Where margins are meaningfully above or below a long term average , current earnings are not necessarily a good indicator of sustainable earnings.
EV/Sales is a useful tool for cyclical stocks because it is a shorthand method for understanding sustainable or through the cycle earnings. It does this by normalising margins:
EV/Sales = EV/EBIT x EBIT/Sales.
In the case of Woolworths ($WOW), margins took a step up due to management decisions to stop investing in price. This was great for short term earnings and the share price. Despite the share price re-rating, earnings multiples still looked reasonable. EV/Sales multiples, however, reached record levels (Green arrows).
When margins normalised due to increased competitive activity, the stock fell sharply. The previously low earnings multiples had provided a false value signal. In contrast, the sales multiple had suggested some caution was necessary.
Post the earnings and share price decline, earnings based multiples looked expensive. The normalisation of sales multiples was a better signal for the basing of the share price. (Green circles).
In this situaiton, the EV/Sales multiple did not provide a perfect sell and buy signal. It did, however, contrast with the signal from earnings based multiples. It was a good cross check to prevent too much optimism at the peak and too much pessimism at the trough.
We have examined the application of EV/Sales in relation to cyclical stocks in more detail here…