Investors use the Price to Sales ratio, which is also commonly known as the P/S ratio, to measure how a company’s share price compares to its revenue over the last 12 months. The P/S ratio may also be thought of as how much investors are ready to pay for each dollar of a company’s sales. It is one of several criteria investors use to assess equities and determine whether a specific store is cheap or overpriced. The “normal” or “average” P/S ratio varies by industry. Relative to its share price, the lower the P/S Ratio, the higher is its sales. The P/S ratio is defined as a company’s share price to its revenue. Some investors regard firms with lower P/S ratios than similar businesses in the same industry as cheap in the absence of additional variables (and stocks with higher ratios overvalued).
How to Calculate Price to Sales Ratio
The price to sales ratio is computed by dividing the stock’s market price by the number sold. It may also be determined by dividing its market capitalization by trailing twelve month sales.
Price to Sales Ratio =Stock Price/Sales per Share
Another way to calculate it, is:
Price to Sales Ratio =Market Cap/Trailing Twelve Month Sales
The Price to Sales ratio is commonly used to analyze the value of cyclical equities and is excellent for assessing firms in the investing phase. The ratio illustrates how long it takes for a company’s sales to match its market capitalization. If a company’s Price to Sales is 3, its sales will take three years to equal its market capitalization. Alternatively, the ratio may be considered the amount of money that investors are ready to spend for every rupee that the firm generates in sales.
Company X has $4 million in net revenue and 400,000 shares outstanding. At the time of writing, the stock is trading at $20. This means its market capitalization is $8 million ($20*400,000).
Price-to-Sales Ratio for Company X = 8,000,000/4,000,000 = 2
Now we’ll compare X to Company Y, one of its competitors.
Company Y also claims $4 million in net sales and 400,000 shares outstanding. The stock is now selling for $100. This means its market capitalization is $40 million ($100*400,000).
Price-to-Sales Ratio for Company Y = 40,000,000/400,000 = 10
Investors in Company Y are prepared to pay $10 for $1 in sales, while those in X are only willing to pay $2 for every $1 of sales. Various factors might explain this disparity, so it’s critical to understand what makes Company Y stock so desirable. If you can’t think of a compelling explanation, stock for Company X could be inexpensive and a smart buy.
What’s considered a good Price to Sales Ratio
High P/S ratio : Investors are now ready to pay more per dollar of trailing twelve month sales for a specific company’s shares than they are for other stocks in the same industry, according to a high P/S ratio. This might indicate that the stock is overpriced by the market and is not a good investment. However, because the value is just what the market is prepared to pay for anything, a high P/S ratio might indicate that the firm has a lot of worth that isn’t exclusively dependent on sales.
Low P/S ratio : A low P/S ratio suggests that investors are now ready to pay less for a company’s shares per dollar of trailing twelve month revenue than other stocks in the same industry. This might indicate that the market’s issue is undervalued and represents a good investment opportunity. On the other hand, a low ratio might suggest that market sentiment and other variables unrelated to sales are more important in influencing the price of this specific stock. Stocks with a lower P/E and P/S ratios, on the other hand, appeal to many investors in the long run.
P/S ratios should not be compared across sectors: To explain this, let’s take an example. Starbucks had a P/S ratio of 1.12 on June 21, 2010, whereas Yahoo! had a P/S ratio of 2.56. In other words, Yahoo! stockholders were paying $2.56 every $1 in revenue, but Starbucks shareholders were only paying $1.12. However, the price-to-earnings ratios of the two businesses were nearly similar at the time (Starbucks: 28.09 and Yahoo!: 27.78). As a result, for $1.00 in earnings, stockholders were paying approximately the same amount. On the other hand, the P/S ratios are less comparable because the profit margins of Yahoo! are far more significant than Starbucks’.
Ideal P/S Ratio: The definition of a “good” P/S ratio varies by sector. While balances below two are generally regarded healthy, and ratios below one is occasionally considered extremely excellent, a company’s ratio must be compared to its rivals and the average industry ratio to evaluate how “good” it is in relative terms. For example, a P/S ratio of 2 for a restaurant chain may be deemed low (excellent), whereas a P/S ratio of 2 for a food wholesaler might be considered high (possibly harmful).
Companies in various industries typically have varying P/S ratios; thus, comparing a restaurant’s P/S ratio to a food wholesaler would be like comparing apples to oranges. A food wholesaler may have a larger volume of sales (and consequently a lower percentage) but a lower profit margin. A restaurant with a more significant profit margin may have a lower sales volume (and, therefore, a higher ratio). In other words, owing to variances in profit margins and sales volumes, two businesses might have comparable earnings but differing P/S ratios.
Why Investors Use P/S Ratio
- The Price / Sales ratio measures the market’s willingness to pay for every rupee of sales per share. Especially in the case of high-growth sectors, the P/S balance can be beneficial as a valuation measure.
- The P/S ratio can be beneficial in the case of cyclical sectors. It also works very well in the case of companies where the entire sector is undergoing significant disruption. Telecom is one such example. There is substantial growth in data, but that will take some time to translate into sales. However, the way it is being disrupted, the impact on sales will be substantial and rapid. The P/S ratio will make a lot more sense in such cases.
- When a firm or industry is experiencing a brief downturn, the P/S ratio is a helpful indicator. Earnings may have begun to decline, but you’re not sure how much you can read into the profits tale. If sales continue to expand at the same rate, you can be confident that profit growth will ultimately return. P/S is a decent backup for the P/E ratio in such instances.
- The P/S ratio may be a great way to double-check your valuation process. The P/E rate, for example, is a combination of performance and perception. There are different opinions of different analysts on the quality of earnings of a company. When it comes to the P/S ratio, reality is more important than perception. As a result, the P/S ratio, when paired with the P/E ratio, provides a more accurate picture.
- The price to sales ratio (P/S) has become a popular tool for fine-tuning stock research and valuation methods. While its utility as a stand-alone strategy is limited, it can be beneficial when used with other valuation techniques. The P/S ratio adds a lot of analytical value in the circumstances like loss-making corporations, cyclical companies, and disruptive industries.
Limitations of Using the P/S Ratio
While the Price to Sales ratio is a good valuation metric in general, it isn’t perfect and it has its share of limitations as well. These limitations are:
- The Price to Sales ratio varies greatly between industries, making it difficult to compare firms in different industries.
- Furthermore, it makes no distinction between a leveraged and a non-leveraged business. Due to high-interest expenses, a company with a low Price to Sales ratio may be on the edge of bankruptcy.
- Another disadvantage is that the ratio provides no insight into the profitability or cost structure of the organization. As a result, the Price to Sales Ratio should always be weighed alongside other criteria, including the debt-to-equity ratio, profits growth, and free cash flow.
- Also, the Price to Sales ratio doesn’t factor in the pace of revenue growth for different companies. For example, company X could be growing its revenue at 80% and be trading at 50x its sales. Whereas a company Y could be growing at 2% year on year and be trading at 10x its sales. The low Price to Sales ratio of Company Y would make it seem more appealing over Company X, without factoring in the different rates of growth.
Price to Sales ratio for Cryptocurrencies
Certain crypto investors use a variant of the Price to Sales ratio to evaluate crypto companies. Crypto investors may use a similar ratio to assess projects and protocols in the decentralized finance market, as most are still relatively new and the crypto landscape is evolving rapidly, much like stock investors use P/S ratios to value newer companies or those in growth phases that have yet to report earnings.
In the same way, the ratio is computed (i.e., the market cap is divided by 12-month trailing revenue). “12-month-trailing income” in the crypto world refers to the total fees paid by a blockchain’s users over the previous year. Some investors may perceive crypto projects with lower ratios to be discounted, but the crypto sector is still young and volatile, so measures like these should be used with care.