The price-to-sales (P/S) ratio is a metric that compares a company’s share price to the company’s revenues. Like other valuation metrics, the P/S ratio allows you dig deeper than the stock’s surface price, helping you decide if the stock is worth its value (or better — undervalued).
How does the P/S ratio work, and how can you use it in your valuation of stocks? Let’s take a brief look.
What is the P/S ratio?
The P/S ratio helps you compare how much value investors place on a company (via market capitalization) to the revenues the company generates for a 12-month period. When you make this comparison, you can easily see if a company is overvalued (a large market cap with lower-than-average sales), undervalued (a small market cap and larger-than-average sales), or valued just right (market cap and sales hovering around the norm for its industry).
How do you calculate the P/S ratio?
To calculate a company’s P/S ratio, you simply divide market capitalization by its 12-month trailing revenue.
P/S ratio = total market capitalization / revenue
The resulting quotient will be a number (such as 3.3). Every industry will have a different “normal” for its P/S ratios. For some industries, a single-digit number will be normal, whereas others will have more double-digit numbers. Whatever the average is for a specific sector, a number lower than the average typically indicates that a stock in undervalued. Investors haven’t valued the market cap high enough, even though the company’s sales are fairly high.
For example, let’s say you’re considering a tech stock for your portfolio. We’ll call it TechieB. At the time of your valuation, TechieB has 12 million shares of stock on the market, each going for around $25 a pop. Its market capitalization is $300 million, which is fairly low for a tech company (we’ll say this is a growth stock). As you dig deeper, you discover that TechieB is generating an impressive amount of revenue. Over the last year, it hit $150 million in revenue. TechieB’s P/S ratio, then, would be two (300 million / 150 million)
What does “two” tell you? Well, it depends on the average P/S ratio for tech stocks. If the average P/S ratio was around six for a specific quarter, then TechieB might be a great buy. The company is undervalued, and you might have an opportunity to buy it at a discount. If the average P/S ratio was lower than two (very rare for tech stocks), then you would probably want to proceed with caution. The stock could be overvalued, and it may not be the best buy for you right now.
How to use the P/S ratio
The P/S ratio is super useful when evaluating companies that have yet to turn a profit (reach “profitability”). Recall that “net profit” is simply revenues minus all costs that a business incurs (everything from employee salaries to the raw materials that make up goods). Start-ups and growth companies may take years before they hit profitability, even if their revenues are fairly high. Because the P/S ratio takes into consideration revenues and not net income, you can better understand if share prices reflect growth, even if profits aren’t coming in yet.
The P/S ratio can also help you measure a company’s current valuation with its past to decide if it’s undervalued. For the best example of this, just look at the e-commerce juggernaut, Amazon. In 1999, Amazon’s P/S ratio was at an all-time high of 40 (for a tech stock, that’s super high). By 2003, the company hit its stride, and it began making immense sales. The price of Amazon’s stock was still relatively low (around US$23), which made the P/S ratio drop to 1.8. If you had noticed the low P/S ratio at that time (versus the much higher P/S ratio of four years previous), you might have bought the deal of the century.
What are the P/S ratio’s limitations?
For one, the P/S ratio one measures revenue, not profits. A company could be saddled with debt, yet still have a fairly high P/S ratio. They may have negative cash flow or never reach profitability, and the P/S ratio wouldn’t necessarily change (though investors’ reactions to this fact could change the ratio).
Secondly, the P/S ratio works best when used to compare companies in the same industry. Because each industry has its own “average” P/S ratio, it would be pointless to try to compare, say, the P/S ratio of a tech company with that of a grocery store.
Foolish bottom line on P/S ratios
P/S ratios can be a great metric to determine if investors’ valuation of a company (as seen in market capitalization) reflects how much a company generates in revenues. Like other valuation metrics, the P/S ratio isn’t meant to be used alone, however. To really understand the value of a stock, you should use the P/S ratio with other metrics, such as the P/E ratio or enterprise value.