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.