The Price to earnings ratio is also known as the revenue multiple or sales multiple. It is a valuation metric showing how much investors are willing to pay for a stock comparative to its returns. It was founded by Kenneth L. Fisher, an expert in the stock market. He realized investor’s unrealistic valuation when a company experienced some growth. The investors would then panic and sell their stocks when the value of stocks goes below their expectations.
Fisher then came up with the price to sales ratio (P/S) to help solve over-valuation. The sales value is used as a base for the formula since sales don’t fluctuate as the earnings. Accounting practices will not affect company sales; hence they remain stable.
Importance of the Price to Sales Ratio
The price to sales ratio is one of the easiest ways of evaluating a company, as it gives investors a clear picture of how much they are paying for a company. The main objective of a company is to make a profit from the sale of goods and services. The price to sales ratio offers the valuation based on the companies operation without adjusting any accounting practice.
The P/S ratio helps startup companies with no net income or new companies determine their assets’ value. A low price to sales ratio indicates an ideal situation signifying that the company is undervalued. However, the ratio needs to be evaluated from the industrial and historical point of view.
It is also a useful measuring tool for measuring companies with temporary negative earnings or in cyclical industries, indicating revival signs. The possibility of future earnings still exists as long as the company is not facing instantaneous insolvency. For instance, retailers experience revenue fluctuations depending on the season. It is, therefore, possible to have intact long-term profitability while sustaining a periodic loss.
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Interpreting the P/S ratio
The price to sales ratio values a stock relative to its market competitors, historical performance, and the general market. A low P/S ratio means a good buy because investors will pay a smaller amount for each sale unit. However, the P/S offers minimal information because it does not consider any debt or expenses, and a company with high sales may not always be profitable.
Calculating the P/S Ratio
The price to sales ratio is calculated by dividing a company’s shares price multiplied by the number of outstanding shares (market capitalization) by its total revenue or sales over 12 months. A lower P/S ratio will attract more investors. It is a helpful ratio for sizing up stock.
The P/S ratio can be calculated in terms of a per-share basis or a company’s market capitalization.
Market capitalization: (shares outstanding*stock price) / annual sales
Per-share: stock price / (the annual sales / outstanding shares)
Let us look at the following example.
A company has a current stock valued at us $3.75, 120 million shares outstanding with annual revenue of 300 million. The P/S value is calculated as follows.
Per share = 3.75 / (300 / 120) = 1.5
Market capitalization = (3.75 * 120) / 300 = 1.5
The total amount of outstanding shares can be found on the income statement or in the documents notes section, while the total sales are available on the income statement. The sales figures used in the formula can be of varying periods.
- Trailing twelve months
- Last twelve months
- Next twelve months
It is important to time stamp the valuation as the value of price to earnings ratio can change at any time. The P/S value is the expectation value and not the company’s accurate valuation to compare and understand the precise valuation of similar companies in the industry.
Limitations of the Price Sales Ratio
One of its limitations is that P/S ratios differ across different industries; thus, it is difficult to compare companies in various sectors. The valuation can help differentiate an unleveraged company from the leveraged as a company can report a P/S ratio with lower value, yet it is almost insolvent.
Another limitation of P/S value is that it does not give any information on the company’s costs or profitability. Therefore, investors must combine the P/S ratio with other valuation metrics and use them individually.
The price-sales ratio is a pointer that shows a company’s efficiency in making a profit concerning its outstanding debts. The P/S is an essential ratio when used in comparing companies in the same industry. It is also vital in spotting companies in recovery situations or counter-checking to see that their overvaluation does not occur. It also needs to be utilized with other valuation and profitability ratios to accurately establish a company’s financial health.