The Price-to-Sales Ratio in Stock Valuation
“The largest profits regularly result from buying stocks at low P/S ratios.”
- Ken Fisher, author of “Super Stocks”
The price-to-sales ratio (P/S) is a fundamental metric that calculates the value the market puts on each dollar of a company’s sales.
As any savvy investor knows, success comes from picking the right company at the right price. The price/sales ratio is a tool that can help an investor determine the right price of a stock- answering the question of whether the stock may be currently over or under valued.
The ratio can be calculated as:
P/S = Price per Share/Revenue per Share
-or-
P/S = Market Capitalization/Revenues
Like the price-to-earnings ratio (P/E), the P/S metric reflects a value ratio placed on a stock. Also like the P/E ratio, the conventional wisdom dictates that a lower P/S offers greater value.
Using the Price-to-Sales Ratio in Stock Valuation
A common approach with the Price/Sales ratio is to assume a ratio of 1 represents a fairly-valued company. The investor then hunts for bargains by looking for stocks with a current P/S ratio of less than 1, ideally around .5. This general approach may not be wise, though, as profit margins differ among industries. Instead, the P/S ratio is best used to compare companies within the same industry to determine how well company is performing relative to its competitors within that industry.
The P/S ratio is especially handy with newer companies, small-caps, and companies that are not yet or not currently profitable. During economic downturns when companies in a certain industry may be unprofitable, it can be used as one data point in valuation measures.
Beneftis and Drawbacks of Price-to-Sales
One of the most frequently cited benefits of the P/S ratio is that, unlike earnings, revenue figures cannot be easily manipulated making the measure more accurate and reliable. On the downside, while earnings take debt into account, sales figures do not. A company with a very attractive P/S ratio may not represent a good investment opportunity if it is highly leveraged. It also does not take into account expenses or the operational efficiency of the company.
More on the Price-to-Sales-Ratio in Stock Valuation
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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