What is the price to sales ratio? - MoneyWeek Investment Tutorials

Summary

The price-to-sales (P/S) ratio is a crucial financial metric used to evaluate stock valuations by comparing a company's market capitalization to its sales. It is calculated by dividing market cap by total sales over the last 12 months. This ratio is favored for its simplicity and resilience against accounting manipulation, making it particularly useful for rapidly growing companies with limited or volatile earnings. However, it has limitations, including ignoring profitability and not accounting for debt. Investors should use the P/S ratio alongside other metrics and apply it carefully within relevant sectors for the best insights.

Takeaways

• 😀 The price-to-sales (P/S) ratio is a crucial metric for evaluating whether a stock is cheap or expensive.
• 📊 To calculate the P/S ratio, divide the market capitalization by total sales over the last 12 months.
• 🔍 This ratio is simple to compute and interpret, making it accessible for investors.
• 💡 Sales figures are harder to manipulate than earnings, which can lead to more reliable valuations.
• 📈 The P/S ratio is especially useful for analyzing fast-growing companies with little or no earnings.
• ⚠️ While the P/S ratio can signal value, it doesn't account for profitability; high sales can still lead to losses.
• 💰 Be cautious of the 'debt trap'; a low P/S ratio might mask underlying debt issues that could jeopardize a company’s stability.
• 🏦 The P/S ratio is less applicable in financial sectors, where revenue recognition differs significantly.
• 🏢 Similarly, avoid using the P/S ratio in asset-heavy industries, as other ratios like the price-to-book ratio may be more informative.
• 🔑 For a comprehensive analysis, use the P/S ratio in conjunction with other financial metrics to make informed investment decisions.

Q & A

What is the price to sales ratio (P/S ratio)?

The price to sales ratio is a financial metric used to evaluate a company's stock price relative to its sales revenue. It is calculated by dividing the market capitalization of a firm by its total sales over the last 12 months.

How is the price to sales ratio calculated?

To calculate the P/S ratio, take the market capitalization of the firm (the number of shares times the share price) and divide it by the total sales over the last 12 months. Alternatively, it can be calculated on a per-share basis by dividing the current share price by sales per share.

What does a P/S ratio below one indicate?

A P/S ratio below one typically indicates that the stock is undervalued and may suggest strong subsequent share price performance.

Why do some investors prefer the price to sales ratio over the price to earnings ratio?

Investors may prefer the P/S ratio because it is based on sales figures, which are harder to manipulate compared to earnings figures. This makes the P/S ratio potentially more reliable for assessing a company's valuation.

What are the drawbacks of the price to sales ratio?

The main drawbacks include that sales do not equal profits, so a firm could have high sales but still be unprofitable. Additionally, the P/S ratio does not account for a company's debt, which could lead to poor investment decisions if the market is concerned about debt repayments.

In what sectors is the price to sales ratio not recommended for use?

The P/S ratio is not recommended for use in financial firms or asset-intensive sectors, such as investment trusts and property investment companies, because these sectors report revenue differently and may require different valuation metrics.

What can investors do to mitigate the risks associated with the P/S ratio?

Investors can mitigate risks by using the P/S ratio alongside other valuation ratios to get a more comprehensive view of a stock's value and by being aware of the specific context of the industry they are analyzing.

What is the significance of sales figures in the P/S ratio?

Sales figures are significant in the P/S ratio because they represent the fundamental revenue-generating ability of a business. Without sales, a company cannot sustain its operations, making sales a critical metric for evaluation.

What should investors consider when interpreting the price to sales ratio?

Investors should consider the broader context, such as the company’s overall financial health, industry norms, and other financial ratios, before making investment decisions based solely on the P/S ratio.

How does the P/S ratio relate to company growth?

The P/S ratio is particularly useful for assessing companies that are growing rapidly but may have little or no earnings. It can provide insights into valuation when traditional metrics like the price to earnings ratio are not applicable.