Valuing A Stock: Price-To-Sales Ratio

A "ratio" is defined as being a relative comparison of one value to another.^[1] In terms of stock and investment valuation, ratios provide an analyst, investor or trader a statistic by which an individual company's performance can be placed in context with competing companies. Price to sales (P/S), price to earnings (P/E) and price to book (P/B) are a few ratios commonly used by the financial industry to quantify company performance.

Price-To-Sales Ratio (P/S)

The price-to-sales ratio (P/S) establishes a relationship between the value of a corporation's stock and its annual revenue. A price-to-sales ratio can be calculated in terms of a company's market capitalisation or on a per-share basis.

Price-to-sales ratio formula:

• Per Share: (Stock Price) / (Annual Sales/Shares Outstanding)
• Market Capitalisation: (Stock Price*Shares Outstanding)/(Annual Sales)

For instance, company ABC has a current stock price of US$3.25, 150 million shares outstanding and an annual revenue of US$500 million. The current P/S values are calculated in using either of the following methods:

• Per share: (3.25)/(500/150) = .975
• Market Capitalisation: (3.25*150)/500 = .975

Applications Of Price-To-Sales Ratio

The P/S ratio is an indicator that illustrates a company's efficiency in generating revenue with consideration to its outstanding debt. It is important to remember that the P/S ratio is most useful when viewed in comparison to companies within the same sector. Without the proper context, the statistic can appear abstract and lose significance.

A P/S ratio is based upon publicly disseminated data. Stock price, shares outstanding and total revenue figures are publicly known and not derived by the corporation for release to the market. In comparison, a price-to-earnings ratio, or P/E, is dependent upon the implementation of company-specific accounting practices in order to arrive at the net earnings divisor. Due to the statistics used in each calculation, the P/S ratio is not easily manipulated.^[2]

The P/S ratio is particularly useful in evaluating cyclical companies, or companies that are not currently profitable. As long as a company is not faced with immediate bankruptcy challenges, the possibility of future earnings exist. For example, in the case of a retailer, revenues often fluctuate with the season; it is possible for a company to sustain a periodic loss while longer-term profitability remains intact.

Although the P/S ratio is seen as an industry staple for investment scrutiny, detractors claim that its relevance in identifying a company's intrinsic value is limited. According to the efficient market hypothesis, all relevant information regarding a company's value is reflected by its current stock price. Thus, the use of stock price as an input for calculation of the P/S ratio is counterintuitive, rendering the P/S ratio largely irrelevant.^[3]

Conversely, many analysts, investors and traders believe that a company's stock price is based on public perception. For those parties, the possibility of investing in an improperly valued company is a potential avenue for financial gain. In the pursuit of equity market bargains, the P/S ratio can be a useful tool and an integral part of fundamental investment analysis.

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