What is Price to Sales (P/S) ratio
Price to sales is a financial metric typically used in stock valuation, which relates de price of the company (market capitalization, the total number of shares outstanding times the price per share) with the revenues said firm generates over a year.
How is Price to Sales ratio calculated?
It may be calculated on a total basis (annual revenues divided by market capitalization), or on a per share basis (revenue per share divided by the stock price).
Additionally, you may use past (trailing) revenues or next year (revenue guidance) to assess the ratio, but in both cases bear in mind that you’re using one year data, and so a very specific timeframe. Also, in a very volatile business, like commodities (think of an oil extracting firm or a mining company) revenues could vary wildly from one year to the other, so you may consider using normalized revenues instead of year specific, otherwise your valuation estimates will tend to overvalue or undervalue depending on the year bias.
What’s the meaning of Price to Sales ratio?
In principle, the lower the ratio, the lower the investor must pay to own a dollar of revenues, the better.
Price to sales can vary greatly from industry to industry, among other things because profit margins do. Therefore, many investors use price to sales as a rough measure of company value in relation to company peers. For those of you who like the math, if you divide the Price to Sales ratio by the Net Profit Margin, you get the Price to Earnings ratio (or earnings multiple).
It wouldn’t be wise to compare price to sales of companies from very different industries, say a high margin service company with a high turnover low margin of a commodity business. And even in the same industry, different business model or strategies can also result in distinct profit margins.
What is Price to Sales used for?
One of the advantages of price to sales (PS) is that it can be applied to any company with revenues, whether reporting net profits or losses, whereas Price to Earnings (PE) can’t.
Price sales may be adept for valuing high growth companies, in which growth is more correlated with higher revenues than with earnings, which can be temporarily affected by varying yearly margins.
Price to Sales ratio makes emphasis in the size of the business, the rationale being that if you’re the (new) owner, you may change the financial structure of the company (take more debt or repay it entirely for example) and that you might take advantages of merging synergies to cut costs and improve profit margins. In this way, Price to Sales may provide insight for the takeover company in case of a merger.
Price to Sales ratio and financial position
One shortcoming of the Price to Sales ratio, is that it doesn’t consider financial strength. All else being equal, a company with little to no debt should have a higher PS ratio than one near bankruptcy, even if revenues are the same. Ok, how higher? That isn’t for this ratio to say.
Just as Price to Earnings may be adjusted by the net debt position, so can Price to Sales. In this improvement, you may use Enterprise Value (Market Capitalization, plus Debt, minus Cash and equivalents) instead of just market capitalization.
Price to Sales summary (TL;DR)
Pros of Price to Sales ratio
- Useful to get a rough comparative valuation of a company.
- May still be applied even if the stock is reporting losses or doesn’t generate cash flows yet.
- May help keeping track of high growth companies.
- May give valuable insight in case of a takeover merger, when being able to change both the financial structure and profit margins of the acquisition target.
Cons of Price to Sales ratio
- It doesn’t consider differences in profit margins, therefore not comparable through different industries or business models.
- Current financial strength or weakness is ignored. An attempt to improve it would be by using Enterprise Value instead of Market Capitalization.
- Other important factors aren’t considered in the ratio per se, like capital allocation, growth prospects, return on invested capital, among many others.
- Ratio loses usefulness when the business is very volatile, and revenues vary greatly from year to year. Using normalized revenues could help alleviate this point.