What is P/S Ratio? How To Use P/S Ratio To Value Stocks?

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 answer.

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 undervalued.