something goes wrong. A high PSR, to me, indicates a limited upside and a large downside.

Let's say Company B has begun to lose money and the stock has tanked. There are certain actions a good management team can take that will probably restore profitability (unless the whole industry has crashed or there's a real fundamental problem). A corporate earnings crisis often allows unusual things to get done (labor givebacks, supplier concessions, cooperation among departments that are normally at odds). Again, IF the management is good, things will improve. If most companies like Company B have 5% profit margins, that's a good earnings target for Company B a year or two out. The upside has become much greater than the downside. I believe a low PSR is one of the best indicators of high upward potential and limited further risk.

In looking for turnaround candidates, I look for a PSR of less than 1, preferably less than .5. (They're hard to find, but if you look in Hoover's stock screen, there are hundreds of them.) Retail and restaurant stocks have historically lower PSRs, but this can be taken into account as well. (Eg, QDIN, one of the Edible 8, had a PSR of about .3 and has recently started to recover beautifully. OOH, I bought ILT hoping for a turnaround, not realizing its PSR was over 4, and sure enough, it's still dropping.) Strange industries like oil and finance I usually avoid using the ratio for (and usuallly avoid buying).

In purchasing growing successful companies, I will personally go up to a PSR of about 2 IF the company has high margins and preferably high market share (eg, I own DWRX and CNXS). Some high-filers have PSRs of 10, 20, or several hundred--I think this is insane.

The research for all this is in Kenneth Fisher's 'Super Stocks' (I know, I'm sure I've referred to this before). If there don't seem to be many stocks in the appropriate range, I like what he says about timing the market, which is basically: 'You don't buy the market, you buy individual stocks. You buy stocks up until the point you can't find any attractive PE and PSR ratios. In that case, you don't buy stocks. There--you've timed the market.'

Anyway, I'll stop floggin' this horse for the moment.

Jack Neefus
College Park, MD

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