Summary - A company’s price to sales ratio is a valuation ratio that investors can use to determine if a stock is undervalued or overvalued. The standard calculation for price to sales is:
P/S Ratio = stock price/total sales per share (over a 12-month period)
The P/S ratio can also be calculated by dividing a company’s market capitalization by its total sales over a twelve-month period.
The price to sales ratio formula generally uses trailing twelve-month data, meaning it uses sales data for the prior 12 months or current fiscal year. It can, however, be a forward ratio, meaning it is based on sales that are forecast for the current year. Sales are considered a relatively smooth data point, which makes the price to sales ratio a useful tool for establishing a proper valuation for a company by comparing their current price-sales ratio with its historic trend. This is particularly important when a company is in an industry where sales can fluctuate greatly between quarters and years.
This also points out one of the limitations of the price to sales ratio. When comparing one company to another, this ratio is only useful if the two companies are in the same industry. The price to sales ratio also tends to be more useful when a company has unstable earnings or has yet to turn a profit. Many growth stocks can fall into this category, especially when they are first starting up. For more mature companies, the price to earnings ratio may be a more accurate measure.
The P/S ratio also does not take into a company’s cost structure so while the data for calculating the price to sales ratio can be gleaned without studying a company’s balance sheet, the balance sheet should still be examined for a deeper look at potential differences between one company and another.
Introduction
Understanding the difference between price and value is a trait shared by savvy consumers and investors. The choice to buy shares of a stock is often times an emotional decision triggered by what the masses are doing. However, one of the keys to successful investing is to ignore the masses, at times, and look to buy stocks that are undervalued or at least properly valued for their industry.
When a stock is undervalued, it means that there is the potential for it to increase in price. Typically, a stock will become undervalued after a period of selling where investors have either chosen to take profit or are responding to some news regarding the stock. Conversely, when a stock is overvalued, it means that there is the potential for it to decrease in price. A stock may become overvalued after heavy buying activity that creates intense demand for a stock or security.
In order to analyze stocks, investors use a variety of tools, such as ratios. One of the more common valuation ratios is the price to sales ratio (also called the price-sales ratio). The price to sales ratio is a comparison of a company’s stock price to its revenues. In this article, we’ll define the price to sales ratio and take a close look at how it is calculated, its benefits and its limitations.
What is the price-sales ratio?
The price-sales ratio (also termed the P/S ratio or price to sales ratio) is a valuation ratio that investors use as part of their fundamental analysis of a company’s stock price. Valuation is a term investors use to indicate the degree to which a stock is accurately priced. The price-sales ratio does this by comparing a company’s stock price to its revenues.
What the price-sales ratio shows the value that investors are placing on each $1 of sales. Therefore, whether a company’s price-sales ratio is high or low is only important in the context of their industry. For example, a stock for WalMart or Target will generally have a low price-sales ratio because they have small profit margins (i.e. it takes a lot of sales to generate $1 of profit). However, a company like Microsoft that has a large profit margin may report a high price sales ratio. As an investor, you wouldn’t want to compare WalMart against Microsoft based on the price-sales ratio. You may, however, choose to compare WalMart against Target or other competitors in their industry.
How is the price-sales ratio calculated?
The P/S ratio is calculated as follows:
P/S Ratio = stock price/total sales per share (over a 12-month period)
The price to sales ratio formula generally uses trailing data, meaning it uses sales data for the prior 12 months or current fiscal year. When the ratio is based on sales that are forecast for the current year, it is considered a forward ratio.
Here is an example that shows the calculation at work for Amazon and Alibaba. Both P/S ratios are based on data from September 30, 2018.
Amazon
Stock price = $2,003.00.
Trailing twelve month (TTM) sales per share = $443.81.
P/S Ratio = 2003/443.81 = 4.51
Alibaba
Stock price = 164.76
Trailing twelve month (TTM) sales per share = $18.64
P/S Ratio = 164.76/18.64 = 8.84
Based on this example, one might say that, although Amazon’s stock may look more expensive (i.e. it costs more on a per share basis), Alibaba’s stock has a premium value.
Another method of calculating the price to sales ratio is by dividing a company’s market capitalization by its total sales over a twelve-month period. A company’s market cap is usually given with any stock quote, but if not it can be easily calculated by multiplying a company’s stock price by its total shares outstanding.
Why is the price-sales ratio important?
Price movement of a stock is not an accurate reflection of value. Sometimes stock price movement is consistent with its underlying fundamentals even when there is significant price movement in one direction or another. Using a ratio like the P/S ratio can help investors determine if a stock is accurately priced. The price-sales ratio is objective in the sense that it is not based on an analyst’s opinion, but rather a data set. Once the values are entered into the formula, the answer will be the same regardless of who does the calculation.
What makes the price-sales ratio a good indicator?
The input needed for the P/S ratio is straightforward. The stock price is the stock price and the sales are not easily manipulated like earnings can be. A company could, particularly if using forward sales, over or underestimate sales, but considering that most investors will look at historical trends, that will generally be exposed. Sales also tend to have less volatility as opposed to earnings growth, which can be significantly affected by one-time charges or gains.
However, the price-sales ratio is more frequently used, and perhaps more accurate for, young companies that have yet to show a profit or highly cyclical companies in industries, such as construction, where the bottom line can fluctuate significantly from one year to the next.
When should investors use the price-sales ratio?
As mentioned above, the data used to calculate the price sales ratio is pretty straightforward so it allows investors to quickly look at how valuations have changed over time. This is particularly important in cases where a company may be showing large swings over time, such as in cyclical industries.
Another good use for the price sales ratio is when a company has yet to turn a profit or is not showing a high level of profit. For many mature companies, their price to earnings (or P/E ratio) may be a more useful metric, but for companies that are growing but are not yet showing a profit, the price-sales ratio can help determine an accurate valuation. A few other reasons why investors and analysts like the price-sales ratio are:
- Sales revenue is always a positive number, so the P/S ratio has some meaning even if a company is in distress, or has yet to turn a profit.
- Sales are harder to manipulate or distort. Other fundamentals such as EPS or book value can be distorted by legal accounting tactics.
- P/S ratios show less volatility than price-earnings (P/E) multiples.
- When analyzing a start-up company, the P/S ratio will probably be less misleading, and therefore more appropriate, than the P/E ratio. The P/S ratio is also a useful metric for companies that are highly cyclical like construction.
Limitations of the price-sales ratio
The major limitation to the price sales ratio is that it is agnostic in terms of how profitable a business is or may be. Every dollar of earnings (profit) has the same value regardless of how many sales had to occur to create that dollar. That’s why, like any ratio, the price-sales ratio is only useful as a comparison tool when looking at companies within the same industry. Other limitations include:
- Companies who have a significant amount of sales volume due to credit. This will increase their P/S ratio, but not indicate profitability as measured by earnings and cash flow.
- Revenue recognition practices can be different between companies and can distort a sales forecast.
- Although the P/S ratio accounts for sales, it does not give insight into a company’s cost structure.
The final word on price sales ratio
Ratios are a useful tool for fundamental analysis of a company and its stock. Liquidity ratios are helpful for determining if a company has enough cash on hand to meet short-term financial obligations. But once an investor has decided that a company is a good stock to own, they have to determine if it is a good value. That’s where investors use tools such as the price-sales ratio.
The price-sales ratio offers a relative valuation that is only useful to investors when they are comparing one company’s P/S ratio with that of another company. Ideally, this should be done with companies that are within the same industry since P/S ratios can vary widely between industries. This is because the price sales ratio is assigning the value that investors are placing on every dollar of profit a company is making. A grocery store chain may generate a lot of sales, but because its margins are so low it can take a lot of sales to show the same level of profit as a software developer that has substantially higher profit margins.
One of the reasons investors like the P/S ratio is that it uses sales figures which can be harder to manipulate than earnings numbers. However, as companies become more mature, and profitable, the traditional price to earnings (P/E) ratio may be a more reliable metric since earnings will always trump sales in the eyes of an investor.
Aside from the fact that the P/S ratio does not look at profit, some other limitations of the price-sales ratio include companies that account for a significant amount of sales via credit which can inflate the ratio without accurately measuring earnings and cash flow, revenue recognition practices which can distort what and when sales are recorded, and the differences in cost structure between companies. All of these can be mitigated somewhat by ensuring that any comparisons are being done between companies in the same industry.
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