What Is Price-to-Sales Ratio?

You’ve made an extensive list of stocks and other marketable securities you want to invest in during the next few months. However, with numerous key Financial Metrics to analyze, it can be daunting to understand which ones to focus on and why. You’ve heard that a common valuation method is to evaluate a company’s price-to-earnings (P/E) ratio and price-to-book (P/B) ratio, but what about the price-to-sales (P/S) ratio?

Although a company’s price-to-sales ratio may not be the first metric you look at, it shouldn’t be the last. Revenue-based valuations like the P/S ratio are considered to be among the “cleanest” of valuation methodologies. Revenues or sales are less impacted than earnings (used in P/E and PEG) or book value (used in P/B) by accounting decisions made by management and the corporate financial structure.

It’s important to know that calculating the P/S ratio is just one of the many ways you can value a company’s stock. We delve into what this specific ratio indicates, how to calculate price-to-sales ratio, what a good price-to-sales ratio looks like, as well as overall limitations of the price-to-sales ratio formula.

What Is Price-to-Sales Ratio?

A number of research studies indicate that using price-to-sales ratios may lead to better investment results than price-to-book-value ratios or price-earnings ratios.

Price-to-sales ratios may identify undervalued firms sooner than the price-earnings approach and avoid some of the accounting complications of the P/E and P/B screens.

Price-to-sales ratios are tied to expectations of future company growth, profitability and risk. Industry knowledge is crucial. A simple screen for low price-to-sales ratios will tend to turn up firms in industries with low profit margins (income divided by sales) or poor sales growth prospects. The higher the expected growth, the higher the price-to-sales ratio that a stock can support. Higher profit margins should also translate into high price-to-sales ratios.

 How to Calculate Price-to-Sales Ratio

Calculating the P/S ratio doesn’t have to be difficult. To find a company’s price-to-sales ratio, all you have to do is divide the current stock price by the sales per share for the most recent 12 months. You can find the current stock price on any website, including AAII.com. Once you find the current stock price, you can calculate the sales per share by dividing the company’s overall sales (found on its income statement) by its number of outstanding shares in the market (found on the bottom of the income statement or balance sheet).

Current stock price ÷ sales per share = P/S ratio

It’s important to note that comparing the P/S ratio must be done between companies in the same industry, similar to the P/B ratio. This is because the ability to turn sales into profits varies for firms in different industries. Also, the price-to-sales ratio does not take debt and other liabilities into account. The issue here is that companies with and without debt could potentially have similar P/S ratios, even though one with debt may be a highly leveraged company that may not make a good investment. Therefore, be careful about solely utilizing the P/S ratio to determine if the stock is viable or not.

How to Analyze Companies by Their Price-to-Sales Ratio

If you take one important fact from this article it would be that the price-to-sales ratio shows how much investors are willing to pay for a stock per dollar of sales.

While the P/E ratio, and versions of it, is the most popular valuation measure, revenue-based valuation methodologies should not be overlooked as a tool for assessing whether a company is inexpensive, fairly priced or expensive. Because these measures are less commonly used, they may lead you to stocks whose bargain valuations have not been uncovered by other investors.

Numerous studies are in agreement about the desirability of investing in out-of-favor stocks as a strategy for obtaining above-average long-term rates of return. The market often overreacts to news—good and bad—by bidding up the prices of companies doing well to the point that they are overvalued, while whittling down the prices of troubled companies to the point that they represent an attractive value.
 
Screening for undervalued stocks on price-to-sales ratio is not a new concept. The technique was first popularized by Kenneth Fisher in his 1984 book “Super Stocks.” Proponents of the price-to-sales ratio argue that earnings-based approaches to selecting stocks are inferior because earnings are influenced by many management assumptions trickling through the accounting books. Basing value relative to sales tends to be more reliable than basing value relative to earnings. Temporary developments—such as costs incurred in the rollout of a new product or a cyclical slowdown—can influence earnings more than sales, often leading to negative earnings. The price-to-sales ratio can provide a meaningful valuation tool when negative earnings render earnings-based models useless.

What Is a Good Price-to-Sales Ratio?

If you’ve just started your research in order to accurately value a company’s overall worth, you’ll want to know what a good price-to-sales ratio versus a bad one looks like. Overall, the P/S ratio is considered a particularly good metric for evaluating emerging, high-growth-potential companies as well as businesses in cyclical industries, companies that offer items or services that are in demand when the economy is doing well like hotel chains and airlines that may not show a net profit each year.

As a general rule of thumb, P/S ratios between 1.00 and 2.00 are generally considered viable and fairly normal and ratios less than 1.00 could be a sign to invest—as long as you look at outstanding debts, revenue and profit margins. Your best bet as an investor is to look for emerging growth companies with low price-to-sales ratios and relatively high profit margins; however, those would be deemed “diamonds in the rough.”

To gain a well-rounded idea of the company you’re about to invest in, you can complement looking at the price-to-sales ratio with examining its operating margin, its enterprise value (market capitalization plus net debt) relative to sales or another revenue-based metric.

Why Should You Compare Price-to-Sales Ratio by Industry?

The main reason you should only use price-to-sales ratios to compare companies in similar industries is because it is extremely difficult to evaluate high profit margin versus low profit margin businesses. For example, if a company isn’t earning a profit yet, investors can look at the P/S ratio to determine whether the stock is undervalued or overvalued.

For some companies, there will be years when earnings and revenue are low because they are cyclical and only produce high profit margins during a booming economy. When the economy is stagnant or not as fulfilling, those same companies will have low numbers. However, that doesn’t mean they aren’t good companies to invest in.

In these more specific cases of emerging or cyclical industries, investors can use price-to-sales ratios to determine how much they are paying for a dollar of the company’s sales rather than a dollar of its earnings.

Limitations of Using the Price-to-Sales Ratio

Advocates of the price-to-sales ratio strategy argue that earnings-based approaches to selecting stocks are imperfect because management assumptions influence earnings. In addition, temporary developments—such as costs involved with new product rollouts or cyclical slowdowns—can affect earnings more than sales, often leading to negative earnings. Simply screening for low price-to-sales ratios will tend to uncover firms that deserve low valuations in addition to promising investment candidates. However, having said this, price-to-sales figures are not infallible. Some common limitations of using the price-to-sales ratio include:

• It’s considered a “rear-facing metric,” meaning it only looks at past performance;
• It can be difficult to use the P/S ratio to track fast-growing companies;
• P/S ratios do not account for debt loads or the status of a company’s balance sheet; and
• You must compare the ratio for firms in similar industries and types of companies.

Criticisms against the price-to-sales ratio do have some legitimacy since sales do not equal profits. Just screening for companies with low price-to-sales ratios is likely to turn up companies with poor profit margins and weak prospects. To effectively use this valuation measure, you should compare the company’s P/S ratio to its past level or to that of companies in the same industry.

How to Find the Price-to-Sales Ratio

On the AAII website, you can search for any stock and find its ticker page. For example, if you type in Amazon.com Inc. (AMZN), the Valuation tab shows key Financial Metrics, including the current price-to-sales ratio as well as the ratio for the past one, three, five and seven years. For comparison, it shows the sector and industry P/S ratios and the stocks’ P/S percentile ranking among all stocks. This process would be similar on any financial or brokerage website you may be using to research potential securities to buy.

Stock ticker pages are a great place to start researching companies you want to invest in before putting your hard-earned money into the market. You can compare and contrast a wide variety of different financial ratios, grades, charts, filings and news as well as events on the AAII stock ticker pages, including price-to-sales ratio metrics.

Learn how to use price-to-sales ratio analysis to your advantage before purchasing marketable securities.

Using the Price-to-Sales Ratio to Invest

Two AAII products include price-to-sales screens investors can use to filter out which companies have the best numbers: Stock Investor Pro, a fundamental stock screening and research database; and A+ Investor, a comprehensive stock screens, grades and rankings suite of tools.

AAII developed a low price-to-sales ratio screen that also considers industry factors and seeks companies with:

• Price-to-sales ratios below historical and industry norms,
• Sales growth above industry norms,
• Liabilities relative to assets below industry norms and
• Relative price strength that exceeds the industry.

The low price-to-sales screen identifies companies with below-average price-to-sales ratios, sales growth that exceeds industry norms, reasonable levels of debt, and above-average price performance relative to its industry. However, you need to view the companies passing this screen as a starting point. The stocks passing this or any other quantitative screen do not represent a “buy” or “recommended” list.

Overall, it is important to perform additional due diligence to verify the financial strength of passing companies and identify those stocks that match your investing tolerances and constraints before committing your investment dollars. Check out Stock Investor Pro or A+ Investor to screen for low price-to-sales ratio companies to invest in.