Spotting potential on the cheap

HOW DO you tell if a share is cheap? Investors have widely varying views about which valuation measure is best when spotting undervalued stocks. Some prefer to look at multiples of a company's net assets or earnings. Others favour more complex measures such as economic value added and cash flow return on investment.

When it comes to a rough and ready way of valuing a share, however, few measures are more revealing than the ratio of a company's market value to its revenues.

As we saw yesterday, this valuation method is better suited to some companies than others. Biotechnology and hi-tech firms might be capitalised at many times their annual revenues, but may still be good value because their future growth potential is so enormous. In these cases, however, no multiple of past financial performance will tell a potential investor whether this is the case.

At the opposite end of the scale, however, the same analysis can be more revealing. "What I like about multiples of sales is that the revenue line is one of the most difficult parts of a financial statement to fudge," says one City fund manager. "Companies can fiddle with their earnings but they can't do much with their sales figures."

So we asked Hemmington Scott, the financial information firm, to produce a list of the 20 firms in the FT All-Share index with the lowest ratio of market value to sales. Booker heads the list with a market-value-to- sales ratio of just 0.03. In effect, this means that every pound of the food distribution group's turnover is valued at just 3p by the stock market. None of the firms in the top 20 is capitalised at more than a tenth of its annual turnover.

Of course, these shares are cheap for a reason. The table reads like a catalogue of corporate disaster stories. It includes Albert Fisher, the fresh food group which has issued one profit warning after another in recent years. BICC, meanwhile, has suffered from the prolonged slump in the electrical cables market.

Other firms, such as Costain, the troubled construction group and Danka Business Systems, which is struggling to stave off bankruptcy, are crippled with huge debts. RJB Mining, meanwhile, is facing the prospect of watching the market for its coal disappear when existing supply agreements with the power generators run out.

Some businesses have very slim profit margins. Car distributors such as Pendragon and Evans Halshaw - in bid talks with each other - have long been out of favour with the stock market because of the huge volumes of cars they have to shift to make any profit.

One fund manager says: "The market has basically lost faith in all these companies to earn any kind of decent return on their revenues in the near future."

Nevertheless, using price-to-sales ratios can help investors spot potential recovery situations. For some of the firms in the table, a very small increase in profit margins could have a dramatic effect on their profitability. As a result, the ratio is frequently used by so-called "value" managers looking for cheap stocks.

One portfolio manager says: "A large volume of sales gives you some level of comfort. But it would be folly to even consider making an investment decision without looking at wide a basket of different value measures."

The stock market usually has a very good reason for giving a company a high or low price-to-sales ratio. Potential stock-pickers would be wise to do their homework before they decide to bet against the market.