The Valuation Conundrum: P/E Ratio vs. P/S Ratio

Did you buy a stock with low P/S ratio and make a loss? Most investors fall prey to the valuation conundrum. Here’s how to read these ratios.

Man holding magnifying glass over a document

Image source: Getty Images.

“Price is what you pay; value is what you get.” It’s a lesson Warren Buffett learned from Ben Graham. But there is more to this sentence than you think. Most often, new investors confuse value stocks with those whose stock prices have fallen significantly or are oversold. While these measures help shortlist value stocks, price-to-earnings (P/E) and price-to-sales (P/S) ratios are other parametres to identify undervalued stocks. 

In this article, I will solve the valuation conundrum of the P/E or P/S. 

The valuation conundrum 

As an equity shareholder, look at a stock like a business owner, and everything will fall into place. As a business owner, if you were to earn $1 million in profit, you could 

  • Either sell 5,000 products for a net profit of $200/product; or 
  • Sell 200 products for a net profit of $5,000/product. 

When does the P/S valuation matter? 

The first point above is the business of volume, where sales matter more than profit. In that business, you need to look at the P/S ratio. Some volume-driven businesses are retailers like Loblaw and software-as-a-service companies like Lightspeed Commerce (TSX:LSPD)(NYSE:LSPD).

Loblaw and Lightspeed have P/S ratios of 0.71 and 5.72, respectively. The huge difference is because of their size. Loblaw is already a market leader in grocery and has a revenue growth rate of around 2%. Lightspeed is a fast-growing omnichannel commerce platform with a revenue-growth rate of over 100%. Excluding acquisitions, it had average organic revenue growth of 51%, and it expects this rate to slow to 35% in the next five years. A 5.72 P/S ratio is cheap for a 35% revenue growth rate company. It is also below Shopify’s P/S ratio of 8.6. 

As these companies become market leaders, their P/S ratio falls, and their P/E ratio grows. Because once these companies achieve the sales threshold, they tend to become profitable. I will elaborate. In the first scenario, the company aims to earn $1 million by focusing on the 5,000 sales volume. The secondary focus is profit. The company aims to increase profit per sale to $200 or more.

Lightspeed Commerce and Shopify are value stocks based on the P/S ratio. These stocks are not capital-intensive and don’t have a huge debt burden, allowing them to scale. Their P/E ratios matter when they become large-cap stocks with market share and limited revenue growth. 

When does the P/E valuation matter? 

The second scenario focuses on reaching the $1 million target through higher profits. That is where the P/E ratio matters the most. For instance, Descartes Systems (TSX:DSG)(NASDAQ:DSGX) and Magna International (TSX:MG)(NYSE:MGA) have large companies, as their clients and securing these clients take longer. But once these clients come on board, they sign long-term contracts and generate significant profit. Hence, their net income grows faster than revenue. 

Descartes and Magna have trailing P/E ratios of 58.3 and 13.5, respectively. Descartes’s net income surged 26%, while its sales surged 18% in the first quarter. Magna’s EPS fell 40%, while its sales fell 5% in the first quarter. This growth is reflected in the ratio. Descartes’s ratio states that for $80 per share price, you are getting the value of 1/58th the current EPS. This value will reflect in the long term, as you get access to all future EPS and dividends the company pays till you sell the stock. 

Still, the two stocks are undervalued as their sales growth slowed. If sales grow, their EPS will grow faster, making the current stock price look like a bargain. Descartes’s valuation looks like a bargain compared to its peer Kinaxis’s P/E ratio of 212. 

Beyond the P/E and P/S ratios 

When determining which stock to buy, you should look at other factors, like the news, the company’s business, the growth outlook, and the macro environment. The P/E and P/S ratios only tell you if the stock price is inflated or cheap depending on current fundamentals.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

The Motley Fool has positions in and recommends Shopify. Fool contributor Puja Tayal has no position in any of the stocks mentioned. The Motley Fool recommends DESCARTES SYS, KINAXIS INC, Lightspeed Commerce, and Magna Int’l.

More on Stocks for Beginners

money cash dividends
Stocks for Beginners

Have $500? 3 Absurdly Cheap Stocks Long-Term Investors Should Buy Right Now

If you're looking for cheap stocks, these three have a huge future ahead of them, all while costing far less…

Read more »

edit Woman in skates works on laptop
Dividend Stocks

3 No-Brainer Stocks to Buy Under $30

These three stocks all offer a huge deal for investors looking for dividends, as well as growth that will last.

Read more »

edit Sale sign, value, discount
Stocks for Beginners

These 3 Growth Stocks Are on Sale and Set to Surge

Some growth stocks are on sale right now that offer massive long-term potential for investors. Here's a trio to consider…

Read more »

Plane on runway, aircraft
Stocks for Beginners

Up 53% From its 52-Week Low, Is Cargojet Stock Still a Buy?

Cargojet (TSX:CJT) stock is up a whopping 53%, nearing closer to 52-week highs from 52-week lows, so what's next for…

Read more »

Businessman holding tablet and showing a growing virtual hologram of statistics, graph and chart with arrow up on dark background. Stock market. Business growth, planning and strategy concept
Dividend Stocks

TFSA Magic: Earn Enormous Passive Income That the CRA Can’t Touch

If you're seeking out passive income, with zero taxes involved, then get on board with a TFSA and this portfolio…

Read more »

Man with no money. Businessman holding empty wallet
Dividend Stocks

2 Stocks Under $50 New Investors Can Confidently Buy

There are some great stocks under $50 that every investor needs to know about. Here’s a look at two great…

Read more »

potted green plant grows up in arrow shape
Stocks for Beginners

3 Growth Stocks I’m Buying in April

These three growth stocks are up in the last year, and that is likely to continue on as we keep…

Read more »

Growth from coins
Dividend Stocks

1 Grade A Dividend Stock Down 11% to Buy and Hold Forever 

If you're looking for the right dividend stock at the right price, you're going to want to consider this insurance…

Read more »