Price-to-Sales (P/S) Ratio Basics - YouTube

The price-to-sales ratio is a tool that investors use to help determine if a company is cheap

or expensive compared to other companies within its industry group.

It compares a company’s stock price to its annual revenues per share, which tells investors

how much value the market puts on each dollar of revenue earned.

The ratio is typically used as part of fundamental analysis, an approach that focuses on a company’s

financial reports to evaluate whether it could be a good potential investment.

Let’s break down the price-to-sales ratio and discuss some of its uses and limitations.

First, let’s look at the calculation.

The price-to-sales ratio divides the company’s stock price by its annual sales or revenue

per share.

Revenue can be found on the top line of the company’s income statement.

It’s the amount of money the company brought in from its normal business operations, aka

sales of its goods or services.

Revenue per share is that revenue divided by the total number of outstanding shares

listed in the equity section of the balance sheet.

By dividing the stock price by the annual sales per share, we see a number that works

as a ratio.

A price-to-sales ratio of one, means investors are paying $1 for every dollar of sales.

A ratio of two means investors are paying $2 for every dollar of sales.

A ratio of .5 means investors are paying 50 cents for every dollar of sales.

Broadly speaking, the lower the ratio, the better, because this means the company can

generate greater sales per investment dollars.

For example, company A has a price-to-sales ratio of 7.5 while the industry’s average

is 18.1.

This suggests that the company is much more efficient at turning investment dollars into

sales than other companies in the industry group.

Now, suppose you’re considering two stocks in the same industry group.

Company B has a price-to-sales ratio of 2.9.

This is lower than the first company and the industry group.

Some investors may interpret this as a sign that company B is a better value than company

A because company B may have a higher likelihood of providing a return on investment and possibly

faster than its competitors.

When comparing companies using ratios, it’s best to compare within the industry group.

For example, in January 2021, the average price-to-sales ratio for the Technology Services

industry group was 15, but for Oil and Gas Consumable Fuels, the industry group average

was 4.

Oil and gas companies tend to have greater debt loads because they have greater expenditures

on equipment.

Different industry groups often have different financial structures so comparing across industries

may you give you an inaccurate picture.

Many investors use the price-to-sales ratio to supplement their analysis of a company’s

earnings because it can help reduce some of the distortions that come with earnings.

The price-to-sales ratio focuses on the ability of the company to sell its products and services.

Additionally, the price-to-sales ratio can be helpful for evaluating young growth companies

that aren’t yet profitable.

For example, strong sales figures can signal a company’s potential before it turns a

profit.

Of course, there’s no guarantee that a low price-to-sales ratio will result in the company

eventually being profitable.

For example, the price-to-sales ratio doesn’t tell you how well management controls expenses

like rent, utilities, wages, and interest payments.

A company could have high revenue but also high expenses and end up with a net loss.

Investors need to conduct further research to determine if a company’s management team

can turn sales into earnings.

Return on equity, return on assets, return on investment, and revenue per employee are

financial ratios that help investors evaluate management effectiveness.

Whether you’re looking to invest in startups or in established companies, the price-to-sales

ratio is an important valuation tool that offers insight into how much investors are

paying for each dollar of sales a company produces.

But, like any analytical tool, the ratio should be used in conjunction with other valuation

methods like the price-to-earnings ratio or the return-on-equity ratio.

Looking at the details of a company’s financial performance can help you determine if it’s

a sound investment.