Education: Value Investing

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When to Utilize a Price-to-Sales Ratio

A value investor has a number of tools at his disposal when it comes to determining whether a stock is currently under or overvalued. Peering into his toolbox, a value investor will run across measures such as the price-to-earnings ratio, price-to-book ratio, price/earnings to growth ratio, etc. Digging a little deeper, one can also uncover a revenue-based valuation called the price-to-sales ratio. Let me help you sharpen this handy tool for future use.

Price-to-Sales Ratio Defined

The price-to-sales ratio (P/S ratio), to put it simply, attempts to calculate how much the market values each dollar of a company's sales. The ratio can be calculated one of two ways:

P/S ratio = Price per Share/Revenue per Share

or

P/S ratio = Market Capitalization/Revenues

"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.

As with P/E, P/B and PEG ratios, the lower the P/S ratio, the better for value investors (for the most part—more on this later in the article). A lower P/S ratio is typically viewed as a better investment primarily because the investor is paying less for each unit of sales.

Benefits 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 (see our article on valuing cyclical stocks). 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.

Possible Abuses

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. As we mentioned in our P/B, P/E and PEG ratio articles, investors should never use any tool as a one-stop decision maker to uncover stocks that are potentially undervalued. Make comparisons to the industry average. Moreover, it is highly beneficial to use a P/S ratio in conjunction with other valuation metrics along with earnings estimate revisions and the Zacks Rank. (Learn more about the Zacks Rank).