Price to Sales (P/S) Ratio is a financial ratio that compares stock price
with sales per share (or market capitalization with total sales). It is
for valuing a stock relative to its own past performance, other companies
or the market itself. P/S Ratio is used in some industries as another
gauge of valuation in addition to the P/E Ratio.
You can calculate the P/S by dividing the market cap of the stock by the
total sales of the company.
P/S Ratio = Market cap (shares outstanding *
market price per share)/Total sales
For example, the P/S ratio is obtained by dividing the market
capitalization by the latest published annual sales figure. So a company
with a capitalization of $1 billion and sales of $3 billion would have a
P/S ratio of 0.33.
You can also calculate the P/S by dividing the current stock price by the
sales per share.
P/S = Stock Price / Sales Price Per Share
P/S will vary with the type of industry. You would expect, for example,
that many retailers and other large-scale distributors of goods would have
very high sales in relation to their market capitalizations, in other
words, a very low P/S. Equally, manufacturers of high-value items would
generally have much lower sales figures and thus higher P/S ratios.
"The largest profits regularly result from buying stocks at low P/S
ratios." These were the words of Ken Fisher, whose theoretical work in the
early 1970s produced this ratio. He used the measure to value stocks,
focusing on companies with P/S ratios less than one.
Much like P/E, the P/S number reflects the value placed on sales by the
market. The lower the P/S ratio, the better for value investors. A lower
P/S ratio is typically viewed as a better investment primarily because the
investor is paying less for each unit of sales.However, this is definitely
not a number you want to use in isolation. When dealing with a young
company, there are many questions to answer and the P/S supplies just one
Advantages of the P/S Ratio
While earnings figures can easily be manipulated, it is much harder to do
so when it comes to sales numbers. Revenues are fairly straightforward and
any tweaks can usually be detected rather easily. This is one of the most
frequently cited benefits of using the P/S Ratio.
The P/S ratio can also be used to evaluate a firm that has failed to make
money in the past year. In highly cyclical industries such as the
automobile industry, sometimes it can be quite tough to post a profit.
Companies may fail to do so for a few years in a row. While this may lead
investors to believe that cyclical stocks are completely worthless, the
P/S ratio may say quite the contrary.
Unless the company is heading towards bankruptcy, this ratio, when
compared to its peers or the industry average, can tell investors whether
or not its sales are being valued at a discount. Let’s say that Reggie’s
Diner (fictitious company) reported negative earnings in the past year,
but has a P/S ratio of 0.72. The industry in which Reggie’s Diner
participates has a P/S ratio of 1.8. This is good news for Reggie’s Diner,
assuming it can start making money in the near future.
Disadvantages of the P/S Ratio
A major problem with the P/S ratio is that sales figures do not take debt
into account, while earnings do. Companies up to their ears in debt, which
may be on the path to bankruptcy, can have low P/S ratios.
Furthermore, the figure does not take expenses into consideration. While
expenses play a key role in the calculation of a company’s profits, they
have nothing to do with a company’s revenues. Sure a company may be
bringing in millions of dollars of revenues, but at what cost? This
practice will eventually catch up to a company.
Lastly, an investor should never make a purchase decision based squarely
on an appealing P/S ratio. Investors should never use any tool as a
one-stop decision maker to uncover stocks that are potentially